PrefBlog

The thing about the United States and its institutions, I’ve found, is that the research is excellent. When Congress or a government agency want to know what’s going on or how something works – they hire some really good people, give them a decent budget, a reasonable time-frame and good authority to get answers and the final product is generally good.

Unfortunately, once the regulators and politicians get ahold of this report, they ignore it and pursue their own idiotic agendae; or the agendae of those who appointed them.

And so it is with the Flash Crash. The Flash Crash report was really good, but now Gary Gensler, a political hack who knows which side his bread’s buttered on, has given a ridiculous speech about possible new rules:

Gensler, speaking today at a conference in Washington, said brokers using computer algorithms might need to face limits on price or the size of orders they can execute for clients. He also questioned whether market participants might benefit from “fuller visibility” of exchanges’ order books.

The CFTC and the Securities and Exchange Commission said in a report last week that a large trader’s attempt to hedge against losses helped set off a chain of events that sent the Dow Jones Industrial Average down 998.50 points on May 6. The trader, who tried to sell 75,000 futures contracts worth $4.1 billion, used an algorithm that gave no regard to price or time.

“The large customer did not execute the trade itself, but used an executing broker,” Gensler said at the Wholesale Markers Brokers’ Association meeting. The event raises questions about whether brokers should “have to adopt certain trading practices when executing a large order,” he said.

Participants in the futures market can only “see up to the tenth offer or bid in an order book,” Gensler said. Liquidity might not have been so “overwhelmed” by a single, large sell order on May 6 if traders had more transparency, he said.

This is insane. The last paragraph is contrary to everything we know about markets. There have been countless studies on the effect of TRACE and of opening access to order books that show that increased tranparency leads to a thinner, more brittle market. Making the order book more accessible will increase the chance that a single dumb order can overwhelm the market, not less.

Additionally, setting the brokers up to police whether portfolio managers’ orders are good enough is just a dumb idea. In the first place, it assumes that brokers are smarter than portfolio managers – a highly dubious assumption – in the second place it adds another layer of red tape to the investment industry, leading to decreased efficiency.

The Flash Crash was caused by a bozo trader taking a huge market impact cost. A few tweaks to the rules seem indicated, but market impact happens every single time an order is executed. Given that there is far more “real money” in the markets than “hot money”, there will, from time to time, be market paroxysms that don’t make much sense. The Flash Crash was unusula only in its size – but Gensler wants to make life safe for the incompetent.

I posted a brief note on Basel 3 when it was announced on the weekend … here are some more thoughts.

The press release states:

. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
…
The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.
…

• The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
• Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

The American Enterprise Institute, quite rightly, considers this rather vague:

Third, the SFRC believes that both the capital conservation buffer and countercyclical buffer are insufficient to protect against sudden shocks. The proposal also suggests that enforcement of the capital conservation buffer may be unduly lenient. Rather than prohibiting distributions of earnings as the buffer is approached, the GGHS announcement indicates that there will only be some restriction on the size of such payouts. Permitting a payout of capital when a firm’s capital cushion is declining toward a critical threshold makes little economic sense.

I’ve seen a lot of lot of generalities about the constraints to be placed on banks when they are in the buffer zone, but no informed opinions, which makes me feel a little better about not having been able to find a schedule of restrictions on the BIS web-site.

However, it does appear – on the basis of what unfounded, uninformed and entirely speculative inferences I can make from the available documents – that banks will still be paying common dividends while in the buffer zone, although the amount of these dividends may be restricted. Who knows, there might be forced reductions but I think paying a penny will be OK. And if they pay common dividends, they have to pay the preferred dividends. So that’s a good thing, and from the perspective of safety the additional buffer will simply be that much more common equity between preferreds and a harsh environment.

The Globe story on the issue mentioned Eric Helleiner:

Nevertheless, the banker’s argument about the economic impact of new regulations got the authorities’ attention. Financial institutions won’t face higher capital standards until Jan. 1, 2013, a delay that seems “kind of long” and is probably “where some of the political compromises are coming in,” said Eric Helleiner, the Waterloo, Ont.-based Centre for International Governance and Innovation’s chair in political economy, who has written several articles about Basel III.

So I looked him up. Those interested in international bureaucracy may wish to review his publications.

There is euphoria over Basel 3:

Canadian banks said Monday they expect to be able to adopt new Basel III rules for maintaining reserve capital with little trouble, meaning dividend hikes and share buybacks could be on the way once Canada’s banking regulator gives the go-ahead.
…
“Based on our first read, we’re encouraged by the announcement and feel very comfortable in meeting these standards within the established timelines, given where our capital ratios stand today,” Janice Fukakusa, chief financial officer of Royal Bank of Canada, (RY-T54.601.102.06%) said at the Barclays Financial Services Conference in New York.

