- Are
the new Basel III rules fair?
- The PCAOB Enters into Cooperative Agreement with
United Kingdom Audit Regulator
- Congressional Oversight
Panel, Examining the Consequences of Mortgage Irregularities for Financial Stability and Foreclosure Mitigation, and the PCAOB
Staff Audit Practice Alert NO. 7
Welcome to the February 2011 newsletter
of the
International
Association of Potential, New and Sitting Members of the Board of
Directors (IAMBD)
Dear Member,
We have the first cooperative
agreement that the PCAOB has concluded since
the passage of the
Dodd–Frank Wall Street Reform and Consumer Protection Act,
which amended the Sarbanes-Oxley Act to permit the PCAOB to share
confidential information with its non-U.S. counterparts under
certain conditions.
The PCAOB Enters into
Cooperative Agreement with United Kingdom Audit Regulator
Washington, D.C., Jan. 10, 2011 - The Public
Company Accounting Oversight Board entered into a cooperative
agreement with the Professional Oversight
Board in the United Kingdom to facilitate cooperation in
the oversight of auditors and public accounting firms that
practice in the two regulators’ respective jurisdictions.
This agreement provides a basis for the
resumption of PCAOB inspections of registered accounting
firms that are located in the United Kingdom and that audit, or
participate in audits, of companies whose securities trade in U.S.
markets.
The PCAOB previously conducted inspections in the
United Kingdom with the POB from 2005 to 2008, but has been blocked from doing so since that
time.
Acting PCAOB Chairman Daniel L. Goelzer
welcomed the arrangement, which
will lay the foundation for the PCAOB and POB to work together to promote public trust in the
audit process and investor confidence in capital markets.
"The POB and the PCAOB both are committed to investor protection
and to having a strong working relationship with each other," said
PCAOB Acting Chairman Daniel L. Goelzer.
"I am pleased that
we have
overcome the obstacles that have prevented PCAOB
inspections in the United Kingdom since 2008. Investors in
U.S.-listed companies increasingly rely on audit work performed
outside the borders of the United States. Agreements like this one
open the door for us to inspect that work and are essential to the
Board’s investor protection mission."
This is the first cooperative
agreement that the PCAOB has concluded since the passage of the
Dodd–Frank Wall Street Reform and Consumer Protection Act, which
amended the Sarbanes-Oxley Act to permit the PCAOB to share
confidential information with its non-U.S. counterparts under
certain conditions.
That amendment removed one of the obstacles to PCAOB
inspections asserted by European and certain other officials.
"This agreement reflects our important relationship with the
POB and serves as an example of
cross-border cooperation between the PCAOB and its counterparts
abroad. We look forward to resuming our work with the POB in the
United Kingdom and to assisting the POB should it conduct
inspections in the United States," said Rhonda Schnare, PCAOB
Director of International Affairs.
"We are
currently working with other oversight
bodies in several non-U.S. jurisdictions to establish
similar cooperative arrangements," she added.
The Sarbanes-Oxley Act directed the PCAOB to
oversee and periodically inspect all accounting firms that
regularly audit companies whose securities trade in U.S. markets.
More than 890 audit firms currently registered with the PCAOB are
located outside of the United States, spanning 87 countries. There
are 59 registered firms located in the United Kingdom.
Congressional Oversight
Panel - Examining the Consequences of Mortgage Irregularities for
Financial Stability and Foreclosure Mitigation
In the fall of 2010, reports began to surface alleging that
companies servicing $6.4 trillion in
American mortgages may have bypassed legally required steps to
foreclose on a home.
Employees or contractors of Bank of America, GMAC
Mortgage, and other major loan servicers
testified that they signed, and in some cases backdated,
thousands of documents claiming personal knowledge of facts about
mortgages that they did not actually know to be true.
Allegations of
“robo-signing” are deeply
disturbing and have given rise to ongoing federal and state
investigations.
At this point the ultimate implications remain
unclear. It is possible, however, that “robo-signing” may have
concealed much deeper problems in the mortgage market that could
potentially threaten financial stability and undermine the
government's efforts to mitigate the foreclosure crisis.
Although it is not yet possible to determine whether
such threats will materialize, the Panel urges Treasury and bank
regulators to take immediate steps to
understand and prepare for the potential risks.
In the best-case scenario, concerns about mortgage
documentation irregularities may prove overblown.
In this view, which has been embraced by the financial
industry, a handful of employees failed to follow procedures in
signing foreclosure-related affidavits, but the facts underlying
the affidavits are demonstrably accurate.
Foreclosures could proceed as soon as the invalid
affidavits are replaced with properly executed paperwork.
The worst-case scenario is considerably grimmer.
