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Basel Committee on Banking Supervision

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The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://journals.law.harvard.edu/hblr//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

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Capturing Time in Financial Statements

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George M. Williams jr*

The Dodd-Frank Wall Street Reform and Consumer Protection Act[1] applies a number of heightened standards to bank holding companies with consolidated assets of $50 billion or more and to nonbank financial companies that have been subjected to supervision by the Board of Governors because of their systemic importance. Among these standards are new liquidity and capital requirements (the “Liquidity Standard”)[2] and a new requirement (the “Resolution Plan Requirement”) to prepare and maintain a resolution plan that articulates how the relevant company could best be dismembered if it represented a threat to the financial stability of the United States.[3] One of the, perhaps unintended, effects of these new standards may be to provide an additional reason for rethinking the form and purpose of financial statements prepared by financial institutions.

The recent financial crisis and the resulting increase in the recognition of how important capital and liquidity requirements are for financial institutions have already exposed some of the ways in which financial statements in their current form are inadequate for complex financial institutions.[4] The usual way of dealing with this inadequacy is to require the institutions to provide supplementary information, rather than to rethink the nature of the basic financial statements.[5] Having the supplemental information is helpful and is often sufficient to re- or deconstruct the standard financial statements, and making the financial statements of certain companies look completely different from those of others does, after all, have disadvantages.

The Liquidity Standard and the Resolution Plan Requirement are examples of how extensive these demands for supplemental information can become. The core requirement of the new liquidity standards is the imposition of periodic stress-testing coupled with liquidity and corporate governance standards.[6] Other portions of the Liquidity Release elaborate on the precise types of information and testing required, establish new capital and leverage requirements and introduce new limits on credit exposures to counterparties.[7]

The Resolution Release requires covered companies to provide resolution plans that extensively articulate how they could be liquidated with minimal harm to the financial system.[8] The provisions of the Resolution Plan Requirement that set forth the precise details are lengthy, and relate to entity structure, investment strategy, documentation of practices and extensive financial data.[9]

The Temporal Dimensions of Capital and Liquidity

Although the requirements spelled out in the Liquidity Release, on the one hand, and the requirement to prepare resolution plans, on the other, nominally relate to different aspects of a financial company’s business, the intense focus on and interlinks between capital, liquidity and liabilities suggests a deeper relationship. The possibility of such a relationship makes it worthwhile to consider the ways in which capital, liquidity and liabilities are related and how these relationships could affect the structure of financial statements for financial institutions.

 

Time and Capital

Capital can be considered either as the number that results from subtracting the value of a company’s liabilities from the value of its assets or as the amounts that have been contributed as consideration for certain kinds of financial instruments, such as common or preferred stock or deeply subordinated, long-term debt.[10] These values can differ, but each purports to represent the ability of a company to withstand losses and continue in business.

In the context of insolvency, capital expressed as the excess of assets over liabilities isolates the point in time where society has determined that it is unfair for a company to continue in business, in the sense that the certainty of loss justifies some notion of structured sharing. On the other hand, capital expressed as consideration received highlights the extent to which the capital remains available over time, with common capital generally never having to be returned while deeply subordinated debt must eventually be repaid. This focus emphasizes the relative usefulness of different kinds of capital, especially the relative ineffectiveness of subordinated debt if repayment roughly coincides with severe financial stress or insolvency. If capital must be repaid at a particular point in time, then to some extent it is not quite (regulatory) capital, at least if capital is considered to be assets over which no one has any claims except shareholders (or their equivalent).

These differences in repayability also introduce a temporal factor into the nature of capital that is typically obscured by the standard company balance sheet. Time is furthermore implicit in the notion that capital must be available as a buffer to intermittent shocks and as a way of accommodating creditors at insolvency, meaning that capital must be reliably available over a range of times. While the standard balance sheet presumes by its structure that capital will be available at insolvency, in reality—at least for financial institutions—the time prior to insolvency or prior to a potential insolvency is perhaps even more crucial, because insolvency can be unpredictable[11] and because the time frames during which creditors and investors (and, in all likelihood, managers) believe they must act become increasingly abbreviated when insolvency appears likely.

Time and Liquidity

The concept of liquidity further expands the role of time in the presentation of a company’s financial position. If liquidity is thought of as the ability to obtain funds in the market, then planning for liquidity requires consideration of both the times at which funds might be needed as well as their likely availability. Similarly, if liquidity is thought of as a store of assets that will be readily accepted as means of payment, then calculating the available level of liquidity requires keeping track of when inflows from investments and transactions are expected to occur. Amounts in deposit accounts and in the form of Treasury securities can in effect be treated as inflows that can occur at any time.

Deposits and Treasurys also represent a third aspect of the way time plays a role in the nature of capital and liquidity. In calculating the extent to which a company’s assets exceed the claims of its creditors and the extent to which the sale of assets can generate liquidity, the ability of assets to retain their value over time is crucial. The closer an asset is to being treated as if it were money, the greater its ability to fulfill at any given time the role to be played by liquidity or capital. This is particularly true for systemically important financial institutions (whether they are bank holding companies or not). Preventing the collapse of the financial system or reducing the risk of such a collapse depends in part on the availability of sufficient funds and fund-like assets to repay the counterparties of the insolvent company and to convince other participants that the system will not freeze up or collapse. The inability (or perceived inability) to obtain such funds in turn signals the possibility of failure (or, equivalently, exclusion from the financial system).

The distribution across time of collateral provided by or to a financial institution is another instance in which the timing of the potential uses of financial instruments or devices can be as significant as their aggregate amount. For example, the aggregate amount of all collateral made available by a financial institution in connection with its borrowings might appear adequate while at the same time actually failing to be so because of an insufficiency of collateral for financings that might need to be re-collateralized in two days or two months. Similarly, a review of the collateral posted to cover various obligations might show that the collateral preferred for certain kinds of obligations, such as repurchase agreements, might be losing value and require supplementation (or replacement) at a rate or in a manner that differs from the behavior of collateral posted for other purposes. This could signal the arrival of financial difficulties at a particular time more clearly than a look at aggregate collateral.

