PrefBlog

Sun Life Financial stated in its 2Q10 Earnings Release:

The regulatory environment is evolving as governments and regulators develop enhanced requirements for capital, liquidity and risk management practices. In Canada, the Office of the Superintendent of Financial Institutions Canada (OSFI) is considering a number of changes to the insurance company capital rules, including new guidelines that would establish stand-alone capital adequacy requirements for operating life insurance companies, such as Sun Life Assurance Company of Canada (Sun Life Assurance), and that would update OSFI’s regulatory guidance for non-operating insurance companies acting as holding companies, such as Sun Life Financial Inc. In addition, it is expected that OSFI will change the definition of available regulatory capital for determining regulatory capital to align insurance definitions with any changed definitions that emerge for banks under the proposed new Basel Capital Accord.

OSFI is considering more sophisticated risk-based modeling approaches to Minimum Continuing Capital and Surplus Requirements (MCCSR), which could apply to segregated funds and other life insurance products. In particular, OSFI is considering how advanced modeling techniques can produce more robust and risk-sensitive capital requirements for Canadian life insurers, including internal models for segregated fund guarantee exposures. OSFI expects to issue a draft advisory in the fall of 2010 for public comment which will change the existing capital requirements in respect of new, rather than in-force, segregated fund business (e.g. post 2010 contracts). OSFI is also reviewing internal models for in-force segregated fund guarantee exposures, a review process that is ongoing. OSFI is considering a range of alternatives for in-force business, including a more market-consistent approach and potentially credit for hedging. Although it is difficult to predict how long the process for reviewing in-force segregated fund guarantee exposures will take, OSFI expects the review to continue for several years, likely into 2013. It is premature to draw conclusions about the cumulative impact this process will have on capital requirements for Canadian life insurance companies.

The outcome of these initiatives is uncertain and could have a material adverse impact on the Company or on its position relative to that of other Canadian and international financial institutions with which it competes for business and capital. In particular, the draft advisory on changes to existing capital requirements in respect of new segregated fund business to be issued by OSFI in the fall of 2010 may result in an increase in the capital requirements for variable annuity and segregated fund policies currently sold by the Company in the United States and Canada on and after the date the new rules come into effect. The Company competes with providers of variable annuity and segregated fund products that operate under different accounting and regulatory reporting bases in different countries, which may create differences in capital requirements, profitability and reported earnings on these products that may cause the Company to be at a disadvantage compared to some of its competitors in certain of its businesses. In addition, the final changes implemented as a result of OSFI’s review of internal models for in-force segregated fund guarantee exposures may materially change the capital required to support the Company’s in-force variable annuity and segregated fund guarantee business. Please see the Market Risk Sensitivity and Capital Management and Liquidity sections of this document.

They also provided more information regarding the effect of a market crash on their earnings. Whereas a 10% drop in equity prices from 2010-6-30 levels would cost $175-225-million, a 25% crash would cost $550-650-million. I was most impressed to see disclosure of the effect of their hedging programmes, which reduced the impact of these market moves by more than 50%. Now all we have to worry about is whether their hedges will, in fact, prove effective if needed!

They are not updating their guidance regarding underlying earnings:

Based on the assumptions and factors described below, in the third quarter of 2009, the Company estimated that its adjusted earnings from operations for the year ending December 31, 2010 would be in the range of $1.4 billion to $1.7 billion. The Company cautioned that its earnings in 2010 would reflect the lower asset levels and account values that were expected in 2010, as well as higher risk management costs, potential volatility and uncertainty in capital markets, the expected higher levels of capital required by regulators, lower leverage, currency fluctuations and the potential for higher tax costs as governments around the world look to address higher deficits.

Updates to the Company’s best estimate assumptions as well as changes in key internal and external indicators during the first half of 2010 did not impact the range of its estimated 2010 adjusted earnings from operations that was previously disclosed in the third quarter of 2009.

They’re also warning of a goodwill impairment charge under IFRS:

The Company anticipates that it will record a net goodwill impairment charge of approximately $1.7 billion, to be recognized in opening retained earnings upon transition to IFRS. This impairment relates to a portion of the goodwill recorded on the acquisitions of Keyport Life Insurance Company in the United States in 2001 and Clarica Life Insurance Company in Canada in 2002. This impairment charge reflects the application of IFRS standards as well as the continuing impact of the economic environment.