In this view, which has been articulated by academics and
homeowner advocates, the “robo-signing” of
affidavits served to cover up the fact that loan servicers cannot
demonstrate the facts required to conduct a lawful foreclosure.
In essence,
banks may be unable to prove that they own
the mortgage loans they claim to own.
The risk stems from the possibility that the rapid
growth of mortgage securitization outpaced the ability of the
legal and financial system to track mortgage loan ownership.
In
earlier years, under
the traditional mortgage model, a homeowner borrowed money from a
single bank and then paid back the same bank. In the rare
instances when a bank transferred its rights, the sale was
recorded by hand in the borrower's county property office.
Thus,
the ownership of any
individual mortgage could be easily demonstrated.
Nowadays, a single mortgage
loan may be sold dozens of times between various banks
across the country.
In the view of some market participants, the sheer
speed of the modern mortgage market has
rendered obsolete the traditional ink-and-paper recordation
process, so the financial industry developed an electronic
transfer process that bypasses county property offices.
This electronic process has, however,
faced legal challenges that could, in an extreme scenario, call
into question the validity of
33 million mortgage
loans.
Further, the financial industry now commonly
bundles the rights to thousands of
individual loans into a mortgage-backed security (MBS).
The securitization process is complicated and requires
several properly executed transfers.
If at any point the required legal steps are not
followed to the letter, then the ownership of the mortgage loan
could fall into question.
Homeowner
advocates have alleged that frequent “robo-signing”
of ownership affidavits may have concealed extensive industry
failures to document mortgage loan transfers properly.
If documentation problems prove to be pervasive
and, more importantly, throw into doubt the ownership of not only
foreclosed properties but also pooled mortgages, the consequences
could be severe.
Clear and uncontested property rights are the
foundation of the housing market.
If these rights fall into question,
that foundation could collapse.
Borrowers may be unable to determine whether they are
sending their monthly payments to the right people.
Judges may block any effort to foreclose, even in
cases where borrowers have failed to make regular payments.
Multiple banks may attempt to foreclose upon the same
property.
Borrowers who have already suffered foreclosure may
seek to regain title to their homes and force any new owners to
move out.
Would-be buyers and sellers could find themselves in
limbo, unable to know with any certainty whether they can safely
buy or sell a home.
If such problems were to arise on a large scale, the
housing market could experience even greater disruptions than have
already occurred, resulting in significant harm to major financial
institutions.
For example, if a Wall Street
bank were to discover that, due to shoddily executed paperwork, it
still owns millions of defaulted mortgages that it thought it sold
off years ago, it could face billions of dollars in unexpected
losses.
Documentation irregularities could also have major
effects on Treasury's main foreclosure prevention effort,
the Home Affordable Modification Program (HAMP).
Some servicers dealing with Treasury may have no legal
right to initiate foreclosures, which may call into question their
ability to grant modifications or to demand payments from
homeowners.
The servicers' use of “robo-signing” may also have
affected determinations about individual loans; servicers may have
been more willing to foreclose if they were
not bearing the full costs of a properly executed foreclosure.
Treasury has so far not provided reports of any
investigation as to whether documentation problems could undermine
HAMP.
It should engage in active efforts to monitor the
impact of foreclosure irregularities, and it should report its
findings to Congress and the public.
In addition to documentation concerns,
another problem has arisen with securitized
mortgage loans that could also threaten financial stability.
Investors in mortgage-backed securities typically
demanded certain assurances about the
quality of the loans they purchased: for instance, that the
borrowers had certain minimum credit ratings and income, or that
their homes had appraised for at least a minimum value.
Allegations have surfaced that
banks may have misrepresented the quality of many loans sold for
securitization.
Banks found to have provided misrepresentations could
be required to repurchase any affected mortgages.
Because millions of these mortgages are in default or
foreclosure, the result could be extensive capital losses if such
repurchase risk is not adequately reserved.
To put in perspective the potential problem, one
investor action alone could seek to force Bank of America to
repurchase and absorb partial losses on up to $47 billion in
troubled loans due to alleged misrepresentations of loan quality.
Bank of America currently
has
$230 billion in shareholders' equity, so if several
similar-sized actions – whether motivated by concerns about
underwriting or loan ownership – were to succeed, the company
could suffer disabling damage to its regulatory capital.
It is possible that widespread challenges along these
lines could pose risks to the very financial
stability that the Troubled Asset Relief Program was designed to
protect.
Treasury has claimed that based on evidence to date,
mortgage-related problems currently pose no danger to the
financial system, but in light of the extensive uncertainties in
the market today, Treasury's assertions appear premature.
Treasury should explain why it sees no danger.