In addition to playing an important role in understanding a company’s financial circumstances in the ordinary case, time becomes increasingly important whenever insolvency is, or appears to be, imminent. Typically, understanding the aggregate cash inflows and outflows over a modestly long period of time (e.g., a quarter or a year) might suffice for understanding the nature and risks of a particular company. In the zone of insolvency or at a time of generalized financial crisis, however, not only the aggregate flows of a one-day period but also even their relative order can be crucial.[12]

Restructuring the Financial Statement

Shortcomings of the Standard Balance Sheet

The basic form of a balance sheet largely obscures all of the ways in which time plays a role in the state of a company’s finances. The principal reflection of the role that time plays is found in categorizations such as “current assets,” “current liabilities” and “long-term debt.” Other information that is relevant to time is found, among other places, in notes to the financials, in the discussion that accompanies the financial statements in reports filed with the Securities and Exchange Commission by publicly-traded bank holding companies or in the specialized reports filed by regulated institutions with their regulators, such as the call reports that are available from the Federal Deposit Insurance Corporation. Information of that kind needs to be combined in some way with the balance sheet and income statement in order to render those statements useful. That still leaves the question of what a balance sheet, even if so supplemented, is supposed to represent. Even though in some sense a balance sheet represents what would happen if a company were liquidated on the date as of which the balance sheet speaks, it does not generally reflect the values that could actually be realized in such circumstances, principally because the valuation conventions on which the balance sheet is based reflect a going-concern assumption, an assumption that obviously plays no further role once an insolvency actually arises.

Given these different ways in which time constitutes an essential part of a company’s financial structure—even for balance-sheet purposes, and not just in the sense that revenues are measured over time—finding a way of representing directly what might be called the time structure of the balance sheet might more adequately model the state of a financial institution than do balance sheets in their current form. Any such representation should allow the various relationships between capital and liquidity to appear and should be capable of natural contraction and expansion in order to reveal the different degrees of detail that are relevant in times of crisis and non-crisis. One possible way of accomplishing such a task may be to create a model of a company’s financial situation that can be viewed at either a level of minute detail or at other levels of aggregation.

Building in Extensible Time Frames

This might be done by converting the basic “vertical” distinction of a standard balance sheet (the separation of assets from liabilities) into a “horizontal” distinction of time frames,[13] thereby creating the ability to separately represent the dynamics over time of different classes of assets and their associated liabilities. For example, a liability to be paid on June 1 would be grouped together with an asset that is intended to be used to satisfy the liability and is liquid or capable of being liquidated.[14] In many ways, this would amount to building some of the notes to the financial statements directly into the statements themselves. There are surely other ways. The purpose of the following discussion is to conduct a thought experiment and consider the usefulness and consequences of the experimental model, particularly with respect to the regulatory goal of understanding, and perhaps partially taming, systemic risk.

Aggregating cash flows (including anticipated borrowings, purchases, interest and dividend payments and receipts) over designated time frames would directly represent anticipated liquidity conditions. The trustworthiness of any such representation would naturally decrease out into the future. It should be noted, however, that conventional financial statements also contain estimates of various future values. Practices could be established to standardize estimates of future payments and receipts. In addition, as future payments change in their status from reasonably anticipated to contractual and from contractual to essentially certain, the way in which the changes take place will be visible as movements in the entries in the “balance sheet,” for example from a column indicating anticipated payments or receipts to one indicating a contractually agreed payment or receipt. Changes of this kind might prove indicative of various kinds of potential success or difficulty.

Different “kinds” of capital could be stratified in terms of their ability to be liquidated within particular time frames and in connection with the satisfaction of particular kinds of liabilities. For example, large investments in corporate real estate would put a company in a different capital position than would small or modest investments of that sort, as would large holdings in certain investment funds as opposed to large holdings of Treasurys. Highly liquid assets would be treated as available at any time to cover any required outflow (i.e., they would be treated in effect as if they were an offsetting cash inflow at the desired point in time), while real property, for example, could be classified as available to cover only obligations that might mature only in the more distant or indefinite future. Collateral supporting the obligations of the financial institution could be similarly stratified, since the distribution of the collateral over time[15] and the changes in the amount and nature of the collateral deployed relates closely to liquidity needs and uses.

A convention would have to be developed for what would constitute the “balance sheet” for a given day, such as the last day of a given reporting period. One possibility might be a summary four-quarter look into the future, with all inflows and outflows after that date either ignored or aggregated as if they took place simultaneously. There might not need to be a separate line for, say, common stock, since the relevant fact is the lack of any constraint forcing a payment at a particular time, although there could, of course, automatically be such a line because the very lack of such constraints might compel or strongly suggest a particular graphic or structural positioning of that information. On the other hand, a “capital” security with required payments could show up in a horizontal line that represents the spread of the required payments over time. Asset valuation adjustments that now are distinguished from one another by either showing up in the income statement or as an adjustment on the balance sheet could now all be represented in different ways on the balance sheet, based on the ways in which they affect actual or projected inflows and outflows. For example, the likely future value of assets that are currently illiquid and perhaps impaired could be shown as having a value at some future date, resulting in the categorization as unavailable for current payments but still ultimately convertible into cash, and any payments currently being made on such assets could be shown as expected receipts at the appropriate times. This would fit with the intuitive notion that an amount that is uncollectable is collected in the extremely distant future, at infinity.

Such a representation of a financial company’s transactions over specified time frames essentially makes the statement that a financial company simply is a financial company because it continuously engages in liquidity transactions. The failure of such liquidity transactions in effect opens a time gap, another way in which time plays a role in the structure of financial statements and financial activity. The existence of an unclosable or unbridgeable time gap constitutes insolvency, regardless of whether the gap arises from the inability to liquidate otherwise unencumbered assets or from the lack of assets.

A crude approximation of a remodeled balance sheet might have the following structure:

Benefits of Time Frames

A representation of a company’s financial situation in this form would appear to be useful both in managing liquidity in an ongoing business and in planning for a resolution in the event of an insolvency or similar crisis. The relationships between certain kinds of assets and liabilities would be represented directly. All levels of detail would be directly accessible and capable of either aggregation or magnification. All time frames would be immediately accessible, so that planning could be carried out for different time frames, including minute-by-minute (maybe) in a crisis.

