Frontiers In Finance For Decision Makers In Financial Services

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frontiers in finance for decision makers in financial services April 2011 Featuring: setting the pace on the regulatory agenda KPMG’s Financial Services Regulatory Centers of Excellence fatca A looming challenge too big to fail? Recovery and resolution planning in the US

Your next move responding strategically to regulatory reform in financial services


F We spent much of the last issue of Frontiers in Finance trying to understand the potential impact of regulatory change, the impact of IFRS on insurance contracts and the banking sector and measures to tackle the critical issue of systemically important financial institutions (SIFIs). It will come as no surprise that regulation is once again one of our features. However, the emphasis is changing. As policymakers and regulators get to grips with the challenges – and dilemmas – of framing new controls for the global financial system, they are finding that it’s not as easy as it seems. On the other side of the fence, financial services firms are realizing that regulatory change will not only bring costs and burdens but also opportunity. As Jeremy Anderson argues in his keynote article, smart companies are already looking at how to strategically turn the new regulatory environment to their advantage and become best in class. KPMG firms pride ourselves on bringing clients market-leading analysis,

advice and service. To this end, we have created three regional Financial Services Regulatory Centers of Excellence – one each in Asia Pacific, Europe and the Americas – to draw together our regulatory expertise and focus it on supporting our firms’ clients. A note on this initiative kicks off our special regulatory feature in this issue, with other articles looking at the impact of FATCA, insurance regulation, Solvency II and Basel 3. We also update the SIFI debate with a view on recovery and resolution planning in the US. The theme for this edition is Your next move. We explore the key issues companies need to consider when embarking on major change. Debt sales and real estate investments are both asset classes whose attractiveness has been fundamentally upset by the crisis; we look at how they are faring now. I hope you find this issue of Frontiers of value.

insights /

scott Marcello regional coordinating Partner financial services Americas region KPMG in the US t: +1 614 249 2366 e: smarcello@kpmg.com

simon Gleave Joint regional coordinating Partner financial services Aspac region KPMG in China t: +86 10 8508 7007 e: simon.gleave@kpmg.com

Hugh von Bergen Global Head of tax financial services KPMG in the UK t: +44 20 7311 5570 e: hugh.von.bergen@kpmg.co.uk

Wm. David seymour Global sector Leader investment Management KPMG in the US t: +1 212 872 5988 e: dseymour@kpmg.com

Jonathan thompson Global chair Building, construction and real estate KPMG in the UK t: +44 20 7311 4183 e: jonathan.thompson@kpmg.co.uk

alison Halsey Editor, Frontiers in Finance Partner, KPMG in the UK

Frontiers in Finance / April 2011

Frontiers in Finance / April 2011 / 45 © 2011 KPMG International. K PMG international is a swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG international. KPMG international provides no client services. no member firm has any authority to obligate or bind KPMG international or any other member firm vis-à-vis third parties, nor does KPMG international have any such authority to obligate or bind any member firm. all rights reserved.


In this issue

4

For your information fyi…

2

Topics

Looking out for opportunities: Uncovering your strategic advantage

8 Seizing opportunities: Current trends in the debt sales market

20

Looking out for opportunities: Uncovering your strategic advantage

4

Seizing opportunities: Current trends in the debt sales market

8

Real estate as an asset class: Is it core to an investment portfolio?

12

Patchwork: Bank taxes and levies

16

Financial Services Regulation feature Setting the pace on the regulatory agenda: KPMG’s Financial Services Regulatory Centers of Excellence

20

Too big to fail? Recovery and resolution planning in the US

24

FATCA: A looming challenge

28

Evolving Insurance Regulation: On the move

32

Basel 3: Time for banks to engage

36

Keeping ahead of the curve: Solvency II and the new IFRS for insurance contracts

40

Insights Updates from KPMG member firms, thought leadership and contacts

44

Setting the pace on the regulatory agenda: KPMG’s Financial Services Regulatory Centers of Excellence

24 36 Too big to fail? Recovery and resolution planning in the US

Frontiers in Finance / April 2011 / 1 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


/ For your information

fyi... Women at the top...

