1. Credit Supply Management & Economic Sustainability: The Legislative Bubble-Shrinker

2. Bubbles & Liquidity Asset bubbles are created by increased credit supply Available credit generates increased liquidity in market, asset prices rise Prudent investors --->irrational speculators  Market actors are mostly herd beasts, following the leader and increasing liquidity/increasing volume as consequences of excess available credit

3. The Bubble Pops The bubble pops: Macro Shock Reinforced downward spiral: falling prices, underwater assets Bank losses increase, reserves become depleted as assets depreciate New loans needed to service old debt Institutions can fail, cheat, or spend their way out Overall credit market constricts when it is most needed: not for investment, for solvency!

4. Business Cycle Business cycle/credit cycle are nearly coterminous, correlation is debated. Business cycle can be driven by credit availability, credit availability at least partially predicated on demand segment of business cycle (what comes first? The chicken or the egg?) Whichever comes first, the results are bubbles and corresponding panics. Prevailing wisdom under Greenspan: “Don’t worry about it”. Almost fatalistic attitude towards mitigating the effects of cyclical fear and greed. So why should we??

5. Hindsight is 20:20 Bubbles can and should be mitigated. Economic inefficiencies arise as evidenced by bailouts, expensive reactionary regulation, credit crunches, recessionary impacts on jobs and compensation. Sustainable cycles allow the costs to be amortized over longer periods of time: Preserves margins for lenders Limits losses by investors Reduces tax burdens imposed by increased spending

6. CFPA Transparency CFPA: Transparency  House Bill proposes giving CFPA ability to promulgate regulation for “who deal or communicate directly with consumers in the provision of a consumer financial product, as the Director deems appropriate or necessary to ensure fair dealing with consumers.”  Requires the CFPA Director to conduct an annual financial autopsy regarding bankruptcies and foreclosures, including any specific financial products or services that have caused substantial numbers of them. Complexity of system makes information asymmetry among market actors a given, widening gap with increased complexity Trend-based investment leads to higher demands for capital and leads to adverse selection among banks

7. General Transparency Prevented by CFPA’s disclosure guidelines General transparency can reduce informational asymmetry  Financial autopsies will likely not stop innovation/loophole mining, but will reduce lag time between the invention of harmful financial products and their elimination from the market or will ensure that they are accompanied by proper disclaimer activity, thus increasing investor awareness of risk.

8. Capital Requirements Capital Requirements: Legislation: Off Balance Sheet activities are required to be part of capital requirement computations, includes: Direct credit substitutes like standby letters of credit, repos, asset sales with recourse, interest rate and credit swaps, securities contracts, forward contracts. Asymmetric risk/reward scenarios in institutional insolvency Higher capital requirements artificially restrict the amounts lent, position sizes and leverage rates A lawyer’s definitional playground: will definitions of capital keep up with innovation?

9. Funeral Plans Funeral Plans for facing potential insolvencies: Legislation: Required of large & complex financial institutions, or face higher capital standards Focused on system-wide protection Reduces asymmetrical risk/reward scenarios when shareholders/management by restricting that activity via adherence to pre-existing dissolution plans.  Reduces overall systemic damage when insolvency of one institution occurs: limits the desperation lending close to insolvency when institutions take on higher yielding, higher risk loans to try to avoid liquidation.

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

12. The Obama Plan An end run around credit-restricting legislation? Mission: Defeat asset bubbles, prevent catastrophic collapse.