Bank regulators should also conduct new stress tests
on Wall Street banks to measure their ability to deal with a
potential crisis.
The Panel emphasizes that mortgage lenders and
securitization servicers should not undertake to foreclose on any
homeowner unless they are able to do so in full compliance with
applicable laws and their contractual agreements with the
homeowner.
The American financial system is in a precarious
place.
Treasury's authority to support the financial system
through the Troubled Asset Relief Program has expired, and
the resolution authority created by the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
remains untested.
The 2009 stress tests that evaluated the health of the
financial system looked only to the end of 2010, providing little
assurance that banks could withstand sharp losses in the years to
come.
The housing market and the broader economy remain
troubled and thus vulnerable to future shocks. In short, even as
the government's response to the financial crisis is drawing to a
close, severe threats remain that have the potential to damage
financial stability.
PCAOB STAFF AUDIT PRACTICE ALERT
NO. 7 - AUDITOR CONSIDERATIONS OF LITIGATION AND OTHER
CONTINGENCIES ARISING FROM MORTGAGE AND OTHER LOAN ACTIVITIES
Staff Audit Practice Alerts highlight new, emerging,
or otherwise noteworthy circumstances that
may affect how auditors conduct audits under the existing
requirements of PCAOB standards and relevant laws.
Auditors should determine whether and how to respond
to these circumstances based on the specific facts presented.
The statements contained in Staff Audit Practice
Alerts are not rules of the Board and do not reflect any Board
determination or judgment about the conduct of any particular
firm, auditor, or any other person.
Background
In the fall of 2010, allegations surfaced
that banks may have misrepresented the
quality of mortgages sold and that those banks could be required
to repurchase the affected mortgages.
Additional allegations have been made that companies
servicing $6.4 trillion in American mortgages may have bypassed
legally required steps to foreclose on homes
Some of these practices
could
result in loss contingencies for certain financial institutions
that may require recognition of liabilities or disclosure in
financial statements.
The situation remains fluid, with estimates of
potential costs associated with foreclosure irregularities and
mortgage repurchases ranging from "manageable" to an exposure for
the industry of up to $52 billion.
Some experts have acknowledged scenarios in which the
title and legal documentation problems related to foreclosures
could lead to significant effects on banks' balance sheets.
Numerous federal and state agencies are
coordinating their efforts to review practices that may not comply
with state foreclosure laws or applicable federal laws and to
provide for better disclosures and improve transparency in the
securitization market.
As part of the efforts to provide for better
disclosures, in October 2010, the United
States Securities and Exchange Commission's (“SEC”) Division of
Corporation Finance sent letters to certain public companies as a
reminder of their disclosure obligations with respect to their
forthcoming quarterly reports on Form 10-Q and subsequent filings.
The letters highlighted continued concerns about
potential risks and costs associated with mortgage and
foreclosure-related activities or exposures.
The sample letter posted to the SEC Web site
stated that companies should consider
certain items for disclosure, including, without
limitation, “the impact of various representations and warranties
regarding mortgages made to purchasers of the mortgages (or to
purchasers of mortgagebacked securities) including to the
government-sponsored entities (GSEs), private-label
mortgage-backed security (MBS) investors, financial guarantors and
other whole loan purchasers.”
The letters further reminded
companies of the requirements for disclosures in Management's
Discussion and Analysis for Forms 10-Q and 10-K under Item 303 of
Regulation S-K and for accruing and disclosing loss
contingencies in the financial statements under the Financial
Accounting Standards Board's ("FASB") Accounting Standards
Codification ("ASC") Topic 450, Contingencies, Subtopic 450-20.
Companies were reminded that, as appropriate, they
should consider the need to
accrue loss
contingencies and to provide clear and transparent disclosure
regarding obligations relating to the various
representations and warranties that were made in connection with
securitization activities and whole loan sales, and to discuss any
implications of any foreclosure reviews, including potential
delays in completing foreclosures.
The letters cautioned companies to
consider a number of matters when preparing their quarterly and
subsequent filings (e.g., litigation risks and
uncertainties related to any known or alleged defects in the
securitization process, including any potential defects in
mortgage documentation or in the assignment of the mortgages).
The letter also
cautioned that some of
these issues are not limited to financial institutions.
This practice alert advises
auditors that the potential risks and costs associated with
mortgage and foreclosure-related activities or exposures, such as
those discussed in the SEC staff letters,
could have implications for audits of financial statements or of
internal control over financial reporting.
These implications might include accounting for
litigation or other loss contingencies and the related
disclosures.
Auditors should consider the effect of these matters
during their reviews of interim financial information, year-end
audits, and attestation engagements on assessments of compliance
with servicing criteria.