Speculation that the economic downturn would not have occurred had there been more women in the world’s boardrooms has prompted heated discussion about gender balance. Recent evidence suggests that groups with a better gender balance are not only better at decision-making but also more profitable. Research from the consultancy Catalyst found a correlation between those companies with the highest representation of women on their corporate boards and those with higher equity returns.

8 March 2011 marked the 100th anniversary of International Women’s Day – a day when countries around the world celebrated economic, political, and social achievements of women past, present and future. www.internationalwomensday.com

Source: www.catalyst.org

New insurance standard could lead to a change in products Under proposed new accounting rules, insurance companies may consider moving out of longer-term products and focusing on offerings where policyholders bear more investment risk. That’s the view of CFOs and senior finance personnel from the world’s leading insurance companies, following a series of high-level discussions with accounting firm KPMG.

Note: For the full report please go to the Financial Services pages on www.kpmg.com

Bank funding gets put under the microscope ‘down under’ Since 2008 Australian banks have found the liabilities side of their balance sheets coming under unaccustomed scrutiny. How banks fund their lending and trading activities is high on the agenda of Governments, regulators, shareholders and customers. The global financial crisis exposed the heavy reliance of Australian banks on offshore capital markets funding. While this has never been a secret, its significance has been overlooked. The dependency on offshore funding, as distinct from domestic deposits, is a means of transmitting instability elsewhere to an otherwise healthy banking system. It’s becoming more apparent that domestic borrowing costs

are being influenced by offshore interest rate levels and, potentially, country risk premiums. www.kpmg.com.au Source: Australian Centre for Financial Studies and KPMG Monograph – The Future of Australian Bank Funding, March 2011

2 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


/ For your information

Social media A numbers guide The numbers highlight the impact that social media is having across the globe.

30bn

pieces of content (e.g., links, photos, notes) are shared on Facebook each month

53%

of American Internet users look for information on Wikipedia, up from 36 percent in 2007

50%

of US CMOs at Fortune 1,000 companies said they launched a corporate blog because ‘it’s the cost of doing business today’

Funds industry in Ireland Ireland is one of the world’s largest jurisdictions for the establishment and servicing of internationally distributed investment funds. The Irish funds industry offers a complete range of services including fund set up, structuring and listing, fund administration, depositary and transfer agency services, compliance, consultancy, tax, audit and legal services. With an experienced and substantial network of industry

professionals specializing in legal, accounting and consulting services, Ireland is home to 47 world-class fund administration companies and 18 trustee/custodians who provide a support structure of over 11,000 industry professionals. Ireland boasts one of the most competitive and high quality service environments across all the leading fund centres.

Upcoming

$3.08bn

will be spent to advertise on social networking sites in 2011, a 55 percent increase over 2010

200m

registered accounts on Twitter as of January 2011

110m

tweets are sent per day on Twitter

Source: www.banking2020.com

June 19–June 22

International Insurance Society Conference Fairmont Royal York, Toronto www.iisonline.org

June 28–June 30

Fund Forum International Grimaldi Forum, Monaco www.icbi-events.com/fundforum KPMG 25% discount code: VIP FKN3A47KPMGPDF Frontiers in Finance / April 2011 / 3

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Change always creates opportunity. The trick is to identify it. 4 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Looking out for opportunities Uncovering your strategic advantage

Jeremy Anderson

The burden of regulation grows; at some times it seems exponentially. In the wake of the crisis, change is inevitable. New regulations are stretching the resources of financial institutions around the world and can be a major disruption to business. But all disruption has its upside. The changing regulatory landscape will open up all sorts of opportunities to extract unforeseen benefit and advantage. The smart companies are already looking at how to turn the new environment to their advantage.