The impairment of goodwill is a non-cash item and will not impact the level of regulatory capital for the Company as existing goodwill is already deducted from available capital for regulatory purposes in the calculation of the MCCSR for Sun Life Assurance.

And there will be a small dilution adjustment:

Under IFRS, all financial instruments that contain a conversion feature to common shares must be included in the calculation of diluted earnings per share, irrespective of the likelihood of conversion. Certain innovative Tier 1 instruments issued by the Company (SLEECS Series A and SLEECS Series B) contain features which enable the holder to convert their securities into common shares under certain circumstances. The impact of including these financial instruments in the calculation of the Company’s diluted EPS will be a reduction in EPS of approximately $0.03 per quarter. If the SLEECs Series A are redeemed at their par call date in 2011, the ongoing reduction on diluted EPS is expected to be reduced to $0.01 per quarter.

And, of more potential interest, they note that they are highly interested in the IFRS exposure draft on Insurance Contracts, which has been previously discussed:

On July 30, 2010 the International Accounting Standards Board issued an exposure draft for comment, which sets out measurement changes on insurance contracts. The Company is in the process of reviewing the exposure draft, however it is expected that measurement changes on insurance contracts, if implemented as drafted, will result in fundamental differences from current provisions in Canadian GAAP, which will in turn have a significant impact on the Company’s business activities and volatility of its reported results. Changes from this exposure draft are expected to be finalized and applicable no earlier than 2013.

The Globe & Mail published an article today, Insurers cry foul over pending rule changes, highlighting a problem that I’m not sure exists:

A key sticking point is the “discount rate,” or interest rate, that insurers use to calculate the current value of payments that they will have to make to customers in the future.

The rate that Canadian insurers are using basically allows them to take credit now for investment performance that they hope to achieve in the future, the IASB argues. Instead, it says, they should be using a current risk-free rate (essentially measured by the return on government bonds). Since that rate is lower, the Canadian insurers’ liabilities will rise when the change kicks in, and it will be especially painful in areas such as life annuities or whole life non-participating insurance, when the insurers value payments that they owe customers decades from now.

That hasn’t been lost on the IASB. Both Julie Dickson, the head of Canada’s banking and insurance regulator, and Jim Flaherty, the Finance Minister, wrote to the international accounting body earlier this year asking it to consider the impact on the Canadian sector.

To my total lack of surprise, I was unable to find the letters from Dickson or Flaherty published anywhere. So much nicer to do things in private, doncha know.

However, the issue has been bubbling for a while. A presentation by Rubenovitch in April 2008 (about six months before they nearly blew up), Manulife decried:

Asymmetrical accounting for asset and liability and earnings volatility that is not relevant and that will not ultimately be realized

which would result if long-term obligations were to be discounted at the risk-free rate, stating, quite rightly that this:

Assumes liquidity required and overstates liability

The problem is, of course, that government bonds do not simply reflect the “risk free rate”. They also represent the liquidity premium. You cannot get a risk-free rate without also losing the liquidity premium and attempts to disentangle the two aspects of corporate bond pricing came to grief during the Panic of 2007 (see chart 3.16 of the BoE FSR of June 2010 and note the amusing little gap in the x-axis).

But I can’t see that the rules actually require insurers to use government rates as their discounting rate. The relevant portion of the IFRS exposure draft states (emphasis added):

30 An insurer shall adjust the future cash flows for the time value of money, using discount rates that:
(a) are consistent with observable current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, in terms of, for example, timing, currency and liquidity.
(b) exclude any factors that influence the observed rates but are not relevant to the insurance contract liability (eg risks not present in the liability but present in the instrument for which the market prices are observed).