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

14. Too Big To Fail AIG FANNIE MAE CITI BOA CIT GOLDMAN

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

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

17. Development of TBTF Continental Illinois – Insolvency in 1984 – Heavily relied on uninsured lender – 8 th largest commercial bank in the nation Government’s bailout – Sustain confidence in the nation’s banking system – Pledge no uninsured lender would lose money – Begun the Era of TBTF

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

19. Development of TBTF Financial consolidation  Traditional banking  Security underwriting  Insurance  Real estate Government safety net  Commercial banks  Investment banks

20. TBTF & Current Financial Crisis TBTF = Government Subsidy – No fear of failure – Lenders put more money – Increase in credit supply – Decrease in cost of fund

21. TBTF = Unfair competitive advantage  Encourage Americans on borrowing  No incentive to monitor  Incentive to make greater risk in investment TBTF and Current Financial Crisis

22. Housing bubble  Easy money from lenders  Incentive to take risk

23. Continuity of TBTF Last administration  TARP program New administration  Treasury new power to stabilize a failing firms Common problem  Prevent short-term consequence  Limitation on executive branch

24. Continuity of TBTF Illiquidity  Cash < Immediate obligations  Rescue can prevent premature liquidation Insolvency  Value of asset < value of liability  Rescue cannot prevent fire-sale of asset

25. Continuity of TBTF AIG rescue  $85 million is not enough  Maturity up to 5 years  Interest rate down by 5.5%  Amount up to $150 million Still no fear of failure  Delay restructuring or merger  Large bonuses – AIG: $165 million

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

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

28. End TBTF through Bankruptcy Myth in bankruptcy  Dissipate the value of the assets  Common negative phrases  Slow actions and procedure

29. End TBTF through Bankruptcy Lehman Brother BankruptcyAIG Government Rescue Loan IndexDay beforeDay afterChangeDay beforeDay afterchange S&P 5001251.71192.7- 4.7%1213.61156.39- 4.71% Volatility25.6631.719.54%30.336.2219.54% TED spread1.352.010.842.193.020.84 13 wk T- Bill 1.460.81 - 0.840.860.02- 0.84 Market did not distinguish between the distress resolution procedures Market instead focuses on the financial distress itself

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

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

32. Problem with Current Bankruptcy Exemption from automatic stay – Derivative contracts – New financial instrument Lost of healthy asset – Lehman: counterparties canceled more than 700,000 of its 900,000 derivatives contracts Lost of going concern value – AIG: forced to liquidate assets to generate collateral

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

34. Conclusion Free market and Capitalism  Alan Greenspan is wrong?  TBTF is not free market! Restore free market  Bad firms die, bad ideas die with it

35. Bank Capital Requirements

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

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

38. How Do Banks Raise Capital? Banks can raise capital by:  issuing new equity (common stock),  Issuing bonds that can be converted into equity,  reducing the bank’s dividends to shareholders, which increase the retained earnings that can be put into capital accounts. Neither option is particularly appealing to existing shareholders because issuance of new equity dilutes their profits and reduction of dividends simply reduces their return on investment.

39. Role of Bank Capital Requirements in the Recent CRISIS and How Higher Reserves Could Have Averted Bank Failures Higher bank capital reserves could have provided a means of satisfying obligations to pay off depositors and creditors as assets were lost or devalued due to risky investments Capital is supposed to act as a first line of defense against bank failures and their knock-on consequences for systemic risk by providing a cushion against losses.

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

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

42. Why is International Cooperation Important? One concern is that banks might have a competitive advantage if they are allowed to hold less capital, allowing them to offer loans at lower prices. Basel I Accord was developed to have uniform capital measures for large internationally active banks in order to enhance the soundness of the international banking system, and to reduce competitive inequalities among these banks that result from differences in international capital standards. U.S. banks were required to hold more capital than most of their foreign competitors before the crisis. U.S. banks are also on a better footing because the U.S. has recapitalized many of them with taxpayer money. Differences in accounting standards: Some bank balance sheets appear up to twice the size under European accounting rules than they would under U.S. standards. European banks are also structured differently. Many are cooperatives or have shareholders such as municipalities that can't raise funds in the same way as institutional shareholders in the U.S.