Her comments were echoed by other Canadian banks presenting at the conference.
…
Rod Giles, a spokesman for OSFI, told Reuters in an e-mail that the regulator will soon issue an advisory to the nation’s big banks providing more clarity on its expectations for future capital outlays.

Bank officials with the clout to hire ex-regulators will be in a far better position to judge the effect of the accord on Canadian regulation than any investor scum, so I won’t speculate too much about the final rules. I suspect, however, that OSFI’s ‘more capital is always better’ mind-set will result in a certain extra capital requirement over and above the global minimum. After all, if it tacks another 20bp on the price of Canadian mortgages, who cares?

Update: Within minutes of the “Publish” button being clicked, OSFI issued Interim Capital Expectations for Banks, Bank Holding Companies, Trust and Loan Companies (collectively, Deposit taking institutions or “DTIs”):

In light of the recent international developments providing greater certainty as to the reform of capital rules, until this Advisory is withdrawn or amended, OSFI expects sound capital management by DTIs, as set out in its guidance, but will no longer require the increased conservatism in capital management announced late in 2008.

As part of sound capital management, and in response to the continuing uncertainty caused by regulatory reform, DTIs must be able to demonstrate on request, both continually and prior to any transaction that may negatively impact their capital levels:

• that they have prudent internal capital targets that incorporate:
  • the impact of the most recent regulatory reform information from the BCBS, GHOS and OSFI;
  • expected market requirements arising from such reforms; and
  • the impact of any such proposed transaction;
• via an up-to-date capital plan, prepared in accordance with OSFI’s guidance on Internal Capital Adequacy Assessment Program (ICAAP)7, that they would have sufficient capital to meet their internal capital targets at all times while taking into account:
  • current regulatory requirements and the most recent regulatory reform information from the BCBS, GHOS and OSFI;
  • the full transition period required to implement such reforms;
  • due consideration of possible alternatives related to finalizing such reforms; and
  • due consideration of remote but plausible business scenarios that may adversely affect their ability to comply with current and reformed regulatory rules.

Please note that this Advisory repeals the October 2008 Advisory titled Normal Course Issuer Bids in the Current Environment.

The Bank for International Settlements has announced:

a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.
…
The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
…
Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period. (Annex 1 summarises the new capital requirements.)

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.
…
A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.
…
Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes.

By “strengthen resolution regimes”, they mean “let regulators pretend they’re bankruptcy judges and eviscerate creditor rights”, but never mind.

The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

The numbers are summarized in the Annex.

US agencies have expressed support:

The U.S. federal banking agencies support the agreement reached at the September 12, 2010, meeting of the G-10 Governors and Heads of Supervision (GHOS).1 This action, in combination with the agreement reached at the July 26, 2010, meeting of GHOS, sets the stage for key regulatory changes to strengthen the capital and liquidity of internationally active banking organizations in the United States and around the world.

No comments from OSFI so far. Maybe they haven’t been told.

Yalman Onaran of Bloomberg reports:

Of the 24 U.S. banks represented on the KBW Bank Index, seven would fall under the new ratios based on calculations using the revised definitions of capital, Keefe, Bruyette & Woods analyst Frederick Cannon said in a Sept. 10 report. Bank of America Corp. and Citigroup Inc., the nation’s No. 1 and No. 3 lenders, would be among those, Cannon estimates. Bank of America would have to hold off paying dividends or buying back shares until the end of 2013, he said.

European banks are less capitalized than U.S. counterparts and may be required to raise more funds under the new Basel rules. Deutsche Bank AG, Germany’s biggest lender, said today it plans to sell at least 9.8 billion euros ($12.5 billion) of stock. Germany’s 10 biggest banks, including Frankfurt-based Deutsche Bank and Commerzbank AG, may need about 105 billion euros in fresh capital because of new regulations, the Association of German Banks estimated on Sept. 6.
…
The committee has yet to agree on revised calculations of risk-weighted assets, which form the denominator of the capital ratios to be determined this weekend. The implementation details of a short-term liquidity ratio will also be decided by the time G-20 leaders meet, members say. A separate long-term liquidity rule will likely be left to next year.

The two liquidity rules would require banks to hold enough cash and easily cashable assets to meet short-term and long-term liabilities. The long-term requirement has been criticized the most by the banking industry, which claims it would force banks to sell $4 trillion of new debt.