In some respects, a representation and analysis in this manner of a company’s capital and liquidity resembles the ways in which stress testing affects (or potentially affects) our understanding of the company’s financial condition. Testing of that sort forces consideration of time frames of varying lengths and of the ways in which affected financial exposures can be dealt with and has become a standard regulatory device, at least in connection with the supervision of large financial institutions.[16] Something like this is precisely what the matching of inflows and outflows into the future represents and accomplishes. A stress test requires consideration of the ways in which the size and relative timing of the projected or contracted inflows and outflows might be affected, and how to plan for and alleviate the consequences.[17] A modified “balance sheet” with a “horizontal” time component accommodates such variation, testing and planning quite easily and, furthermore, suggests in a fairly direct way what the relevant factors are and what the consequences of changing their values might be. In other words, developing a modified balance sheet for at least certain financial institutions would simplify the conduct of stress-testing and would, in fact, provide a factual and conceptual framework for articulating what a stress test does.

The single counterparty exposure limits contained in the Liquidity Release also reflect an awareness of flows, and not just a static conception of liability, in the following way: An exposure can be reduced by obtaining a guarantee or other form of credit support; however, even though the one exposure is reduced, another exposure is created, namely to the guarantor. The networking of exposures models, implicitly, the potential direction and timing of flows.

The ways in which the treatment of capital and liquidity in the Basel III Framework relate to the modified “balance sheet” described above are slightly more indirect. The discussion of capital in the Basel III Framework emphasizes the kinds of capital that are completely or largely free of any provision that would compel or provide an incentive for payment or repayment. In the discussions on adjustments (e.g., with regard to deferred tax benefits and good will) the emphasis is understandably on the extent to which the value assigned to the capital indicates the availability of real means to make payments. Any requirements that capital be repaid or redeemed, that payments, whether in the form of interest or dividends, be made with respect to capital, or that some kinds of capital, upon the occurrence of certain events, become less restricted and more available for the payment of creditors in general[18] obviously link the idea of kinds or qualities of capital to the idea of time. The availability of capital that is not subject to requirements that it be returned remains a rather general notion except at insolvency, since the fact that it is unrestricted does not mean that capital is currently available. It could, for example, for locked up in illiquid investments.

The liquidity requirements established as part of the Basel III efforts attempt to overcome somewhat that (potential) lack of availability in several ways.[19] A Liquidity Coverage Ratio mandates that the “stock of high-quality liquid assets” must equal or exceed the “total net cash outflows over the next 30 calendar days.”[20] “High quality liquid assets” are identified by reference to both “fundamental characteristics,” such as low credit risk and ease of valuation, and “market-related characteristics,” such as the size of the relevant market and the diversity of buyers and sellers in that market.[21] “Total net cash outflows” include outflows that are likely to occur under conditions of market stress.[22] The liquid assets that count toward the satisfaction of this ratio must be unencumbered and may not serve as hedges or as collateral.[23] Net cash outflows are calculated by subtracting a portion of the expected cash inflows from the expected outflows in the stress scenario.[24]

In addition, a “Net Stable Funding Ratio” must be met, which requires that the “available amount of stable funding” must always exceed the “required amount of stable funding.”[25] “Stable funding” is characterized as “the portion of those types and amounts of equity and liability funding expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. The amount of such funding required of a specific institution is a function of the liquidity characteristics of the various types of assets held, [off-balance-sheet] contingent exposures incurred and/or the activities pursued by the institution.”[26] Note, however, that what counts as stable funding does not have to be liquid at any time prior to the time at which it is needed to cover payment requirements. For example, amounts that constitute common capital might at any given point in time be invested in assets that are not currently available for liquidation. As a consequence, “stable funding” must be understood to mean something like “capable of being liquidated without too much trouble and without conflicting with liabilities associated with such sources of funding.” In other words, stable funding consists of access to assets that are not constrained or are loosely constrained by any commitments that can, hopefully, be sold to cover cash needs with respect to assets that cannot otherwise be easily monetized. In this respect, the manner in which required stable funding is calculated resembles the calculation of one-year’s worth of liquid risk-based capital. It is somewhat unclear whether values characterized as equity and equity-like will necessarily be available as sources of funding just because they are nominally not subject to payment constraints. To some extent, the various monitoring procedures proposed by the Basel III Liquidity Framework may provide information that could at least partially overcome the lack of any necessary connection between equity and liquidity.

It is fairly clear how a balance sheet that is “stretched out” horizontally to reflect timing could accommodate both liquidity coverage ratios and net stable funding ratios. It would do so by allocating various assets to the payment of either stressed or expected payouts over the required time periods. Using such a remodeled balance sheet would make the intended function of both ratios graphically apparent. The remodeled balance sheet would, however, in all likelihood require more precise decisions to be made about (i) which of the assets whose value might be encompassed by the number representing equity capital are actually reasonably capable of monetization in the time frames required, and (ii) which times are the relevant times at which monetization must occur. Changes in the values represented by the remodeled balance sheet would appear not just as aggregates but as sub-aggregates allocated to specific times or time periods, potentially creating a (near) continuum of changes over projected time. By disaggregating much of the information represented by the Liquidity Coverage Ratio and the Net Stable Funding Ratio, a remodeled balance sheet potentially enables insights into the ways that the distribution of flows across time (including the different distributions of inflows and outflows and the distribution of the differences or net values), rather than just the aggregate values on a calculation date, might affect or predict the financial well-being of a large, active financial institution.

In addition to time, the practicalities of dealing with a potential crisis and with the proposed requirements for living wills compel the incorporation of at least one more dimension, namely “space,” in any remodeled balance sheet. Information must be available regarding not only the times and amounts of inflows and outflows, but also about the persons to and from whom flows are owed or expected.[27] For example, all swaps between an insolvent financial company being resolved by the FDIC and the same counterparty must, if transferred, be transferred to the same replacement for the insolvent company, whether the transferee is an existing market participant or a new bridge institution.[28] Any determination of possible setoffs obviously requires an awareness of all transactions between the insolvent institution and each particular customer, client or counterparty. Part of being alert for potentially risky situations consists in monitoring the behavior, creditworthiness and asset concentrations of each other company with which a significant financial company does business. The kind of “space” involved is the position of the significant financial company in the total network of other financial institutions that constitutes the financial system, although this “space” can in all likelihood be determined only for the nearest neighbors of the significant financial company (i.e., those with which it directly engages in transactions).