31 As a result of the principle in paragraph 30, if the cash flows of an insurance contract do not depend on the performance of specific assets, the discount rate shall reflect the yield curve in the appropriate currency for instruments that expose the holder to no or negligible credit risk, with an adjustment for illiquidity (see paragraph 34).
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34 Many insurance liabilities do not have the same liquidity characteristics as assets traded in financial markets. For example, some government bonds are traded in deep and liquid markets and the holder can typically sell them readily at any time without incurring significant costs. In contrast, policyholders cannot liquidate their investment in some insurance contract liabilities without incurring significant costs, and in some cases they have no contractual right to liquidate their holding at all. Thus, in estimating discount rates for an insurance contract, an insurer shall take account of any differences between the liquidity characteristics of the instruments underlying the rates observed in the market and the liquidity characteristics of the insurance contract.

I don’t see anything unreasonable about this.

The Globe & Mail had reported earlier:

Despite their disappointment in the rules, at least some Canadian insurance executives say they are still optimistic that they will succeed in making their case as it appears that the draft is very preliminary and that the IASB is open to feedback. The insurers intend to present the accounting board with figures that demonstrate the impact the rules will have on their results.

I will be most interested in seeing those figures, particularly their derivation of the discount rate. Detail please!

KPMG comments:

Aspects of the proposed insurance model which are likely to attract debate include determining a discount rate for obligations based on their characteristics as opposed to the return on invested assets, and the treatment of changes in assumptions driving the measurement of the insurance obligation. The effects of changes in assumptions, whether financial such as interest rates or non-financial such as mortality and morbidity rates, would be required to be recognised in the statement of financial position and the statement of comprehensive income each reporting period.
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Neil Parkinson, KPMG’s Insurance Sector Leader for Canada, emphasized the implications for Canadian insurers: “The IASB’s proposals would affect how all insurers measure their profitability and their financial position, and would likely result in greater volatility in many of the key measures they report. This volatility would be magnified for longer term insurance products, and is of particular concern for Canadian life insurers.”

I don’t see anything on the insurance companies’ websites themselves.

One way or another, this is an issue well worth following. Volatility in key measures? Great! Lets have a little more volatility in key measures and a little less “Whoopsee, we need $6-billion and a rule-change TODAY, came out of nowhere, honest!”

Update: Reaction in the UK is soporific:

Peter Vipond, director of financial regulation and taxation at the Association of British Insurers, said current insurance accounting methods have been inconsistent and haven’t adequately captured “the economics of the industry.”

“We are pleased that the IASB aims to offer a modern approach based on current measures that may offer investors a clearer view of insurers’ obligations and performance,” Vipond said in an e-mailed statement.

I believe – but am not sure! – that UK insurers use gilts to hedge annuities much more than corporates, in which case this change won’t make too much difference to them.

Update, 2010-8-4: Price-Waterhouse highlights the volatility issue:

Gail Tucker, partner, PricewaterhouseCoopers LLP, added:

“Industry reaction will be divided on these proposals. They will create increased volatility in insurer’s reported results going forward, as market movements will now affect reported profit. There will also be significant changes to the presentation of the income statement which stakeholders will need to take the time to understand. Today’s developments will also cast their net wider than the insurance industry, affecting all companies that issue contracts with insurance risk, such as financial guarantee contracts.

“Given the profound impact of these proposed changes, it is vital insurers work closely with industry analysts to make sure they fully understand the changes and what insurers’ accounting will look like going forward. As there is only a small window during which the industry has an opportunity to influence the final outcome of these proposals, insurers need to act now in assessing the implications of the new model on both their existing contracts and business practices.”

Update 2010-8-9: The MFC Earnings Release 2Q10 sheds some light (a little, anyway) on their objections:

We determine interest rates used in the valuation of policy liabilities based on a number of factors, as follows:
(a) we make assumptions as to the type, term and credit quality of the future fixed income investments;
(b) to reflect our expected investable universe, we adjust the publicly available benchmarks to remove the issues trading extremely tight or wide (i.e., the outliers);
(c) we assume reinvestment rates are graded down to average long-term fixed risk free rates at 20 years; and
(d) consistent with emerging best practices we limit the impact of spreads that are in excess of the long-term historical averages.

In other words. they are making an implicit assumption that they are always perfectly hedged.