Staff Audit Practice Alert No. 3, Audit
Considerations in the Current Economic Environment ("Practice
Alert No. 3"), was issued in December 2008 to assist auditors in
identifying matters related to the current economic environment
that might affect audit risk and require additional emphasis.
Among other things, Practice
Alert No. 3 provides auditors with information on selected
financial reporting areas, including contingencies and guarantees
that may be affected by the economic environment, and reminds
auditors of
the requirements regarding accounting estimates.
Audit risks that existed in December 2008 with
respect to contingencies and guarantees, as well as potential
other issues, continue to exist today.
These
audit risks potentially
affect the risk of material misstatement, as evidenced by recent
concerns regarding problematic foreclosures and asserted claims or
potential litigation relating to representations and
warranties made in connection with securitizations or whole loan
sales.
Auditors may need to consider the possible effects
that these issues might have on the nature, timing, and extent of
planned audit procedures.
Matters for the auditor’s
consideration
In light of continued concerns about potential
risks and costs associated with mortgage and foreclosure-related
activities or exposures, this practice alert
reminds auditors of their responsibilities with respect to
auditing loss contingencies, disclosures, and other related
topics.
Auditing Litigation,
Claims, and Assessments
Companies that may be affected by mortgage and
foreclosure-related activities or exposures
may need to accrue for or provide disclosures relating to legal
contingencies.
AU sec. 337, Inquiry of a Client's Lawyer
Concerning Litigation, Claims, and Assessments, establishes
requirements with respect to litigation, claims, and assessments.
This standard states that in order to identify
litigation, claims, and assessments, and to become satisfied with
the accounting and reporting of such matters, the auditor should
gather sufficient and appropriate audit evidence relevant to the
following factors:
• The
existence of a condition, situation, or set of circumstances
indicating an uncertainty as to the possible loss to an entity
arising from litigation, claims, and assessments;
• The period in which the underlying cause for
legal action occurred;
• The degree of probability of an unfavorable
outcome; and
• The amount or range of potential loss.
AU sec. 337 discusses the
procedures the auditor should perform regarding
litigation, claims, and assessments
and also states that although certain audit procedures may be
undertaken for other purposes, they might
also disclose litigation, claims, and assessments (e.g.,
reading minutes of meetings of stockholders, directors, and
appropriate committees held during and subsequent to the period
being audited; reading contracts, loan agreements, leases, and
correspondence from taxing or other governmental agencies; or
inspecting similar documents).
Further,
the auditor should
obtain a letter from the client's lawyer to assist the auditor in
corroborating the information furnished by management concerning
litigation, claims, and assessments.
Auditing Accounting
Estimates
Companies involved in mortgage and
foreclosure-related activities may need to
estimate and accrue amounts for other potential loss contingencies
including those related to various representations and warranties.
AU sec. 342, Auditing Accounting Estimates,
establishes requirements regarding obtaining and evaluating
sufficient appropriate audit evidence for accounting estimates.
In auditing accounting estimates,
the auditor normally should consider the
company's historical experience in making past estimates as well
as the auditor's experience in auditing companies in the same
industry.
However, changes in facts, circumstances, or a
company's procedures may cause factors different from those
considered in the past to become significant to the accounting
estimate.
For example,
a company's
historical experience relating to repurchasing loans sold into
securitization structures may not be indicative of future trends
in that area.
According to AU sec. 342, when planning and
performing procedures to evaluate the reasonableness of the
company’s accounting estimates, the auditor should consider, with
an attitude of professional skepticism, the subjective and
objective factors included in the estimate.
When evaluating accounting estimates relating to
mortgage loan repurchase losses, such factors may include, among
others, estimated levels of defects based on the company's review
or experience, default expectations, investor repurchase demand,
or appeal success rates.
Evaluating
Financial Statement Presentation and Disclosure
Information essential for a
fair presentation in conformity with generally accepted
accounting principles should be set forth in the financial
statements (which include the related notes).
When such information is set forth elsewhere
in a report to shareholders
"it should be referred
to in the financial statements."
If management omits from the financial statements,
including the accompanying notes, information that is required by
generally accepted accounting principles, the auditor should
express a qualified or adverse opinion and should provide the
information in the audit report, if practicable.
In addition, the auditor should read the other
information accompanying the interim and annual financial
statements contained in reports filed with the SEC, including the
Management's Discussion and Analysis of Financial Condition and
Results of Operations sections of annual reports and other
filings.
The
auditor should consider
whether that information or the manner of its presentation is
materially inconsistent with the financial statements.
If the auditor concludes that there is a
material inconsistency or becomes
aware of information that he or she believes is a material
misstatement of fact, the auditor should determine if the
financial statements, the audit report, or both, require revision.