Moving on again Attitudes change quickly in response to a crisis, particularly in a highly global and inter-connected industry like financial services. One month’s insight rapidly becomes next month’s cliché. We are already taking for granted that regulation and oversight are going to be stricter; that most financial services operations are going to be more constrained; that margins could be depressed for a significant period. This is the reckoning all global financial services face. In recent issues of Frontiers in Finance, we have been exploring the potential impact in a number of directions. First, of course, we have been trying to understand what it is that global, regional and national regulators are trying to achieve with their proposed changes and how these will work in practice. That process continues in this issue with a major feature on regulatory developments. Second, we’ve been trying to sketch out a future financial services sector

which may look more like a regulated utility than the dynamic, competitive industry we knew before the crisis. And in response to this, we’ve been warning of the dangers to economic growth and competitiveness of overzealous regulation. Financial services play a crucial role in wealth creation, individual liberty and social development. It is right that we in the industry should seek to defend it against prejudiced and counter-productive proposals. And yet… while we need to continue analyzing and understanding the details, we also need to start developing a more positive attitude: how can financial institutions identify opportunities emerging from the new regulatory environment, and implement profitable change? How can you achieve operational, organizational and service excellence – ultimately strengthening your position in this challenging context? When the environment offers lemons, how best to make lemonade? Frontiers in Finance / April 2011 / 5

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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While the individual details of impacts vary, in broad terms every firm will be in the same boat.

All in it together The first point to note is that any particular regulatory environment is common to all similar institutions. While the individual details of impacts vary, in broad terms every firm will be in the same boat. Almost by definition, then, there is the opportunity for those who move smartly and rapidly to open up a lead on the competition. Organizations need to see the opportunity they can exploit in the regulatory constraints and economic environment that they currently face. Change always creates opportunity. The trick is to identify it. Business models The second issue is strategic. At KPMG, we have been looking hard, both in Frontiers and in individual specialized publications, at the potential impact of regulatory change on companies’ business models. As long as uncertainty remains, it may seem premature to embark on definitive re-shaping of a company, withdrawing from some product and market sectors, say, or refocusing into other territories. But companies are constantly reviewing and revising their strategy in the light of new market conditions, new competition, changing customer expectations and the evolution of technology. Just as few companies compete head-to-head with exactly the same business model, so there will be few which need to respond in exactly the same manner to changes in the regulatory framework. But the broad changes to regulation are clear. Financial services providers which react decisively can gain advantage.

6 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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The opportunities will be there. With the right frame of mind they can be identified and exploited.

Operational benefits A third set of issues are tactical and operational. If, as we believe, the financial services sector is entering a significant period of comparatively constrained returns and profitability, it is all the more important to identify actions which can cut costs, boost margins, increase flexibility and promote operational excellence. New regulations will require new systems and processes, new data recording and reporting. If these are simply introduced as another layer of administration and management, then they will indeed simply add to costs. But if they can be devised in such a way that they also bring operational benefits and efficiencies, companies can extract net benefit. The kinds of information which regulators are increasingly requiring – on customer segmentation, on risk assessment, on individual products and service metrics – are precisely those which can lead to a more granular and precise analysis of business performance. The leaders at converting data into knowledge and understanding will be best placed to sustain performance and profitability. There are many processes and procedures available to help companies search for opportunities in a changing environment. Some are more formal and structured than others. Some may depend on the objective perspective of external consultants while others rest on the insights of those senior managers who know the business best. There are as many right answers

as there are financial services firms facing challenges – and that’s pretty much all of them. What is important, is to face the challenge directly and actively. Others will be doing so. At KPMG, we believe that our own creation of three Risk and Regulatory Centers of Excellence responds to these challenges in two ways. First, of course, it creates a resource base and center of expertise from which we can better support our firms’ clients in formulating their own responses. Second, it is, we hope, an illustration of our own continuing search for operational and service excellence. A positive frame of mind I was struck by the unequivocal conclusion, in the US Financial Crisis Inquiry Report, that regulatory failure was at the root of the crisis: “... widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts… More than 30 years of deregulation and reliance on selfregulation by financial institutions… had stripped away key safeguards, which could have helped avoid catastrophe.” We suggest the explanation is more complex; issues such as structural imbalances in economies, a lack of macro-prudential oversight and over leverage all contributed to the crisis. Indeed the Minority Report from the same Commission responds that “explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are… deficient.”