In principle, the ways in which a significant financial company’s exposures (cash inflows and outflows, collateral) relate to other financial companies can be indicated in a remodeled balance sheet by typographical convention. For example, at each point in, or for each period of, time, the portion of each number displayed horizontally in the remodeled balance sheet that relates to another financial company can be displayed separately in a vertical column. This would allow separate (i) disaggregations of relationships with a given financial company at each point in time; (ii) aggregations of all exposures to a given financial company at each point in time; and (iii) analyses of the development over time of both the disaggregated and the aggregated exposures.

Remodeling balance sheets of large financial institutions to reflect both the temporal and spatial aspects of the institutions’ activities would display directly the way assets, inflows and outflows vary over time and shift (in terms of the other parties involved) over space. A joint representation of inflows and outflows over both space and time should provide, at a fairly basic level, some direct indication of what financial company’s systemic position is and how it is constituted. Representations of systemic importance are uncommon and controversial. One virtue of a spatially and temporally remodeled balance sheet might be its potential ability to resolve some of this controversy. By its very nature, a remodeled balance sheet would also permit the rapid adaptation of plans as trends change, for example, as relevant time periods close to the present increase in importance.

Any indication of an individual financial company’s systemic position would need to be complemented by similar information regarding the other large financial companies with which any given financial company is linked. Whether such information would in theory be available in all relevant cases would in all likelihood depend on whether all the relevant financial companies are regulated and whether their regulators impose similar reporting standards. If it were practical to collect remodeled balance sheets, prepared on a consistent basis, from most or all of the significant financial companies, not only the systemic importance of each institution but the fundamental behavior of the system as a whole might be more easily observed.

Even a collection of remodeled balance sheets of all financial companies in the U.S. or world financial system would presumably be incapable of revealing the potential existence of a dangerous exogenous shock, such as a housing crisis—simply because it is exogenous. Nevertheless, it seems possible that the appearance in remodeled balance sheets of certain kinds of data will be suggestive of a coming exogenous shock, which could be further studied and perhaps verified using other kinds of data. In addition, remodeled balance sheets may show more clearly than ordinary balance sheets how a shock might propagate, both from institution to institution and from some aspects of the financial system to others.

It might be argued that value-at-risk models that are continuously updated already take into account the temporal aspects of balance sheets (or of the overall financial situation of a company). While models of that kind do in fact consider future exposures by calculating their present value, they essentially erase the distribution of exposures with respect to one another because the results are numerical aggregations. This has two effects. First, the focus of the calculations amounts to a generalized insolvency test which neither relates to the potential results of an actual insolvency on the date of calculation nor provides a direct indication of the timing of the potential difficulties. Rather, it reflects what might be called the likely results of a controlled run-off of a liquidating trust for the company in question. This is not to deny that the results of making the necessary calculations can serve a usual early warning function. Second, given a proper distribution of values and times, the results of calculating value-at-risk can conceivably obscure the existence of periods of significant risk for a company if those risks arise from mismatches in the availability of funds in comparison to the temporal distribution of liabilities. A remodeled balance sheet provides the necessary temporal distributions without interfering with any calculations of value at risk. By providing these distributions in detail, however, such a balance sheet potentially raises the question of whether such calculations are necessary, or, phrased differently, whether the information such calculations provide useful information in addition to that provided by the balance sheet. To take a simple mathematical analogy, calculating value-at-risk might be like integrating (or trying to integrate) certain expressions when what we really want to find out is whether the curves represented by the expressions are discontinuous at any points (where, by analogy, the discontinuities represent liquidity or solvency problems). The answer might be that it provides redundant information that is nevertheless useful for quick or more tractable evaluations or evaluations by outsiders who are not entitled to all of the information in an extensive, remodeled balance sheet.

In this regard, it is interesting to consider the information that a remodeled balance sheet would provide in connection with certain more specific requirements of the Liquidity Regulation and the Resolution Regulation.

Under the Liquidity Regulation it will be necessary, among other things, to keep track of which assets are unencumbered, what the credit exposures are to counterparties, and how financial companies are to control their liquidity and capital needs and exposures by corporate governance mechanisms. Which assets are unencumbered (in the sense of being subject to a lien) and which have not already been allocated to serve as a hedge or source of future payment would already be indicated (or be capable of being indicated) by the kind of modified balance sheet described earlier, as would credit exposures to any combination of counterparties. The fact that information of this kind, as well as more standard information about flows and projected flows, would in effect constitute the balance sheet would provide any corporate governance arrangement that might be implemented with a very large portion of the information the governing persons and bodies might need, and do so in an accessible, replicable and stress-testable form. Much of the information necessary for capital planning would also be available “free” as a result of the modified balance sheet.

As far as the informational requirements of the Resolution Requirement are concerned, a remodeled balance sheet would appear to supply directly, even without explicit consideration of an insolvency, almost all of the required information. It addition, given the interrelationships that such a balance sheet would display, many of the plans and strategies seem likely to be easier to articulate, since they could be linked directly to the financial interrelationships. In all likelihood, a substantial number would not need to be articulated at all, except in a trivial sense, since they would reveal themselves on the face of a detailed version of the balance sheet. A remodeled balance sheet would also provide a significant amount of the information required for the credit exposure reports that may also ultimately be implemented in connection with the Resolution Regulation, once the counterparty credit limits have been finalized.[29] Roughly speaking, the Resolution Regulation seems in essence to require the financial picture of an organization that would be given by a remodeled balance sheet plus some names and addresses that would make finding the right people, machines and documents easier in a crisis.

Conclusion

The important roles accorded to liquidity and resolution plans in Dodd-Frank and the centrality of liquidity in any understanding of large financial institutions as they are structured today and, more importantly, as they interact with other financial institutions, all suggest that something like a modified balance sheet should not just be a response to these regulatory demands but should instead be a candidate for itself being the central regulatory demand, around which other demands could be organized and take shape.