If the auditor concludes that the financial statements
or audit report do not require revision, the auditor should
request the company to revise the other information.
FASB ASC Topic 450, Contingencies, Subtopic 450-20
requires that when a loss is not both
probable and estimable, an accrual is not recorded, but disclosure
of the contingency is required to be made when there is at least a
reasonable possibility that a loss or an additional loss has been
incurred.
Companies involved in mortgage and foreclosure-related
activities or exposures may need to establish new disclosures or
enhance existing disclosures regarding litigation and other
contingencies or estimates.
For example, companies that sold or securitized loans
but may not have complied with representations and warranties may
be at risk of being forced to repurchase such loans.
These companies may need to disclose or enhance
their existing disclosures regarding the nature, timing, and
uncertainty of their potential exposures as additional claims
arise and are resolved.
Communication with Audit
Committees
To the extent potential risks and costs associated
with mortgage and foreclosure related activities or exposures are
identified, auditors are reminded of their responsibility to
communicate with the audit committee.
AU sec. 380, Communication With Audit Committees,
includes requirements regarding communications relating to
management judgments and accounting estimates.
Other communication with the audit committee includes
such matters as the clarity and completeness of the company's
financial statements, which include related disclosures and a
discussion of items that have a significant impact on the
representational faithfulness, verifiability, and neutrality of
the accounting information included in the financial statements.
For example, in appropriate circumstances, this
discussion would include the auditor's view on disclosures
relating to representations and warranties that were made in
connection with securitization activities.
Reviewing Interim Financial
Information
The objective of a review of
interim financial information is to provide the auditor
with a basis for communicating whether he or she is aware of any
material modifications that should be made to the interim
financial information for it to conform with generally accepted
accounting principles.
AU sec. 722, Interim Financial Information, requires
the auditor to make inquiries regarding unusual or complex
situations that may have an effect on the interim information.
These situations
may include
changes in estimated loss contingencies as well as trends and
developments affecting accounting estimates.
If information obtained from performing review
procedures leads the auditor to believe that
the interim financial information may not be in conformity with
generally accepted accounting principles in all material respects,
the auditor should make additional inquiries or perform other
procedures considered appropriate to provide a basis for
communicating whether any material modifications should be made to
the interim financial information.
AU sec. 722 provides additional requirements in cases
where the auditor believes that a material modification should be
made to the interim financial information.
Ongoing Audit Considerations
As additional information is determined in future
periods regarding the potential risks and costs associated with
mortgage and foreclosure-related activities or exposures, auditors
planning or performing an audit should acquire a sufficient
understanding to assess how the additional information affects the
nature and potential magnitude of the
associated risks.
Auditors should modify the
overall audit strategy and the audit plan as necessary if
circumstances change significantly during the course of the audit,
including changes due to a revised assessment of the risks of
material misstatement or the discovery of a previously
unidentified risk of material misstatement.
Accordingly, auditors may need to consider, e.g., how
documentation issues in the loan origination process at a bank
affect the auditors' initial risk assessment, overall audit
strategy and the audit plan.
Risks of material misstatement can arise from a
variety of sources, including external factors, including
conditions in the company's industry and environment and
company-specific factors, such as the nature of the company, its
activities, and internal control over financial reporting which
can affect the judgments involved in determining
accounting
estimates or create pressures to manipulate the financial
statements to achieve certain financial targets.
In an integrated audit, many factors can affect
the risk associated with a control including the design of the
control, nature of the control and the frequency with which it
operates as well as the competence of the
personnel who perform the control or monitor its
performance and whether there have been changes in key personnel
who perform the control or monitor its performance.
Accordingly, an increase in the volume of foreclosures
or loan repurchases could affect the risks associated with related
controls.
Attestation Reports on
Assessments of Compliance with Servicing Criteria
Section 1122 of the SEC's Regulation AB requires an attestation report by a
registered public accounting firm on a servicer's assessment of
compliance with servicing criteria.
These criteria include, among other things,
maintaining collateral or security on pool
assets as required by the transaction agreements or related
pool asset documents; and initiating, conducting, and concluding
loss mitigation or recovery actions in accordance with the
timeframes or other requirements established by the transaction
agreements.
In adopting Regulation AB, the SEC provided that
AT sec. 601, Compliance Attestation, applies to the preparation of
these attest reports and generally requires that, in assessing
whether the servicer has complied with the criteria, an auditor
should consider risk factors similar to those an auditor would
consider when planning an audit of financial statements, as well
as factors relevant to the compliance engagement.