The Canadian Securities Administrators have released CSA/IIROC Joint Staff Notice 23-308 – Update on Forum to Discuss CSA/IIROC Joint Consultation Paper 23-404 “Dark Pools, Dark Orders and Other Developments in Market Structure in Canada” and Next Steps. Film of the semi-open meeting is available from IIROC.

Use of SORs by Marketplaces

This issue revolves around the concept of a marketplace-owned smart order router using information about hidden orders on that marketplace when making routing decisions. Although some felt that this practice was not a concern as this is a routing decision only, others thought that all visible orders at a given price should have priority over all hidden orders.

CSA staff are assessing whether the use of marketplace-owned SORs which take into account hidden liquidity available on their own book gives that marketplace an unfair advantage over other marketplaces and SORs. CSA staff are also considering the impact that this practice has on investors and will be examining whether marketplaces that provide information on hidden liquidity to their proprietary SORs should be required to provide the same information to other third-party SORs in order to meet the fair access provisions of NI 21-101.8

I think it’s just disgusting that marketplaces use proprietary information to improve their product and compete. If they want business, they should take their old school buddies out to lunch, just like everybody else.

Market-Pegged Orders

Some forum participants raised concerns over market-pegged orders, specifically whether market-pegged orders have a negative impact on price discovery because they are simply free-riding the quotes from other marketplaces or whether the unrestricted use of such orders created a disincentive to display liquidity. Others were of the view that many order types are variations of pegs, and that the concept was simply centralizing a process which could be, and is currently, done by dealer algorithms or manually, and thus would result in a reduction of message traffic between market participants. This was also consistent with the majority of the responses to the Consultation Paper, which did not raise concerns with pegged orders.We will continue to review proposed order types from marketplaces.

Perhaps not the most ringing endorsement of Pegged Orders, which I strongly endorse (as an option, not as a panacea), but a positive development nevertheless.

High Frequency Trading

It was suggested at the forum that regulators also review high frequency trading, particularly as its growth may have impacted time priority benefits and the ability of some market participants to achieve trade execution. We continue to monitor developments in this area, and particularly recent initiatives in the U.S. aimed at reviewing short-term trading strategies and their impact on the market. A review of issues associated with high frequency trading was also included in the scope of the project to examine electronic trading discussed above.

IIROC staff continue to monitor changes in patterns of trading on Canadian marketplaces, and the impact of “high frequency trading” is included in that monitoring. Changes in technology and the development of competitive multiple marketplaces have significantly increased message traffic and order to trade ratios. Future rates of growth in high frequency trading will be dependent upon decisions which may be made with respect to such issues as sub-penny pricing.

I continue to be dismayed at the fact that High Frequency Trading is considered an actual issue; my reasoning is:

• A High Frequency Trader requires a 12% return on equity from trading to make it worth their while
• A long-term investor requres a 0% return on equity from trading to make it worth their while. They make money for their clients from overall market moves, their uncanny ability to assess big picture issues and the impressive depth of their analysis (but mainly overall market moves).
• Therefore, the established long-term players have a 12% cost of capital advantage over HFT, but cannot compete despite this.
• Therefore, most institutional money managers are lazy and stupid. Those who complain are lazy and stupid blowhards

I’ve examined every link in this chain of reasoning and have been unable to find a flaw; but perhaps an Assiduous Reader will help me out a bit.

The G-20 Statement

We are taking strong steps toward increasing the stability and strength of our financial systems. Significantly increased resources for international financial institutions are helping stabilise and address the impact of the crisis on the world’s most vulnerable. Ongoing governance and management reforms, which must be completed, will also enhance the effectiveness and relevance of these institutions.
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Further progress is also required on financial repair and reform to increase the transparency and strengthen the balance sheets of our financial institutions, and support credit availability and rapid growth, including in the real economy. We took new steps to build a better regulated and more resilient financial system that serves the needs of our citizens. There is also a pressing need to complete the reforms of the international financial institutions.
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The G-20’s highest priority is to safeguard and strengthen the recovery and lay the foundation for strong, sustainable and balanced growth, and strengthen our financial systems against risks. We therefore welcome the actions taken and commitments made by a number of G-20 countries to boost demand and rebalance growth, strengthen our public finances, and make our financial systems stronger and more transparent.