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

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

45. Risk Based Capital Requirement The risk-based standards originated in an effort to correct for some of the leverage limit’s manifest blind spots, notably its failure to take account of credit risk and off-balance-sheet items. This ratio is designed to reflect the credit risks posed to an institution by various categories of assets in its portfolio and is expressed in terms of capital required against a percentage of “risk-weighted assets” (total assets after their face amounts have been adjusted to reflect their current risk).  Current capital regulations require an institution to hold minimum regulatory capital equal to 8% of its risk-weighted assets. At least 50% of this amount must consist of Tier 1 capital components with the remainder held in Tier 2 capital. Under this system, lesser amounts of capital are required to be held against lower-risk assets. Bank assets are divided into four risk-weighted categories of 0%, 20%, 50%, and 100%.  Riskier assets are placed in the higher percentage categories. For example, the 0 percent category includes cash and U.S. Treasury securities, while loans are generally in the 100 percent category. Risk-weighted assets, tier 1 capital, tier 2 capital and all three of the aforementioned capital ratios (tier 1 leverage, tier 1 risk-based and total risk-based) are also included in your bank’s quarterly Call Report.  Banks are expected to meet a minimum tier 1 risk-based capital ratio of 4 percent.

46. Components of Capital ComponentsMinimum Requirements Core Capital (Tier 1)  Common stockholders’ equity  Qualifying, noncumulative, perpetual preferred stock  Minority interest in equity accounts of consolidated subsidiaries  Less: goodwill and other intangible assets Note: Tier 1 must represent at least 50 percent of qualifying total capital and equal or exceed 4 percent of risk-weighted assets. There is no limit on the amount of common shareholder's equity or preferred stock, although banks should avoid undue reliance on preferred stock in Tier 1. Banks should also avoid using minority interests to introduce elements not otherwise qualified for Tier 1 capital. Supplementary Capital (Tier 2)  Allowance for loan and lease losses  Perpetual preferred stock and related surplus  Hybrid capital instruments and mandatory convertible debt securities  Term subordinated debt and intermediate-term preferred stock, including related surplus  Revaluation reserves (equity and building)  Unrealized holding gains on equity securities Note: Total of Tier 2 is limited to 100 percent of Tier 1 ALLL limited to 1.25 percent of risk-weighted assets Subordinated debt, intermediate-term preferred stock and other restricted core capital elements are limited to 50 percent of Tier 1 Deductions (from sum of Tier 1 and Tier 2) Investments in unconsolidated subsidiaries Reciprocal holdings of banking organizations’ capital securities Other deductions (such as other subsidiaries or joint ventures) as determined by supervisory authority Any assets deducted from capital are not included in risk-weighted assets in computing the risk-based capital ratio Total Capital (Tier 1 + Tier 2 - Deductions)Must equal or exceed 8 percent of risk-weighted assets

47. New Basel Capital Requirements: Final provisions are scheduled for implementation by December 2012 Key elements of capital proposals: raising the quality, consistency and transparency of the capital base; strengthening the risk coverage of the capital framework, particularly with respect to counterparty credit risk exposures arising from derivatives, repos and securities financing activities; introducing a leverage ratio requirement as an international standard; measures to promote the build-up of capital buffers in good times that can be drawn upon during periods of stress, introducing a countercyclical component designed to address the concern that existing capital requirements are procyclical – that is, they encourage reducing capital buffers in good times, when capital could more easily be raised, and increasing capital buffers in times of distress, when access to the capital markets may be limited or they may effectively be closed; global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.

48. Old Standards: New Standards: Amount Includable in Total Capital Elements of Capital No Limit Tier 1 Common shareholders’ equity Noncumulative perpetual preferred Minority interests in consolidated subsidiaries Includible Only Up to Amount of Tier 1 Tier 2 Amount Includible In Tier 2 Capital Cumulative preferred (perpetual or long-term) Long-term preferred Convertible preferred No Limit Intermediate-term preferred Subordinated debt Debt-equity hybrids, including perpetual debt Only Up to 50% of Tier 1 Amount Includable in Total Capital Elements of Capital No Limit Tier 1 Common shareholders’ equity Additional Going Concern Capital (common shares and retained earnings) No LimitTier 2 Minority interests in consolidated subsidiaries Cumulative preferred (perpetual or long-term) Long-term preferred Convertible preferred Intermediate-term preferred Subordinated debt Debt-equity hybrids, including perpetual debt New Basel Capital Requirements:

49. Pros: Cons: Forcing the banks to operate with larger safety buffers Raising the quality, consistency and transparency of the capital base Enhancing risk coverage Supplementing the risk-based capital requirement with a leverage ratio* Reducing procyclicality and promoting countercyclical buffers Addressing systemic risk and interconnectedness All elements of capital would have to be disclosed to improve the transparency of the capital base Halt banks’ ability to expand in emerging markets and will most likely cause huge holes in capital stocks of Japanese, European financial institutions Force banks to stop counting minority- owned stakes as part of their equity capital PROS and CONS of the new Basel Requirements (“Basel III”):

50. How Does the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) Change Capital Adequacy Requirements? Stricter Prudential Standards for Certain Financial Holding Companies for Financial Stability Purposes (Section 1104) Contingent Capital (Section 1116)  Financial holding companies will be subject to stricter standards to maintain a minimum amount of long-term hybrid debt that is convertible to equity Requirement for Countercyclical Capital Requirements (Section 1255)  Each appropriate Federal banking agency shall, in establishing capital requirements under this Act or other provisions of Federal law for banking institutions, seek to make such requirements countercyclical so that the amount of capital required to be maintained by a banking institution increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the institution

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

52. How does the Regulatory Capital Enhancement Act of 2009 (H.R. 2660) suggest changing capital adequacy requirement? Amends the Federal Deposit Insurance Act to require each appropriate federal banking agency to prescribe capital standards, including a leverage limit and a risk-based capital requirement, for special purpose entities, or similar types of vehicles or entities, that are sponsored by insured depository institutions it regulates. Requires such capital standards to conform, to the extent practicable, with the capital standards prescribed under the Act. Authorizes an appropriate federal banking agency, by regulation, to establish any additional relevant capital measures for such entities or vehicles necessary to guard against the risk that they become undercapitalized. Requires the appropriate federal banking agencies to define jointly a "special purpose entity," with a focus on trusts and other legal entities established by or for an insured depository institution to fulfill narrow, specific, or temporary objectives, including: (1) the holding of financial assets transferred during a securitization process; (2) issuing applicable securities representing claims on such assets; (3) receiving and reinvesting cash flows from such assets; and (4) distributing proceeds to holders of the securities

53. PROS and CONS of the newly proposed regulations:

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

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

56. The Million Dollar Question Can bank capital regulation prevent future financial crises?

57. Bank Regulation: Proposed Changes to Corporate Governance

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

59. The Corporate Structure of a Bank In general, the corporate structure of banks does not vary widely with the traditional corporate structure, which is divided into three branches: shareholders, directors, and managers Shareholders are the equity holders, or owners, of the corporation; according to Professor Levine, shareholders can be divided into two types: 1) Diffuse shareholder: small, or minority shareholders Vote for directors Vote on matters including mergers and acquisitions, or other fundamental changes in business strategies (albeit indirectly through board member elections) 2) Concentrated shareholder: large, sometimes institutional, investors Occasionally elect their own representatives to the board of directors, Can negotiate incentive packages to align management interests with that of shareholders

60. The Corporate Structure of a Bank: Board of Directors Board of Directors: besides making employment decisions and monitoring management, directors in banking firms have further responsibilities beyond mere fiduciary duties: 1) Ensure the bank’s activities are in the best interest of not only the shareholders, but depositors as well as the government (taxpayer) 2) Abide by laws and regulations reflecting the government's interest in maintaining safe and sound financial institutions The Comptroller of the Currency has published a handbook detailing the responsibilities of bank boards of directors; these include: 1) Select competent management 2) Supervise the bank’s affairs 3) Adopt sound policies and goals under which management must operate in the administration of the bank’s affairs 4) Avoid self-serving practices 5) To be informed of the banks position and management policies 6) Maintain reasonable capitalization 7) To ensure the bank has a beneficial influence on the economy and the community in which it rests Compensation: amongst other managerial oversight responsibilities, the board also oversees the level and structure of top executive compensation; this duty is perhaps the most critical in aligning the interests of management with that of shareholders