A recent report[30] by the Federal Deposit Insurance Corporation on how it would have resolved Lehman Brothers Holdings if the resolutions provisions of Title II of Dodd-Frank had been in effect at the time provides an interesting, indirect and somewhat ironic—given the content of the Resolution Regulation—confirmation of this conclusion. The report describes the principal advantages of Title II over bankruptcy proceedings: the availability (i) of dedicated sources of liquidity to prevent relevant markets from seizing up and (ii) of bridge institutions for holding derivatives and thereby preventing their termination while holding other activities that should be preserved or maintained. These advantages purportedly follow from an understanding of the unique ways in which the insolvencies of certain kinds of financial institutions might affect certain markets or even the larger economy.[31] These effects are considered to be significantly different from the effects of the insolvencies of large industrial companies. The nature of the new possibilities created by Title II makes it immediately clear what kinds of information and planning are necessary to benefit from them.[32] This kind of information and planning can be derived directly from modified balance sheets, as described above, without starting from any supposed special requirements of resolution plans and, unlike the requirements set out in the Resolution Regulation, without any particular reference to the way a financial company would be resolved under the Bankruptcy Code.

 

Preferred citation: George M. Williams jr, Capturing Time in Financial Statements, 2 Harv. Bus. L. Rev. Online 150 (2012), https://journals.law.harvard.edu/hblr//?p=2140.

* George M. Williams jr is a partner at Dewey & LeBoeuf where he specializes in corporate, banking and securities law and is also the chairman of the firm’s Corporate Opinion Committee.  The views expressed in this article are his own and do not necessarily reflect those of the firm or its clients.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[2] Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594, 604 (proposed Jan. 5, 2012) [hereinafter Liquidity Release].

[3] Resolution Plans Required, 76 Fed. Reg. 67,323 (proposed Nov.1, 2011) [hereinafter Resolution Release].

[4] For example, discussions of when or if asset values are to be marked to market, difficulties in valuing asset-backed securities, the relative lack of information about a company’s liquidity and collateral position, and the opacity of balance sheets with regard to the nature (other than arithmetic) of shareholders’ equity all reveal a need for having more information than that provided in ordinary financial statements. For a discussion of some of these data issues, see Dimitrios Bisias et. al., A Survey of Systemic Risk Analytics 38–39, (Office of Financial Research, Working Paper No. 0001, Jan. 5, 2012) [hereinafter Risk Analytics], available at http://www.treasury.gov/initiatives/wsr/ofr/Documents/OFRwp0001_BisiasFloodLoValavanis_ASurveyOfSystemicRiskAnalytics.pdf.

“[L]egacy supervisory accounting systems sometimes fail to convey adequately the risk exposures from new complex contingent contracts, and from lightly regulated markets with little or no reporting requirements. In fact, supervisors do not even have consistent and regularly updated data on some of the most basic facts about the industry, such as the relative sizes of all significant market segments.”

Id. at 9.

[5] This can be seen by reviewing the periodic reports of public bank holding companies.

[6] Liquidity Release, supra note 2, at 599.

[7] A counterparty can actually consist of a number of related individuals or entities.

[8] See generally Resolution Release, supra note 3, at 67,323.

[9] See generally Informational content of a resolution plan, 12 C.F.R. § 381.4 (2012).

[10] These two perspectives are implicit throughout the structure of balance sheets, corporation law definition of capital and surplus and regulatory releases regarding risk-based capital, such as those found in the appendices to Regulation Y of the Federal Reserve Board.  12 C.F.R. pt. 225 app. A–G (2012).

[11] This is due uncertainties such as asset prices, the availability of funding, forbearance, customer and market reactions, and regulatory decisions.

[12] For example, whether sufficient funds are available will depend on whether large inflows or outflows occur early or late in the day, and whether closing out all transactions occurs periodically or all at once.

[13] For something similar in terms of a more purely cash-flow analysis, see Liquidity Release, supra note 2, at 607 n. 66.

[14] For example, by placing it above or below the liability on parallel, horizontal lines.

[15] That is, the time at which it could be called upon for payment purposes.

[16] For a condensed description, see Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems 46–47, (June 2011)  available at http://www.bis.org/publ/bcbs189.pdf. The Liquidity Release requires ongoing stress-testing, conducted in a prescribed manner. See Liquidity Release, supra note 2.

[17] See Risk Analytics, supra note 4, at 100; Liquidity Release, supra note 2.

[18] In other words, various kinds of conditional capital.

[19] See generally Basel Committee on Banking Supervision, Basel III: International framework for liquidity risk measurement, standards and monitoring, (Dec. 2010) [hereinafter Basel III Liquidity Framework], available at http://www.bis.org/publ/bcbs188.pdf.

[20] Id. at 3.

[21] Id. at 4–5.

[22] Id. at 4.

[23] Id. at 6.

[24] Id. at 12.

[25] Id. at 25.

[26] Id. at 25–26.

[27] See the remarks supra regarding counterparty exposure limits.

[28] Dodd-Frank Act, supra note 1, § 210(c)(9).

[29] Resolution Release, supra note 3, at 67,327.

[30] The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act, 5(2) FDIC Q. 31 (2011), available at http://www.fdic.gov/bank/analytical/quarterly/ 2011_vol5_2/FDIC_Quarterly_Vol5No2_entire_v4.pdf.

[31] These effects are considered to be significantly different from the effects of the insolvencies of large industrial companies due to the unique nature of financial businesses, the tightness and complexity of their interrelations, and the manner in which markets can freeze when the value of a whole class of assets becomes suspect.

[32] This includes comprehensive information regarding capital and liquidity needs, asset and liability classes and the respective counterparties and collateral, as well as the computational power and general financial databases necessary to keep track of, evaluate and manage all of these matters.

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Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?

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Gaurav Toshniwal*

Two issues related to financial regulation have received significant academic and regulatory attention since the financial crisis:  Contingent Convertible Bonds (“CoCos”) and banker compensation.  The discussion, however, has largely been silent on the interaction between the two.  This brief note explores the potential conflicts that may exist in the design and implementation of CoCos because of the incentive structure created by managerial compensation.  Regulators, academics and market participants will need to address these concerns in designing the regulatory framework for CoCo instruments and managerial compensation.