That sounds like a lot of “highest” priorities to me!

We are building a more resilient financial system that serves the needs of our economies, reduces moral hazard, limits the build up of systemic risk, and supports strong and stable economic growth. We have strengthened the global financial system by fortifying prudential oversight, improving risk management, promoting transparency, and reinforcing international cooperation. A great deal has been accomplished. We welcome the full implementation of the European Stabilization Mechanism and Facility, the EU decision to publicly release the results of ongoing tests on European banks, and the recent US financial reform bill
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The first pillar is a strong regulatory framework. We took stock of the progress of the Basel Committee on Banking Supervision (BCBS) towards a new global regime for bank capital and liquidity and we welcome and support its work. Substantial progress has been made on reforms that will materially raise levels of resilience of our banking systems. The amount of capital will be significantly higher and the quality of capital will be significantly improved when the new reforms are fully implemented. This will enable banks to withstand – without extraordinary government support – stresses of a magnitude associated with the recent financial crisis. We support reaching agreement at the time of the Seoul Summit on the new capital framework. We agreed that all members will adopt the new standards and these will be phased in over a timeframe that is consistent with sustained recovery and limits market disruption, with the aim of implementation by end-2012, and a transition horizon informed by the macroeconomic impact assessment of the Financial Stability Board (FSB) and BCBS. Phase-in arrangements will reflect different national starting points and circumstances, with initial variance around the new standards narrowing over time as countries converge to the new global standard.
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We agreed to strengthen financial market infrastructure by accelerating the implementation of strong measures to improve transparency and regulatory oversight of hedge funds, credit rating agencies and over-the-counter derivatives in an internationally consistent and non-discriminatory way. We re-emphasized the importance of achieving a single set of high quality improved global accounting standards and the implementation of the FSB’s standards for sound compensation.

Naturally enough, credit rating agencies are a favourite whipping boy. But hedge funds? None were bailed out, although many went bust.

The second pillar is effective supervision. We agreed that new, stronger rules must be complemented with more effective oversight and supervision. We tasked the FSB, in consultation with the International Monetary Fund (IMF), to report to our Finance Ministers and Central Bank Governors in October 2010 on recommendations to strengthen oversight and supervision, specifically relating to the mandate, capacity and resourcing of supervisors and specific powers which should be adopted to proactively identify and address risks, including early intervention.
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The third pillar is resolution and addressing systemic institutions. We are committed to design and implement a system where we have the powers and tools to restructure or resolve all types of financial institutions in crisis, without taxpayers ultimately bearing the burden, and adopted principles that will guide implementation. We called upon the FSB to consider and develop concrete policy recommendations to effectively address problems associated with, and resolve, systemically important financial institutions by the Seoul Summit. To reduce moral hazard risks, there is a need to have a policy framework including effective resolution tools, strengthened prudential and supervisory requirements, and core financial market infrastructures. We agreed the financial sector should make a fair and substantial contribution towards paying for any burdens associated with government interventions, where they occur, to repair the financial system or fund resolution, and reduce risks from the financial system. We recognized that there are a range of policy approaches to this end. Some countries are pursuing a financial levy. Other countries are pursuing different approaches.
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The fourth pillar is transparent international assessment and peer review. We have strengthened our commitment to the IMF/World Bank Financial Sector Assessment Program (FSAP) and pledge to support robust and transparent peer review through the FSB. We are addressing non-cooperative jurisdictions based on comprehensive, consistent, and transparent assessment with respect to tax havens, the fight against money laundering and terrorist financing and the adherence to prudential standards.
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The financial crisis has imposed huge costs. This must not be allowed to happen again.

They lose a huge amount of credibility here. There have been financial crises since the invention of money; there will be financial crises for as long as the human race exists. Optimisim and irrational exuberance is embedded in our genes.

The recent financial volatility has strengthened our resolve to work together to complete financial repair and reform. We need to build a more resilient financial system that serves the needs of our economies, reduces moral hazard, limits the build-up of systemic risk and supports strong and stable economic growth.
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We took stock of the progress of the Basel Committee on Banking Supervision (BCBS) towards a new global regime for bank capital and liquidity and we welcome and support its work. Substantial progress has been made on reforms that will materially raise levels of resilience of our banking systems.