The Basel committee has another meeting scheduled for Sept. 21-22 and said it may gather in October to finish its work.

I can’t help feeling that the emphasis on capital misses the point. Banks did not fail due to insufficient capital, although more is always helpful, obviously. The banks failed, or came close to failing, or were crippled in the panic because:

• They held concentrated portfolios, particularly of CDOs that, while having a face value of X, had exposure to mortgages of many times that amount since they were comprised of subordinated tranches of structured mortgages
• Interbank (and inter-near-bank in the case of AIG) exposures were not collateralized and the uncollateralized risk was weighted according to the credit rating of the sovereign of the counterparty’s regulator (i.e., when BMO buys RBC paper, that is risk-weighted as if it has bought Canada paper). Interbank exposures should be penalized by the rules, not encouraged!

I don’t have much time for commentary because this is PrefLetter weekend … but discussion of this will form a big part of future posts, never fear!

The Investment Industry Regulatory Organization of Canada has announced its release of the Review of the Market Events of May 6, 2010:

The factors that contributed to the trading patterns are:

• The existence of large sell imbalances: A number of the securities showed more sell interest beginning at the opening of trading on May 6 and in some cases the ratio of sell volume to buy volume was upwards of 3:1.…
• Electronic trading activity in the securities: High Frequency Traders (“HFT”) and Electronic Liquidity Providers (“ELP”) were trading in a number of the securities reviewed. Although the definitions of the above terms are open to discussion, we are using these terms to identify fast and relatively dominant electronic traders. The review shows that after the sudden sharp decline in the US indices, a number of HFTs and ELPs quickly withdrew from the Canadian market causing a dramatic and rapid decline in available liquidity. This withdrawal was particularly apparent on the buy side putting further pressure on prices. Some HFT entities remained in the market but predominately on the sell side and we noted markedly reduced liquidity. The withdrawal of HFTs and ELPs was particularly apparent in the heavily traded ETFs that were reviewed. IIROC is aware that some of the ELP and HFTs withdrew from the US market due to their concern about significant latencies in their data feeds from the US markets.
• “Traditional” market makers were not active in the review securities with the exception of the four highly liquid ETFs. IIROC found that market makers were present and fulfilling their obligations on the other securities reviewed including their oddlot and spread goals.…
• The triggering of Stop Loss Orders: In many cases the triggering of Stop Loss Orders was a major contributor to the deeper price declines experienced by a number of the securities reviewed. The analysis suggests that many of the egregious price declines were due to Stop Loss Order activity from Stop Loss “market” Orders as opposed to Stop Loss “limit” Orders.

No data is presented in the report that support any of the conclusions. Trust your regulators! They’re very smart, and beholden to nobody.

Recommendations are:

• The CSA and IIROC should review the current market wide circuit breaker to determine if the current trigger levels are appropriate and whether an independent Canadian-based circuit breaker level is required.
• IIROC along with the CSA should investigate whether single stock circuit breakers in the form of temporary trading halts should be implemented in Canada.
• All marketplaces should adopt volatility controls and the form and the level of these controls should be reviewed to assess to what degree they ought to be harmonized.
• All IIROC dealers should consider how to effectively manage Stop Loss Orders in the current high-speed, multi-market environment. IIROC firms should also provide their RRs and clients, including those who enter their orders directly on to the marketplace without personalized advice, with guidance on the use of Stop Loss Orders effectively in a high speed, multimarket environment.
• IIROC should review the current erroneous and unreasonable price policies and procedures, taking into account the experience of May 6.

Circuit breakers? While my natural inclination is that nothing should get in the way of two parties agreeing to a trade, I can’t really get excited over circuit breakers one way or another anyway. When the market gets as wild as it did during the flash crash, the only sensible thing to do is to go out and get a cup of coffee.

It appears that there will be more regulatory paperwork surrounding Stop Loss orders, but we’ll see how that works out. Anybody stupid enough to use a stop-loss order in the first place isn’t going to be impressed by another piece of paper.

Update: The SEC has approved new circuit breaker and trade-busting rules:

The Securities and Exchange Commission today approved new rules submitted by the national securities exchanges and FINRA to expand a recently-adopted circuit breaker program to include all stocks in the Russell 1000 Index and certain exchange-traded funds. The SEC also approved new exchange and FINRA rules that clarify the process for breaking erroneous trades.
…
A list of the securities included in the Russell 1000 Index, which was rebalanced on June 25, is available on the Russell website. The list of exchange-traded products included in the pilot is available on the SEC’s website. The SEC anticipates that the exchanges and FINRA will begin implementing the expanded circuit breaker program early next week.
…
For stocks that are subject to the circuit breaker program, trades will be broken at specified levels depending on the stock price:

• For stocks priced $25 or less, trades will be broken if the trades are at least 10 percent away from the circuit breaker trigger price.
• For stocks priced more than $25 to $50, trades will be broken if they are 5 percent away from the circuit breaker trigger price.
• For stocks priced more than $50, the trades will be broken if they are 3 percent away from the circuit breaker trigger price.

Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks depending on how many stocks are involved:

For events involving between five and 20 stocks, trades will be broken that are at least 10 percent away from the “reference price,” typically the last sale before pricing was disrupted.

For events involving more than 20 stocks, trades will be broken that are at least 30 percent away from the reference price.

This paper was referenced in the recent BoC analysis of capital ratio cost/benefits as the “LEI Report”.

The Bank for International Settlements has released a report titled An assessment of the long-term economic
impact of stronger capital and liquidity requirements:

This simple mapping yields two key results, with the central tendency across countries measured by the median estimate. First, each 1 percentage point increase in the capital ratio raises loan spreads by 13 basis points. Second, the additional cost of meeting the liquidity standard amounts to around 25 basis points in lending spreads when risk-weighted assets (RWA) are left unchanged; however, it drops to 14 basis points or less after taking account of the fall in RWA and the corresponding lower regulatory capital needs associated with the higher holdings of low-risk assets.

Their approach relies heavily on the theory that output losses due to bank crises may be ascribed entirely to the crisis (although they do acknowledge that “that factors unrelated to banking crises, and not well controlled for in these studies, may also influence the output losses observed in the data.”):

Why should the effects of banking crises be so long-lasting, and possibly even permanent? One reason is that banking crises intensify the depth of recessions, leaving deeper scars than typical recessions. Possible reasons for why banking related crises are deeper include: a collapse in confidence; an increase in risk aversion; disruptions in financial intermediation (credit crunch, misallocation of credit); indirect effects associated with the impact on fiscal policy (increase in public sector debt and taxation); or a permanent loss of human capital during the slump (traditional hysteresis effects).

One of the papers they quote in support of their approach is Carlos D. Ramirez, Bank Fragility, ‘Money Under the Mattress,’ and Long-Run Growth: U.S. Evidence from the ‘Perfect’ Panic of 1893:

This paper examines how the U.S. financial crisis of 1893 affected state output growth between 1900 and 1930. The results indicate that a 1% increase in bank instability reduces output growth by about 5%. A comparison of the cases of Nebraska, with one of the highest bank failure rates, and West Virginia, which did not experience a single bank failure reveals that disintermediation affected growth through a portfolio change among savers – people simply stop trusting banks. Time series evidence from newspapers indicate that articles with the words “money hidden” significantly increase after banking crises, and die off slowly over time.

Ramirez continues:

The intuition behind the explanation of why financial disintermediation affects
growth is straightforward. In the absence of deposit insurance or any other institutional arrangement that restores confidence on the banking system, depositors who experience losses or whose money becomes illiquid, even temporarily, may become reluctant to keep their money in the banking system. They simply stop “trusting” banks. This lack of trust may affect all depositors, including those that did not experience losses. With a high enough degree of risk aversion and a high enough probability of a bank run or failure depositors may be induced to reshuffle their liquid asset portfolio away from the banking system. To the extent that the panic induces a portfolio change in asset holdings away from the banking system and into more rudimentary forms of savings, such as keeping the money “under the mattress,” financial intermediation, and thus, growth are adversely affected.

According to me, this raises a red flag about the use of these data to determine the the severity of bank crises in the current environment, even without considering the difficulty of disentangling the degree of recession actually caused by the Panic versus the degree of economic stupidity that was merely brought to light. The Nebraskans kept their money “under the mattress” due to a lack of deposit insurance – just how relevant are the mechanics to what is going on now?

Additionally, the underlying rationale behind the desire to avoid banking crises points to an alternative solution to the problem: rather than reducing the chance of a systemic banking crisis, why not increase the range of alternative intermediation pathways?

Currently, regulators are doing everything they can – by way of Sarbox, completely random regulatory punishment for having been involved in the underwriting and distribution of investments that went bad, TRACE, costs of prospectus preparation, etc. – to deprecate the direct capital markets. A concious effort should be made in the other direction; the option of issuing public debt should be made more attractive to companies, not less.