For example, in assessing risk, the auditor considers
whether the servicer or its parent has identified noncompliance as
part of an internal investigation, internal audit, or other
compliance review.
The Rock Center for Corporate
Governance at Stanford University Working Paper
Series No. 86
Stanford GSB Research Paper No.
2063,
October 29, 2010
Fallacies, Irrelevant Facts, and Myths in the
Discussion of Capital Regulation:
Why
Bank Equity is Not Expensive
Anat R. Admati, Peter M.
DeMarzo, Martin F. Hellwig, Paul Pfleiderer.
Admati, DeMarzo and
Pfleiderer are from the Graduate School of Business,
Stanford University; Hellwig is from
the Max
Planck Institute for Research on Collective Goods,
Bonn
We examine the pervasive
view that
“equity is
expensive,” which leads to claims that
high capital requirements are
costly and would affect credit markets adversely.
We find that
arguments made to support this view are
either
fallacious, irrelevant, or very weak.
For example, the return on equity contains a
risk premium that must go down if banks have more
equity.
It is thus
incorrect to assume that the
required return on equity remains fixed as capital
requirements increase.
It is also incorrect to translate higher
taxes paid by banks to a social cost.
Policies that subsidize
debt and indirectly penalize equity through
taxes and implicit guarantees are distortive.
Any desirable public subsidies to banks’
activities should be given directly and not in ways
that encourage leverage.
Finally, suggestions that
high leverage serves a necessary disciplining role
are based on inadequate theory lacking empirical
support.
We conclude
that bank equity is not socially expensive, and that
high leverage is not necessary for banks to perform
all their socially valuable functions, including
lending, taking deposits and issuing money-like
securities.
To the contrary,
better capitalized banks
suffer fewer distortions in lending decisions and
would perform better.
The fact that
banks choose high leverage does not imply that this
is socially optimal, and, except for government
subsidies and viewed from an ex ante perspective,
high leverage may not even be privately optimal for
banks.
Setting equity requirements
significantly higher than the levels currently
proposed would entail large social benefits and
minimal, if any, social costs. Approaches based on
equity dominate alternatives, including contingent
capital.
To achieve
better capitalization quickly and efficiently and
prevent disruption to lending, regulators must
actively control equity payouts and issuance.
If remaining challenges are addressed,
capital regulation can be a powerful tool for
enhancing the role of banks in the economy.
Executive Summary
There is a pervasive
sense in discussions of bank capital regulation that
“equity is expensive” and that
higher equity requirements,
while beneficial, also entail a cost.
The arguments we examine,
which represent many of those most often made in
this context, are fallacious,
irrelevant, or very weak.
Our analysis leads us to
conclude that significantly
higher equity requirements entail large social
benefits and minimal, if any, social costs.
We list below
some of the arguments made
against high equity requirements and explain why
they are either incorrect or unsupported.
Some common arguments made
against significantly increasing equity
requirements:
1. Increased equity
requirements would force banks to “set aside” or
“hold in reserve” funds that can otherwise be used
for lending.
This argument
confuses liquidity
requirements and capital requirements.
Capital requirements
refer to how banks are funded
and in particular the mix between debt and equity on
the balance sheet of the banks.
There is
no sense in which capital is
“set aside.”
Liquidity requirements relate
to the type of assets and
asset mix banks must hold.
Since they address different
sides of the balance sheet, there is
no immediate relation
between liquidity requirements and capital
requirements.
2.
Increased equity requirements would increase banks’
funding costs because equity requires a higher
return than debt.
This argument is
fallacious, because
the required return on equity, which
includes a risk premium,
must decline when more equity is used.
Any argument or analysis that
holds fixed the required return on equity when
evaluating changes in equity capital requirements is
fundamentally flawed.
3.
Increased equity requirements would lower the banks’
Return on Equity (ROE), and this means a loss in
value.
This argument is also
fallacious.
The expected ROE of a bank
increases with leverage and would thus indeed
decline if leverage is reduced.
This change only compensates
for the change in the risk borne by equity holders
and does not mean that shareholder value is lost or
gained. Shareholders willing to take additional risk
can increase their average return by buying stock on
margin.
4.
Increased equity requirements would increase banks’
funding costs because banks would not be able to
borrow at the favorable rates created by tax shields
and other subsidies.
It is true that, through
taxes and implicit guarantees,
debt financing is subsidized
and equity financing is effectively penalized.
Policies that encourage high
leverage are distorting and paradoxical, because
high leverage is a source of systemic risk.
The subsidies come from
public funds.
If some activities performed
by banks are worthy of public support, subsidies
should be given directly to those activities.
5.
Increased equity requirements would be costly since
debt is necessary for providing “market
discipline” to bank managers.