• The amount of capital will be significantly higher when the new reforms are fully implemented.
• The quality of capital will be significantly improved to reinforce banks’ ability to absorb losses.

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We reiterated support for the introduction of a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to Pillar I treatment after an appropriate transition period based on appropriate review and calibration. To ensure comparability, the details of the leverage ratio will be harmonized internationally, fully adjusting for differences in accounting.

That part, about the leverage ratio, is significant.

We support the BCBS’ work to consider the role of contingent capital in strengthening market discipline and helping to bring about a financial system where the private sector fully bears the losses on their investments. Consideration of contingent capital should be included as part of the 2010 reform package.

A sop for Canadian simpletons.

We are following through on our commitment to reduce moral hazard in the financial system. We are committed to design and implement a system where we have the powers and tools to restructure or resolve all types of financial institutions in crisis, without taxpayers ultimately bearing the burden. These powers should facilitate ‘going concern’ capital and liquidity restructuring as well as “gone concern” restructuring and wind-down measures. We endorsed and have committed to implement our domestic resolution powers and tools in a manner that preserves financial stability and are committed to implement the ten key recommendations on cross-border bank resolution issued by the BCBS in March 2010. In this regard, we support changes to national resolution and insolvency processes and laws where needed to provide the relevant national authorities with the capacity to cooperate and coordinate resolution actions across borders.
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We welcomed the FSB’s interim report on reducing the moral hazard risks posed by systemically important financial institutions. We recognized that more must be done to address these risks. Prudential requirements for such firms should be commensurate with the cost of their failure. We called upon the FSB to consider and develop concrete policy recommendations to effectively address problems associated with and resolve systemically important financial institutions by the Seoul Summit. This should include more intensive supervision along with consideration of financial instruments and mechanisms to encourage market discipline, including contingent capital, bail-in options, surcharges, levies, structural constraints, and methods to haircut unsecured creditors.

Also significant, and possibly what Carney’s Ban the Bond speech was all about. In other words, our esteemed leaders want to bypass bankruptcy courts and degrade creditors’ rights.

We pledged to work in a coordinated manner to accelerate the implementation of over-the-counter (OTC) derivatives regulation and supervision and to increase transparency and standardization. We reaffirm our commitment to trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through central counterparties (CCPs) by end-2012 at the latest.

I wish somebody could explain to me why a system emphasizing single-point failure is superior to a network. My fearless prediction is that the next crisis will be preciptitated by a sovereign default that wipes out a bunch of banks and makes a huge chunk of the collateral in the CCPs worthless. There will, of course, be endless political games regarding what constitutes eligible collateral (see, for example the ECB and Greek bonds, as well as the outright buying highlighted on June 21). And, of course, the banks will have a huge incentive to pledge the lowest grade of eligible collateral possible.

OTC derivative contracts should be reported to trade repositories (TRs). We will work towards the establishment of CCPs and TRs in line with global standards and ensure that national regulators and supervisors have access to all relevant information. In addition we agreed to pursue policy measures with respect to haircut-setting and margining practices for securities financing and OTC derivatives transactions that will reduce procyclicality and enhance financial market resilience. We recognized that much work has been done in this area. We will continue to support further progress in implementing these measures.
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We committed to accelerate the implementation of strong measures to improve transparency and regulatory oversight of hedge funds, credit rating agencies and over-the-counter derivatives in an internationally consistent and non-discriminatory way. We also committed to improve the functioning and transparency of commodities markets. We call on credit rating agencies to increase transparency and improve quality and avoid conflicts of interest, and on national supervisors to continue to focus on these issues in conducting their oversight.
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We committed to reduce reliance on external ratings in rules and regulations. We acknowledged the work underway at the BCBS to address adverse incentives arising from the use of external ratings in the regulatory capital framework, and at the FSB to develop general principles to reduce authorities’ and financial institutions’ reliance on external ratings. We called on them to report to our Finance Ministers and Central Bank Governors in October 2010.

Not many surprises, but disappointing nevertheless.