Nevertheless, we have to recognize that global political pressure for muchincreased regulation exists, and this will be reality for some time. I believe it’s now time for financial services companies to engage constructively with the forthcoming changes, to recognize the political reality and work to encourage governments to address the wider root causes of the failures and minimize the potential unintended consequences of the changes.

For more information please contact: Jeremy Anderson Global Chairman, Financial Services KPMG in the UK T: +44 20 7311 5800 E: jeremy.anderson@kpmg.co.uk

Frontiers in Finance / April 2011 / 7 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Seizing opportunities: Current trends in the debt sales market Before the financial crisis, the global debt sales market was fairly simple. In the main, it was a matter of banks and other lenders disposing of non-core and non-performing loan portfolios to private equity investors looking to purchase distressed assets. That aspect of the market still exists. But there has also been a major boost from post-crisis portfolio reconfiguration and balance-sheet restructuring.

8 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Stuart King

Non-core and distressed assets There has long been a trend, particularly among American and European financial institutions, to separate non-core and distressed assets into purpose-built business units, focused on asset wind-down and disposal. In most cases, this strategy has been applied to non-core assets, both performing and non-performing, as well as to markets and product lines that no longer align with the institution’s long-term business strategies, which are capital or risk-weighted asset (RWA) intensive or that no longer match the current funding profile of the owner. With a significant amount of debt coming to maturity in the next couple of years, many market observers are concerned that increased refinancing activity will cause further pressure on an already tight market. In many cases, institutions are signaling a preference for servicing these assets before considering disposal to strategic and/or financial buyers. Regulation stimulates disposals At the same time, regulators are increasingly encouraging large financial institutions that are partly statecontrolled to shed assets and shrink their balance sheets. This is especially so in Europe, where new Basel 3 proposals on liquidity and capital provide further impetus to organizations to optimize their regulatory capital and funding positions; institutions are feeling new pressure to strengthen their portfolio management capabilities, which may – in turn – stimulate further

portfolio disposals. As a result, large portfolios of performing assets are being brought to market to release cash, slim down balance sheets and repay government bail-outs. A buyer’s market? Significant opportunities have opened up, particularly for the few strategic buyers with excess liquidity and an appetite for growth. In Europe, for

In Europe, for example, Santander has recently acquired banking operations and assets in Poland, Germany and the UK to fuel its existing expansion plans. example, Santander has recently acquired banking operations and assets in Poland, Germany and the UK to fuel its existing expansion plans. But while these transactions have been substantial, there have been few major transactions where a strategic buyer has acquired non-core banking assets.

Nick Colman

Jonathan Hunt

In part, this is because many banks are unwilling or unable to acquire large portfolios which cannot be easily funded, tie up precious capital, or increase RWA. Many banks are starting to become frustrated at what they see as derisory pricing for ostensibly better quality loans. However, the assets that banks are trying to sell do not always lend themselves well to the portfolios of the traditional ‘distressed debt’ and financial purchasers. So while many of these debt funds, investment banks and collection agencies may have capital to deploy, many are finding that performing debt portfolios require larger investments, which – when combined with more rigid investment and servicing rationale – has led to a limited number of performing/ subperforming transactions in 2010 and 2011. Nevertheless, there are signs that price expectations between buyers and sellers in many non-core performing loan markets are starting to align. In part, this has been encouraged by a growing willingness on the part of sellers to consider extending funding lines to the acquirer. This has effectively allowed traditional financial investors to focus on lower quality and difficult-tomanage assets where the price gap is often less. In the first edition of a new publication series,1 KPMG’s Portfolio Solutions Group has examined recent debt portfolio activity in a number of markets across Europe, the Americas and Asia-Pacific. Key conclusions are as follows. Frontiers in Finance / April 2011 / 9

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Europe The past few years have been turbulent for the European debt sale market, with a number of factors coalescing to cause additional complexity and – in many cases – risk. Each has the potential to influence the outlook for both buyers and sellers in the European debt sales market: Ongoing concerns over sovereign debt in a number of countries have resulted in a crisis of confidence. Widening bond yield spreads between these countries and other EU members (namely Germany) have allowed speculative investors to trade on these assets as if they were distressed investments. This has meant that buyers have been less willing to spend time and resources pricing illiquid loan portfolios. The European Commission has been actively developing a detailed approach for assessing restructuring aid flowing to banks from member states. To date, the Commission has issued four communications related to this issue, one of which details the specific features that must be included in a restructuring (or viability) plan for institutions seeking crisis-related state aid.