Contingent Capital Instruments

The financial crisis exposed the inadequacy of equity capital at the major financial institutions.  In response, academics, regulators and banking executives have focused on bolstering banking capital requirements, partly through innovative capital instruments.[1] One such instrument is the Contingent Convertible Bond.[2] This bond converts into equity capital based on a pre-set trigger, thereby augmenting a bank’s capital during a financial crisis.[3]

The trigger could be based on three different types of metrics: 1) capital-based triggers that rely on accounting measures of capital adequacy, 2) regulatory discretion-based triggers that allow regulators to mandate conversion of CoCos into common equity during a banking crisis, and 3) market-based triggers that are triggered by declines in stock prices or increases in the premiums of credit default swaps. [4] The potential problems with these different mechanisms have been discussed at length: accounting-based measures may respond too slowly in a financial crisis, market-based measures may be susceptible to banking runs and market manipulation and regulatory discretion-based triggers may lead to ad hoc decisions.[5] In response, some commentators have suggested a dual trigger mechanism—for instance, one that relies on accounting measures coupled with regulatory discretion.[6]

Regulators and banking executives are divided on the benefits of CoCos and their optimal design.  The Basel III committee has recommended further study on whether contingent capital instruments should be counted towards equity capital for banking institutions.[7] Regulators in America and Britain have also been ambivalent about approving CoCo transactions.[8] Nevertheless, some regulators have embraced CoCos wholeheartedly.  The Swiss National Bank has been particularly aggressive on capital rations; it has mandated capital adequacy ratios of nineteen percent for the major Swiss banks, of which nine percent can be fulfilled with CoCo instruments.[9]

Banking executives are similarly divided on CoCos.  Some are concerned about the efficacy of Cocos or about the level of investor demand for such instruments.[10] Others, however, have embraced the instruments.  For instance, Credit Suisse has announced that it will issue billions of dollars worth of CoCos; its initial plan to raise CoCo capital was highly successful and the bank successfully raised two billion dollars.[11]

Although there is continuing disagreement over the design of CoCos and their role in fulfilling capital adequacy requirements, these instruments are likely to play a significant role in providing capital support for banking institutions in future financial crises.


Bankers Pay

Banker compensation levels and pay structures have come in for significant criticism since the crisis.[12] Previous compensation policies are said to have exacerbated risk taking and richly compensated bankers despite poor long term performance.[13] Some have viewed the problem of banker pay as a corporate governance problem.[14]

Bebchuk and Spamann have suggested that corporate governance reforms alone may not be sufficient to address these problems because shareholders are incentivized to take risks beyond the socially optimal level.[15] Furthermore, bondholders and other creditors are also not incentivized to monitor financial risks because of the implicit government guarantee of bank debt during a financial crisis.[16] Accordingly, the authors propose that banking executive should be compensated through a broader basket of securities including common shares, preferred shares and debt instruments issued by the bank.[17]


Exploring the Link between CoCos and Banker Pay

The academic literature has largely been silent on the interaction between CoCos and banker compensation.  The socially optimal design and implementation of CoCos will be impacted by managerial incentives created by compensation structures.  This problem is particularly acute when managerial compensation is partially or exclusively in the form of CoCo instruments.  Several banks have announced that they are considering paying senior executives and bankers with such instruments.[18] Barclays, most prominently, has sought approval from the UK regulators for paying its bankers with CoCo instruments.[19] Before approving such plans, regulators need to understand what the proper incentive structure for bankers should be.  In particular, they will need to address the following two problems.

First, are bankers incentivized to select the socially optimal design for CoCo instruments?  Managers may have considerable influence in the design of CoCo instruments, including selecting the type of trigger (e.g. capital-based) and the trigger level at which the CoCo mandatorily converts into common equity (e.g. if capital adequacy ratio falls below seven percent).  Managerial compensation structures will influence their preferences on these design choices.  If bankers are primarily compensated with equity stock, they are likely to design CoCo instruments with weak triggers because they would not want their equity holdings diluted by the conversion of these instruments into common equity.  If bankers, by contrast, are primarily compensated with CoCos instruments, they may design inefficiently strong triggers because they could potentially acquire cheap stock during a crisis.  Thus, the pay structure of bankers will determine their ex-ante preference for different design features of CoCo instruments.

Second, are banking executives incentivized to optimally trigger conversion during a financial crisis?  Although the trigger may be “mandatory” in design, managers are likely to have significant discretion regarding the trigger point because of their ability to disclose (or withhold) material information, their use of other market signaling devices, and their discretion over when to approach financial regulators.  During a financial crisis, will managers have the appropriate incentives to aid an optimal conversion of these instruments?  How will this be impacted by whether managers are partially or solely compensated with equity or CoCo instruments?  For instance, if managers are compensated primarily with equity instruments and a mandatory CoCo conversion dilutes equity holders, then managers may be incentivized to delay disclosure of material information to prevent such a conversion from taking place.  By contrast, if they are compensated primarily through CoCo instruments, managers might view a financial crisis as a mechanism for acquiring cheap equity in their bank and therefore take overly conservative positions in the bank’s financial disclosures.  Thus, different managerial compensation packages may determine the ex-post behavior of bankers when it comes to triggering the conversion of CoCo instruments into equity capital.

In designing and implementing a regulatory framework for CoCos, regulators need to be aware of the potential conflicts of interest that could be created by banker compensation structures.  Potential solutions could include regulating both the level of discretion afforded to managers in designing and implementing CoCo instruments and the magnitude of executive compensation that is linked to or denominated in CoCo instruments.

* J.D. Candidate, 2012, Harvard Law School.

[1] See Hal S. Scott, Reducing Systemic Risk Through the Reform of Capital Regulation, 13 J. Int. Econ. L. 763, 763 (2010).

[2] See id. at 770.

[3] See id.

[4] See Louise Pitt et. al, Contingent Capital: Possibilities, Problems and Opportunities 6, Goldman Sachs Global Markets Institute (March 2011).

[5] See id.

[6] See Robert L. McDonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[7] See Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems 3, Basel Committee on Banking Supervision (2010), available at http://www.bis.org/publ/bcbs189.pdf.