61. Board of Directors, Continued Risk: generally associated with the safety and soundness aspects of regulatory supervision; risks include: 1) Credit 2) Market 3) Liquidity 4) operational 5) legal 6) reputational A risk management system, no matter the type of risk involved, includes four basic components: 1) identification 2) measurement or quantification 3) controls 4) monitoring tools Controls

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

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

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

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

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

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

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

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

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

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

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

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

74. Other Regulatory Measures Designed to Limit Compensation Risk The FDIC premiums Bank tax Pay czar International coordination and considerations  World Economic Forum (Davos)

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

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

77. CFPA Consumer Financial Protection Act

78. Consumer Protection What are the arguments for the CFPA?  Consumer protection is an "orphan mission”  Banking regulators primary goal is to ensure safety-and- soundness not consumer protection  Banking regulators lack expertise in consumer protection  Regulatory arbitrage

79. Enforcement & Regulatory Authority

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

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

82. Research Unit Conducts research on financial counseling/education Researching, analyzing, and reporting on:  Current and prospective developments in financial products  Consumer awareness, understanding, and use of communications regarding financial products  Consumer awareness and understanding of costs, risks, and benefits  Consumer behavior with respect to financial products  Experiences of traditionally underserved customers Identify priorities and effective methods for consumer financial education

83. Community Affairs Provides information, guidance, and technical assistance regarding the provision of consumer financial products and services to traditionally underserved consumers and communities

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

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

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

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

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

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

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

91. What Can Be Regulated? Prohibit/limit mandatory predispute arbitration Identify certain practices and products as unfair, deceptive or abusive Take preventative measures to avoid unfair, deceptive, or abusive practices and products Regulations to ensure timely, appropriate, and effective disclosure to consumers Agency may develop ‘model disclosure’ which will be per se compliant Prescribe manner, settings, and circumstances for provision of products and services to ensure that the risks, costs, and benefits of products are accurately represented to consumers Consumer access to information/reports

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

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

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

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

96. Opposition to the CFPA Three major criticisms:  That it is based on flawed understanding of crisis  The CFPA will have significant unintended consequences, including but not limited to reducing competition, consumer choice, and availability of credit to consumers for productive uses  CFPA will be a bureaucratic nightmare, mainly because of its undefined scope and expensive and wasteful regulatory overlap with other agencies

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

98. Credit Rating Agencies

99. Background 3 Biggies – Fitch, S&P and Moody’s  Others in US  Basel’s list of internationals History  Generally good  Last decade of criticism mounting  Current attack  Completely wrong on new securities (standards/duty)  Conflicts of interest

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

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

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

103. What They Do, Continued Advisory Services create lowest possible quality at each rating level (regulatory arbitrage-type pattern) Obvious conflict of interest in rating issuances and SPV’s which they advised during formation o Feel an obligation to rate as promised o Very few rating agencies have a policy of not rating projects they have advised on

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

105. Regulatory Reliance, Continued Basel II – recognized ratings from External Credit Assessment Institutions (ECAI’s)  Allows regulators worldwide to use ratings from ECAI’s in order to determine reserve requirements Insurance Regulators – Use credit ratings to evaluate insurance companies’ reserves

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

107. Problems, Continued Downgrade of worthless CDO’s held by big banks  regulators raised the required level of reserves  price drops depleted currently held assets, lowering the value of existing reserves  margin calls triggered on highly leveraged deals, depleting reserves even more

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

109. Problems, Continued Quasi-Regulatory Role  Profit driven private companies are not properly positioned to represent public interests  Proper Role: regulation is inherently adversarial, CRA’s are currently far from that  Many accuse CRA’s of “sleeping in the same bed” with the big name Wall Street CEO’s; not suited for regulating Wildfire Effect: After a downgrade…  Reserve Requirements increase  Existing Reserve Asset Values decrease  Margin Calls and Loan Covenants are triggered