While there are theoretical
models that show that debt can sometimes play a
disciplining role, arguments against increasing
equity requirements that are based on this notion
are very weak.
First,
high leverage actually creates many frictions.
In particular, it creates
incentives for banks to take excessive risk.
Any purported benefits
produced by debt in disciplining managers must be
measured against frictions created by
debt.
Second, the notion that debt plays a
disciplining role is
contradicted by the events of the last decade, which
include both a dramatic increase in bank leverage
(and risk) and the financial crisis itself.
There is little or no
evidence that banks’ debt holders provided any
significant discipline during this period.
Third,
many models that are designed to attribute to
debt a positive disciplining role completely ignore
the potential disciplining role that can be played
by equity or through alternative governance
mechanisms.
Fourth, the supposed discipline provided by
debt generally relies upon a fragile capital
structure funded by short term debt that must be
frequently renewed.
Reduced fragility, which is a
key goal of capital regulation, would be at odds
with the functioning of this purported disciplining
mechanism.
Finally, one must ask if there are no less
costly ways to solve governance problems.
6. Increased equity
requirements would force or cause banks to cut back
on lending and/or
other socially valuable
activities.
First, higher equity capital
requirements do not
mechanically limit banks’ activities,
including lending, deposits taking and the issuance
of liquid money-like securities.
Banks
can maintain all their existing assets and
liabilities and reduce leverage through equity
issuance and the expansion of their balance sheets.
That said, because equity
issuance improves the position of existing
creditors, and may also be interpreted as a negative
signal on the bank’s health, banks might privately
prefer to pass up lending opportunities if they must
fund them with equity.
However, this “debt overhang”
problem can be alleviated if regulators require
undercapitalized banks to recapitalize quickly by
restricting equity payouts and mandating new equity
issuance.
Once better capitalized,
banks would make better lending and investment
decisions, because they would have reduced
incentives to take excessive risk and indeed would
be less affected by distortions due to debt
overhang.
7. The fact that banks tend
to fund themselves primarily with debt and have high
levels of leverage implies that this is the
optimal way to fund bank activities.
It does not follow that just
because financial institutions choose high leverage,
this form of financing is privately or
socially
optimal.
Instead, this observed
behavior is the result of factors unrelated to
social concerns, such as tax incentives and other
subsidies, and to frictions associated with
conflicts of interests and inability to commit in
advance to certain investment and financing
decisions.
Recommendations
1.
Recognizing, as we have argued, that bank equity is
not expensive, regulators should use equity
requirements as a powerful, effective, and flexible
tool with which to maintain the health and stability
of the financial system.
High leverage is not required
in order for banks to perform all their socially
valuable functions, such as providing credit and
creating deposit iii services.
High leverage is in fact
quite harmful to their ability to do so and leads to
socially suboptimal lending decisions.
2.
Regulators should routinely use restrictions on
equity payouts and the removal of discretion with
respect to equity issuance to help banks, and to
assure that they achieve and maintain adequate
equity capitalization.
Prohibiting, for a period of
time and for all banks, any
dividends and other equity payouts, and
possibly imposing equity issuance on a pre-specified
schedule, is an efficient way to help banks
build their equity capital
quickly and efficiently without leading to
the contraction of credit.
If done under the force of
regulation, withholding payouts or issuing
additional equity would not lead to negative
inferences about the health of any particular bank.
It would also alleviate the
debt overhang distortion that might lead banks to
reduce lending.
3.
If certain activities of the banking sector are
deemed to require subsidies, then subsidies should
be given in direct ways that alleviate market
frictions and not through a system that encourages
high leverage.
Tax shields and implicit
government guarantees subsidize debt finance and
effectively penalize equity as a form of financing
banks.
This policy is undesirable
given the systemic risk and additional frictions
brought about by high leverage.
4.
Better resolution procedures for distressed
financial institutions, while necessary, should not
be viewed as alternatives to having significantly
better capitalized banks.
Since such procedures are not
likely to eliminate the cost of financial distress,
reducing the likelihood that a resolution procedure
is needed is clearly important, and higher equity
requirements are the most effective way to do so.
5.
Higher equity requirements are superior to a
“bailout fund” supported by bank taxes.
While charging banks upfront
potentially could remove the subsidy associated with
bailouts, failure to properly adjust the tax to the
risk of individual banks could create significant
distortions in bank lending and investment,
particularly excessive risk taking.
Equity requirements, as a
form of self-insurance where the bank backs up its
liabilities more directly, would be priced
by
financial markets and be more effective in reducing
the need for government intervention.
6.
Approaches based on equity are superior to those
that rely on non-equity securities such as long term
debt or contingent capital to be considered part of
capital regulation.