[8] See Anousha Sakoui & Patrick Jenkins, Stability Concerns over Coco Bonds, Financial Times, Nov. 6, 2009, http://www.ft.com/cms/s/0/7982578c-ca75-11de-a3a3-00144feabdc0.html#axzz1IxBwhf2L; Nicole Bullock & Francesco Guerrera, Wall Street and Fed in Discussions Over CoCos, Financial Times, Nov. 12, 2009, http://www.ft.com/cms/s/0/f312d108-cf2a-11de-8a4b-00144feabdc0.html#axzz1IxBwhf2L.

[9] See Switzerland Gets Extra Tough With Its Banks. Others Will Follow, The Economist, Oct. 7, 2010, http://www.economist.com/node/17202233?story_id=17202233.

[10] See Sara S. Muñoz, A Hard Road for New ‘Coco’ Securities, Wall St. J., Oct. 15, 2010, http://online.wsj.com/article/SB10001424052748703631704575552231208013398.html.

[11] See Jennifer Hughes, Credit Suisse Cocos Issue Deluged, Financial Times, Feb. 17, 2011, http://www.ft.com/cms/s/0/31da02a0-3ac6-11e0-9c1a-00144feabdc0.html#axzz1IxBwhf2L.

[12] See, e.g., Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 61-66, Financial Crisis Inquiry Commission (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.

[13] See id.

[14] See id. at 279.

[15] See Lucian A. Bebchuk and Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 274–75 (2010).

[16] See id. at 266–67.

[17] See id. at 253.

[18] See Francesco Guerrera et al, Banks Keep Close Eye on Barclay’s Cocos Plan, Financial Times, Jan. 30, 2011, http://www.ft.com/cms/s/0/e939a8a6-2ca2-11e0-83bd-00144feab49a,s01=1.html#axzz1IxBwhf2L.

[19] See Jennifer Hughes & Patrick Jenkins, Barclays Forced to Adapt Cocos Bonus Plan, Financial Times, Feb. 14, 2011, http://www.ft.com/cms/s/0/7e1cac78-387b-11e0-959c-00144feabdc0.html#axzz1IxBwhf2L (noting that Barclay’s initial plan had to be modified because the UK regulators were undecided on the efficacy of such compensation arrangements).

Preferred citation: Gaurav Toshniwal, Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?, 1 Harv. Bus. L. Rev. Online 77 (2011), https://journals.law.harvard.edu/hblr//?p=1162.

By

The Coconundrum

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Frederick Ryan Castillo*

Digging deeper into their analytical toolbox, policymakers, academics, and regulators are increasingly exploring whether, and to what extent, a system of contingent capital can strengthen the resilience of the banking sector. The global financial crisis unearthed fragile and troubled banks, riddled with excessive leverage, poor quality capital buffers, and liquidity problems. Because these institutions were deemed “too big to fail,” governments were forced to intervene and prop them up by way of costly, taxpayer-funded bailouts. With the benefit of hindsight, regulators are now looking at contingent capital as a potentially speedy and less costly alternative for recapitalizing banks in periods of financial distress.[1]

But is contingent capital a desirable, feasible and sustainable proposition, or is it an overly-simplified theoretical concept fraught with practical difficulties and unrealistic expectations?

Contingent capital—also known as “contingent convertibles” or “CoCos,”[2] “regulatory hybrid securities,”[3] “contingent capital certificates,”[4] or “embedded contingent capital”[5]—refers to debt instruments which mandatorily convert into equity upon the happening of one or more pre-defined events or triggers.[6] Regulators have tinkered with the idea of requiring systemically important banks to issue these instruments as integral components of their capital structures. When a bank encounters a liquidity or capital crisis, the CoCos will be converted into equity, thus increasing the bank’s capital buffers and avoiding the need to seek governmental intervention.

Proponents of contingent capital, who include Mark Flannery[7], Robert McDonald[8], the Squam Lake Working Group[9], and John Coffee, Jr.[10], view it as a desirable and workable mechanism. Contingent capital, it is argued, will ease financial distress, reduce bank leverage, minimize incidents of bank insolvency, avoid costly public bailouts, set up a speedy bank resolution regime, internalize bank failure costs, and insulate the rest of the financial system from possible systemic spillover effects.[11] The Basel Committee on Banking Supervision (BCBS) also observes that the use of contingent capital would lessen moral hazard by increasing private sector involvement in the resolution of future banking crises.[12]

In contrast, critics such as Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer point out that contingent capital and related “bail-in” mechanisms are too complicated to design, pose difficult implementation concerns, and are less effective than the straightforward approach of requiring banks to have more equity capital.[13]The Association of British Insurers has also voiced its concerns as to how the instruments would work in practice, noting that investors in CoCos would be made to absorb “haircuts” or losses when conversion takes place.[14]

However, it may be said that on the balance, the reservations critics have with respect to contingent capital focus largely on the practical difficulties likely to be encountered once these instruments are put into use, and not on the desirability of contingent capital as a potential tool for stabilizing banks. As Coffee points out, contingent capital is not an “abstract academic idea,” but “its optimal design remains open to legitimate and necessary debate.”[15]

Taking the debate a point further, it appears that the feasibility and sustainability of CoCos ultimately turns on a careful consideration and resolution of four key areas.

First, consensus with respect to the appropriate trigger (i.e. the point at which conversion of debt into equity takes place) needs to be reached. At present, there is a wide spectrum of proposals on this issue, with some advocating that the trigger be determined by a country’s regulatory authority, while others are arguing that a more objective measure, such as a reference to a market index or a specified capital ratio, be used.[16] For instance, in August, the BCBS issued a proposal that would allow capital instruments to be written off or converted to common shares at the discretion of the relevant authority if: (a) the bank was judged to be non-viable by the relevant authority or (b) the bank had received a public sector capital injection without which it would have become non-viable.[17] The Squam Lake Working Group suggests a double trigger: regulators must declare the existence of a systemic crisis, and the bank must fall below a given capital ratio.[18] In contrast, Flannery argues that the trigger should not depend on the state of the financial system, but rather on the contemporaneous market value of the firm’s outstanding common equity.[19]

Second, regulators must facilitate the market’s acceptance of CoCos by clarifying their essential investment features and, where appropriate, engaging in meaningful discourse with leading industry groups. For instance, a particular concern among investors is whether credit rating agencies are willing and able to adequately assess the risk features of CoCos.[20] In this regard, Fitch Ratings’ early November statement that it expects to be able to rate these new-generation bank hybrid securities may stimulate renewed interest in CoCos.[21] News last October that Swiss authorities are open to the use of CoCos to fund the capital requirements of UBS and Credit Suisse is also a welcome development.[22]

Third, the appropriate tax treatment of CoCos needs to be settled. The primary issue here is whether tax authorities would be willing to recognize contingent capital as debt (thereby allowing tax-deductible interest expenses) despite the instrument’s convertibility into equity.[23] If so, banks will enjoy the benefits of debt financing and will gravitate toward the use of CoCos in their capital structures.