Additionally, I have previously proposed that Investment Banks be treated differently from Vanilla Banks, not by a strick separation such as Glass-Steagall, but by imposing differing schedules for different types of banks, so that the latter would be penalized for holding assets while the former would be penalized for trading them (where “penalized” refers to higher capital requirements). The idea can be extended: bring back the Trust Company, which would get a preferential capital rate for first mortgages with loan-to-value of less than 75% and a penalty rate of everything else.

In the financial system as in the financial investments, bad investments (bad banks) can hurt you: it is concentration that kills you. And the point is related to my other big complaint about the regulatory response to the crisis: right in the age of networking, regulators are emphasizing systems which are vulnerable to single point failure.

Just as an example, the BIS paper notes:

The final approach used in this exercise relies on the Bank of Canada’s stress testing framework. This methodology is based on the idea that the failure of a bank arises from either a macroeconomic shock or spillover effects from other distressed banks. Spillover effects arise either because of counterparty exposures in the interbank market or because of asset fire sales that affect the mark to market value of banks’ portfolios. In this context, a greater buffer of liquid assets can only be beneficial insofar as it helps the bank to avoid asset fire sales, which would otherwise lead to losses.

You could get the same benefit by reducing the degree of interbank holdings, but such a solution is not even considered. BIS, it appears, will continue to risk-weight bank paper according to the credit rating of the sovereign – if you want an example of moral hazard, that’s a good one right there.

Anyway, BIS comes up with a figure of 13bp per point of capital ratio:

Column A of Table 6 reports the results of this exercise. In order to keep ROE from changing, each percentage point increase in the ratio of TCE to RWA results in a median increase in lending spreads across countries of 13 basis points.

… but this is subject to four major problems acknowledged by BIS:

• The existing literature, which is the basis for this report’s estimates of the costs of banking crises, may overestimate the costs of banking crises. Possible reasons include: overestimation of the underlying growth path prior to the crises; failure to account for the temporarily higher growth during that phase; and failure to fully control for factors other than a banking crises per se that may contribute to output declines during the crisis and beyond, including a failure to accurately reflect causal relationships.
• Capital and liquidity requirements may be less effective in reducing the probability of banking crises than suggested by the approaches used in the study. This would reduce the overall net benefits for a given level of the requirements. However, to the extent that net benefits remain positive, it would also imply that the requirements would need to be raised by more in order to achieve a given net benefit.
• Shifting of risk into the non-regulated sector could reduce the financial stability benefits.
• The results of the impact of regulatory requirements on lending spreads are based on aggregate balance sheets within individual countries, so that they do not consider the incidence of the requirements across institutions. They implicitly assume that theinstitutions that fall short of the requirements (ie, that are constrained) do not react more than those with excess capital or liquidity (ie, that are unconstrained). These effects may not be purely distributional.

I consider the third point most important. To the extent that higher capital ratios imply higher spreads implies a greater role for the shadow banking industry, then the real effect of higher capital levels will be to shift important economic activity from the somewhat flawed regulated sector to a sector with no regulation at all.

I certainly support the idea that we should have layers of regulation – a strong banking system surrounded by a less regulated / less systemically important investment banking sector, surrounded in turn by a wild-n-wooly hedge fund/shadow bank sector … but regulators are, as usual fixing yesterday’s problem with little thought for the implications.

As highlighted in MFC’s 2Q10 Report to Shareholders, OSFI has released a letter to the Canadian Life and Health Insurance Association regarding Seg Fund Capital Requirements [footnote changed to link – JH]:

As mentioned publicly by the Superintendent in the fall of 2009, OSFI has been, as part of this [MCCSR Advisory Committee review] process, conducting a fundamental review of segregated fund capital requirements. We are proceeding to act on the results of this review. In particular, two work streams are underway with respect to internal modeling for the capitalization of segregated fund guarantee exposures.

The first area of work is the implementation of changes to underlying calibration standards for modeling segregated fund guarantee exposures. While we are currently continuing to consult through the MAC process, we expect to issue a draft advisory in the fall of 2010 for public comment. We expect that this will change the existing capital requirements in respect of new (rather than in-force) segregated fund business (e.g. post 2010 contracts).

It is not clear whether or not this draft advisory will include leverage caps on assets including seg funds.

The letter does not make any predictions about the effects on capital expected in the draft advisory:

It is premature to draw conclusions about the cumulative impact this process will have. For example, considered as a whole, there could be increases in some lines of business and decreases in others – and increases may be offset by other changes, such as hedge recognition. In addition, the impact is likely to vary from company to company. As usual, OSFI will be consulting with the CLHIA and your members on proposed changes and will provide ample notice prior to the implementation of new guidance.

… but I suggest that an increase in required capital is something of a slam-dunk.