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

111. Recent Developments, Continued SEC Regulations of 2007: Rules for NRSRA’s  NRSRA’s must either avoid or disclose and manage certain conflicts of interest  Prohibits certain unfair, abusive or coercive practices SEC Regulations of 2008: still no teeth  Opted to not impose public disclosure requirement of information used to assess ABS’s  Requires maintenance of certain records  Prohibits analysts from being involved in determining fee structure, and from receiving gifts over $25…

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

113. Recent Developments, Continued Proposed Legislation (cont’d)  Requires that Policies and Procedures are spelled out for how ratings are done, how conflicts of interest are managed and disclosed, how compensation and promotions are determined  SEC power to prohibit certain conflicts of interest  Requires disclosure of revenues for non-rating services (advisory), who and amount paid by each  Requires SEC to review NRSRA’s at least once annually

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

115. Recent Developments, Continued State Attorney Generals bringing suits  Attempting to recover state employee pension fund monies (especially CA & OH)  First Amendment has kept CRA’s undefeated in court thus far  New suits are based on CRA’s knowledge of inaccurate ratings  Must prove knowledge and misrepresentation  “The First Amendment doesn’t extend to the deliberate manipulation of financial markets” Rodney A. Smolla, dean of the Washington and Lee University School of Law

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

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

118. Regulatory Structure

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

120. General Increase in Government Intervention Regulations Heightened Supervisory Power Requires market discipline Improves corporate governance Improves bank function

121. General Increase in Government Intervention Increase market discipline Increase cost efficiency Increase profit efficiency Reduce asymmetric information Reduce transaction costs Decrease stability Economies of scale in compliance costs Discourage entry of new firms Consolidation into larger banks Reduction of competition

122. General Increase in Government Intervention Increased Regulation requires increased information disclosures Information disclosures are costly Compliance is expensive

123. Regulatory Consolidation: FIRA FIRA OCCOTS State Bank Supervision (from Federal Reserve)

124. FIRA: Efficient Information Sharing NCUA Fed FDIC OCC OTS Financial Intermediaries FDIC FIRA NCUA OTS OCC Fed

125. Regulatory Consolidation: CFPA CFPA FDICOTS Federal Reserve NCUAFTC

126. CFPA: Potential Benefits and Problems Potential Benefits:  Higher standard of accountability  New customers  Innovation of standardized financial instruments Potential Problems:  Hinder innovation in other areas  Profit inefficiency  Lower growth rates

127. Regulatory Additions: SEC & CFTC SEC Executive Compensation Disclosures Credit Rating Agencies Corporate Governance Derivatives Hedge Funds >$100M CFTC

128. Inadequate Funding SEC Needs:  Increased assessments on institutions  Exemption from appropriations process  > $1.026B 2010 CFTC Needs:  >$14.6M  38 new jobs  Larger Staff

129. Regulation of OTC Derivatives by SEC & CFTC Current Proposal: Only standardized derivatives enforceable when traded on exchanges Customized derivatives enforceable only when traded over- the-counter Historically: Speculative trading allowed only on exchanges CDS’s are enforceable only if one party has an insurable interest, or has a real pre- existing risk

130. Increased Capital Requirements U.S. core capital requirements for banks far exceed international averages Largest banks in U.S. ranked in top 20 of The Banker’s Top 1000 listing* May move financial relationships abroad Trade-off between cost efficiency and profit efficiency *(ranking firms by strength measured in Tier 1 capital using data from 2009)

131. Restrictions On Banking Activities Obama’s Recommendations: Commercial banks retain investment banking operations BUT: Banks banned from investing in hedge funds or private equity Limit bank growth: Limit market share of liabilities a bank is allowed to take on Ban proprietary trading “Loopholes”: Murky definition of proprietary trading Treasury Department may allow banks to drop their status as bank holding companies and avoid such regulations

132. Trade-offs ConsPros Profit inefficiency Cost inefficiency Growth Restriction Bureaucratic Inefficiency ControlTransparencyStability

133. Considerations Costs will ultimately be borne by clients “Risk management is not about the elimination of risk; it is about the management of risk.” –Thomas F. Siems Macro-decisions

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