Lastly, differences in the legal treatment of CoCos across relevant jurisdictions need to be sufficiently understood. Interestingly, the BCBS has already commenced this process by requesting feedback from market participants, including investors in bank capital instruments, on all aspects of its August proposal (on contingent capital and triggers), including “any legal or operational obstacles to their implementation.”[24] The BCBS has even encouraged industry practitioners to work with regulators in drafting terms and conditions for contingent capital instruments while “respecting relevant national constraints.”[25] Whether sufficient harmonization and acceptance of contingent capital across varying legal jurisdictions will be achieved, however, remains to be seen.

The discussion on contingent capital will likely continue and escalate in the coming weeks, but the ultimate verdict on its feasibility and sustainability will not be immediate. The conundrum of contingent capital presents broad challenges to the financial sector and to the economy as a whole, as stakeholders seek new and innovative ways of stabilizing the banking sector and preventing another financial crisis.

* LL.M. Candidate, 2011, Harvard Law School.

 

[1] See Damian Paletta, ‘Contingent Capital’ Idea Gaining More Steam Within Fed, Wall St. J. (Oct. 13, 2009), http://blogs.wsj.com/economics/2009/10/13/contingent-capital-idea-gaining-more-steam-within-fed; Steve Slater & Clara Ferreira-Marques, Contingent Capital: Cure or Cost for Banks?, Reuters (Oct. 27, 2009), http://uk.reuters.com/article/idUKLNE59Q01K20091027; Giuseppe De Martino, Masimo Libertucci, Mario Marangoni, & Mario Quagliariello, A Proposal for Countercyclical Contingent Capital Instruments, VOX (Oct. 30, 2010), http://www.voxeu.org/index.php?q=node/5728; BoE’s Tucker-CoCos Could Transform Bank Landscape, Reuters (Nov. 16, 2009), http://blogs.reuters.com/financial-regulatory-forum/2009/11/16/boes-tucker-cocos-could-transform-bank-landscape.  See also Press Release, Bank for International Settlements, Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee (Dec. 17, 2009), http://www.bis.org/press/p091217.htm.

[2] See CoCo Nuts, The Economist (Nov. 5, 2009), http://www.economist.com/node/ 14816673?story_id=14816673.

[3] Squam Lake Working Group on Financial Regulation, An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities (Council on Foreign Relations, Center for Geoeconomic Studies, Working Paper 2009) at 2.

[4] Mark J. Flannery, Stabilizing Large Financial Institutions with Contingent Capital Certificates (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485689.

[5] Julie Dickson, Superintendant, Financial Institutions Canada, Remarks at Financial Services Invitational Forum (May 6, 2010) at 4, http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/speeches/jdlh20100506_e.pdf.

[6] Id.

[7] See Flannery, supra note 4.

[8] See Robert J. Mcdonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers. ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[9] See Squam Lake Working Group, supra note 3.

[10] See John Coffee, Jr., Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1675015.

[11] See Flannery, supra note 4, at 3; Coffee, supra note 10, at 10, 33; McDonald, supra note 8, at 2, 21.

[12] See Basel Committee on Banking Supervision, Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (2010), available at http://www.bis.org/publ/bcbs174.pdf.

[13] See R. Admati, Peter M. DeMarzo, Martin F. Helllwig, & Paul C. Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (2010), http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1669704.

[14] Huw Jones, UK Insurers Say CoCo Capital Poorly Thought Out, Reuters (Nov. 9, 2010), http://www. reuters.com/article/idUSLDE6A812Z20101109.

[15] Coffee, supra note 10, at 9.

[16] See Coffee, supra note 10, at 34–35.

[17] Basel Committee on Banking Supervision, supra note 12; see also Martin Dozier, Basel Committee Commences Consultation Regarding Contingent Capital Requirement, Financial Markets Blog (Aug. 19, 2010), http://www.alston.com/financialmarketscrisisblog/blog.aspx?entry=3922; Press Release, Bank for International Settlements, Basel Committee Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (Aug. 19, 2010).

[18] Squam Lake Working Group, supra note 3, at 4.

[19] Flannery, supra note 4, at 11.

[20] See Tracy Alloway, CoComplications, Financial Times Alphaville (Nov. 18, 2010), http://ftalphaville.ft. com/blog/2009/11/18/83946/cocomplications; see also Tracy Alloway, Will Rate CoCo Bonds for Food, Financial Times Alphaville (Nov 9, 2010), http://ftalphaville.ft.com/blog/2010/11/09/398811/will-rate-coco-bonds-for-food; Tracy Alloway, Cuckoo for CoCos, Financial Times (Nov 11, 2010), http://ftalphaville.ft.com/blog/2009/11/11/ 82756/cuckoo-for-cocos.

[21] “Mark Brown, Fitch Statement on Bank Hybrid Securities Seen as Constructive, Fox Business (Nov. 8, 2010), http://www.foxbusiness.com/markets/2010/11/08/fitch-statement-bank-hybrid-securities-seen-constructive/#ixzz16QleaUzf.

[22] Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters (Oct. 4, 2010), http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.

[23] See Coffee, supra note 10, at 44; McDonald, supra note 8, at 16; Humphreys & Pinedo, supra note 2.

[24] Basel Committee on Banking Supervision, supra note 12, at 3.

[25] Id.

Preferred citation: Frederick Ryan Castillo, The Coconundrum, 1 Harv. Bus. L. Rev. Online 29 (2010), https://journals.law.harvard.edu/hblr//?p=832.