Contingent capital, and
related “bail-in” proposals, where debt is converted
to equity when a trigger event occurs, are
complicated to design and present many
implementation issues.
There is
no compelling reason that the
“debt-like” feature of contingent capital has social
value.
Simple approaches based on
equity are more effective and would provide more
reliable cushions.
Some important parts of the
above paper
The Benefits of Increased
Equity Capital Requirements
Before examining the
arguments that purport to show that increased
capital requirements are costly, it is important to
review some of the significant benefits associated
with better capitalized banks.
The recent financial crisis,
as well as ones that have preceded it, have made it
very clear
that
systemic risk in the
financial sector is a great concern.
Financial distress in one
large institution can rapidly
spill over into others and cause a credit
crunch or an asset price implosion.
The effects of systemic
risk events such as the one just experienced are not
confined to the financial sector of the economy.
As history has repeatedly
demonstrated, these events
can have extremely adverse consequences for the rest
of the economy and can cause or deepen recessions or
depressions.
Lowering the risk of financial
distress among those institutions that can originate
and transmit systemic risk produces a clear social
benefit.
An
obvious way to lower systemic risk is to require
banks to fund themselves with significantly more
equity than they did before the last crisis
unfolded.
In the build up to the last
crisis important parts of the financial sector had
become very highly leveraged. Indeed, several banks
had balance sheets in which equity was only two or
three percent of assets.
Such a thin cushion obviously
leaves little room for error.
Even a moderate shock that reduces asset values by
one or two percent puts such thinly capitalized
banks on the brink of insolvency.
Even if it is not actually
insolvent, suspicions of its
exposure may stop other institutions from providing
the short-term funding that it relies on.
In the last crisis, even
before the breakdown of Lehman Brothers, there were
several instances during which interbank markets
froze because of such distrust among market
participants.
With greater capital cushions,
there would be less risk of such systemic breakdowns
from mutual distrust.
Another consideration
concerns corrective measures
when losses have occurred.
If supervisors – or short-term
creditors – are concerned with the bank’s capital
ratio, then, following a reduction of capital
through losses, the bank must either recapitalize or
deleverage by selling assets.
Deleveraging puts pressure on
asset markets, inducing prices to fall, with
negative repercussions for other market
participants, who also have these assets on their
books.
The extent of deleveraging
depends on what the bank’s capital position is.
If bank
capital is 3% of the balance sheet, then following a
loss of 1 million dollars, the bank attempting to
deleverage must liquidate more than 30 million
dollars worth of assets just to re-establish that 3%
ratio.
The systemic repercussions on
asset prices and on other institutions will be
accordingly large.
Capital requirements based on
higher equity ratios would reduce the chances that
such chain reactions occur, and would dampen those
that do occur.
If governments see the need to
avoid the social costs of systemic crises by
stepping in to support their banking sectors, then
an additional benefit of increased equity
requirements comes from reducing the burden on
taxpayers.
This benefit is produced in
two ways.
First, increased
equity requirements reduce the probability that
bailouts will be necessary, since the equity cushion
of the bank can absorb more substantial decreases in
the asset value without triggering a default.
Second, if a bailout
does become necessary, the amount of required
support would generally be lower with a larger
equity cushion, since a larger portion of losses
would be absorbed by the equity.
Both the diminished
probability of a systemic event and the decreased
amount of support required in the event of a crisis
significantly reduce the costs to taxpayers.
There are additional benefits
of higher equity capital requirements beyond the
major ones just given.
These are generally related to
the reduction in conflicts of interest and the more
aligned incentives that are created with less
leverage.
In particular, more equity
capital reduces the incentives of equity holders
(and managers working on their behalf or compensated
by return on equity (ROE)) to undertake excessively
risky investments.
Dear
Potential, New or Sitting Member of the Board,
You
have the duty to prudently represent the interests of the
shareholders.
You have to understand the needs and desires
of employees, customers and regulators.
You have to do your
best to understand the risks in your organization, and to exercise
oversight.
Year after year, you have to do more, and you
have more responsibilities.
Our Mission: To help you make
informed business decisions in good faith.
Our International
Association provides networking, training, certification, alerts and
updates you can use.
Best Regards,
George
Lekatis
President of the International Association of Potential,
New and Sitting Members of the Board of Directors (IAMBD)
General
Manager, Compliance LLC
1200 G Street NW Suite 800, Washington DC
20005, USA
Tel: (202) 449-9750
Email:
lekatis@members-of-the-board-association.com
Web:
www.members-of-the-board-association.com
HQ: 1220 N. Market Street
Suite 804, Wilmington DE 19801, USA
Tel: (302) 342-8828
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