Update, 2010-8-9: According to the FSB:

The FSB will set out the key features and powers of effective national resolution regimes as well as a menu of resolution tools that authorities should have at their disposal, with the ability to act at an early stage. These should include tools of burden sharing among stakeholders of financial firms such as powers to dilute or extinguish equity to absorb the losses and, if equity is extinguished, impose losses on unsecured creditors as appropriate, and to hold management accountable. The proposed resolution tools should include powers that facilitate a “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including arrangements for the provision of temporary funding and the establishment of a temporary bridge bank to take over and continue operating certain essential functions. We are examining viable mechanisms to convert debt into equity: some of these may be contractual with the conversion triggers and terms set out in the debt instrument; however they might need to be buttressed by statutory powers in the resolution regime.

In other words: who needs bankruptcy courts, when you’ve got regulators?

Mr Thomas Jordan, Vice-Chairman of the Governing Board of the Swiss National Bank, provided introductory remarks at the half-yearly media news conference, Geneva, 17 June 2010:

It is essential that capital requirements be significantly increased and that they rise in line with the degree of systemic importance of a bank. This is the only way to ensure that the banks internalise the risks which, until now, they have been able to pass on to the general public, to some extent. Moreover, progressive capital requirements should create an incentive for banks to reduce their systemic importance, with its associated risk potential.

Bravo! Capital surchages have long been advocated on PrefBlog and will serve not just to discourage banks from becoming too big, but will also act as a countercyclical buffer … and the question of countercyclical buffers is one that seems to have been relatively neglected lately.

Bank capital surcharges were last discussed on PrefBlog in the post Bank Capital Surcharge Proposals Gaining Ground.

Remember Repo 105, which was discussed March 12? The Examiner in the Lehman bankruptcy explained it:

Unlike an ordinary repo transaction, Lehman did not record the borrowing of cash from a Repo 105 transaction even though Lehman was obliged to repay the borrowing. Instead, Lehman established a long inventory derivative asset representing the obligation under a forward contract to repurchase the full amount of securities “sold.”3009 As Lehman’s internal Repo 105 Accounting Policy explained, assuming Lehman borrowed $100 cash in exchange for a pledge of $105 of fixed income collateral, Lehman booked a $5 derivative, which represented Lehman’s obligation to repurchase the securities at the end of the term of the repo transaction. The $5 arose from the fact that when it came time to repurchase the pledged securities, Lehman paid $100 cash for $105 worth of securities. The transaction therefore had a $5 value to Lehman reflecting the market value of the “overcollateralization” amount of the Repo 105 transaction. Because it had a positive fair value of $5, the derivative was recorded as an asset under SFAS 133.

My continued irritation with the Bank of Canada’s Central Clearing cheerleading has led me into another thought … Canadian repos are going to settle with central clearing … derivatives are going to settle with central clearing, as discussed on May 11, tangentially on March 17, by John Hull, December 16 and October 5. Lots before then, of course, but those links carry enough information to make the point.

Anyway, the objective of Central Clearing is to increase the chance that no trades at all wil fail, increase the chance that all trades will fail, increase the potential for contagion in the financial system and increase the number of really good jobs available for ex-regulators. I feel quite certain it will do all of those things.

But … what happens when a firm goes down, or is on the ropes? It is overwhelmingly likely that all of its centrally cleared derivative and repo trades will settle in full. That’s the whole point, right? But what if it goes down? The fact that all of these trades settled in full means there will be less money in the kitty to pay off debt holders and commercial paper holders.

Risks to holders of debt and commercial paper have therefore increased, and there may be other implications as well. Remember Confederation Life? When it went down, all of its profitable FX trades settled tootsy-sweetsy, while all of the unprofitable ones (i.e., about half, given hedging) were delayed while the receiver decided who was going to get paid.

The next crisis will see some very strange games being played. Why would you buy commercial paper from a bank or brokerage, when instead you can pay $99 for the future right to sell them a 1-day T-Bill at $200?

Has there been any discussion or analysis of the reordering of creditor priority inherent in wholesale central clearing? I haven’t seen any, but I’d like to. Here in Canada, of course, it’s impossible even to determine the relative seniority of a BA vs. a BDN!