Overall, the European debt sales market is showing positive signs for the future, and an increasing number of markets across Europe are freeing up in terms of debt sales. The mandate of Ireland’s National Asset Management Agency is to facilitate the restructuring of credit institutions of systemic importance to the Irish economy by acquiring certain assets from Irish banks, then holding, managing and realizing those assets. In effect, the agency has mainly been acquiring property development loans, at a discount, in return for government bonds. Overall, the European debt sales market is showing positive signs for the future, and an increasing number of markets across Europe are freeing up in terms of debt sales.

The Americas While the US and Brazil continue to be the most active debt sale markets in the Americas, there are increasing signs of renewed activity across the region, including in Argentina, Chile, Colombia, Peru and Mexico. The last quarter of 2010 saw a marked increase in private deals in the US (conducted without government intervention), and most investors and market observers expect the level of deal activity to either continue or increase over the next two years. Investors in Brazil can expect to see several portfolios come to market next year, though mainly in the unsecured retail sector, and can expect a continuation of the market’s steady rise since the lows of 2008. Activity throughout the rest of the region, particularly in South America, has been promising, yet inconsistent. The Argentinean market has seen a number of relatively small deals over the past two years, and trade in NPL/non-core assets is expected to continue in 2011. Banks in both Chile and Colombia are expected to slowly start selling assets in 2011,

10 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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after both countries experienced a sudden drop in activity following a string of very large transactions in late 2007 and early 2008. And while other markets, such as those in Peru and Mexico, are attracting some regional investors, the potential flow of deals available overall remains uncertain. For the Mexican market, in particular, the semi-monopoly of the market by a handful of investors has often resulted in lower prices being offered to sellers. In the US, the Federal Deposit Insurance Corporation (FDIC) recently suggested that the nation’s largest financial institutions could be recovering from the financial crisis at a far faster pace than their smaller rivals. One of the reasons quoted was fewer new NPLs among the large banks. However, the number of banks and savings associations on the FDIC’s list of problem institutions climbed to 860 at the end of September 2010, its highest level since 1993. Some industry participants believe that the FDIC will continue to be a seller of problem assets, primarily focused in commercial real estate and construction portfolios.

Asia Asian countries are in the midst of reassessing their positions following the global economic crisis. However, the impact of rising non-performing loans, and the shedding of non-core assets by financial institutions, resulted in an increase in the number of portfolio and single credit opportunities in 2010; much of this activity has been driven by the sale of various Lehman assets across the region, including those in the Philippines, Japan and Thailand. 2010 also saw a marked increase in buyer appetite as a number of existing and new distressed players sought to deploy capital after a cautious 2009. And while pricing expectation gaps continued, market feedback indicates that the majority of portfolio deals were successfully sold. Market feedback also indicates that ‘cherry picking’, especially in relation to larger corporate debt, continued to be a feature of many deals in 2010. It appears that the number of opportunities is likely to increase in 2011, especially as banks and financial institutions seek to implement capital management regimes (in relation to future Basel 3 requirements) with a

focus on reducing high risk weighted assets and assets that are deemed non-core. A number of banks in Korea and Malaysia are also in the process of establishing ‘bad banks’ with a view to improving the overall management of many of their riskier assets. Overall The traditional debt sales market, primarily driven by core/non-core portfolio restructuring and by the disposal of under-performing assets, is receiving a major additional boost from new regulatory activity. This is bringing pressure to bear on institutions to divest substantial parts of their businesses, bringing large portfolios of performing assets to market. Significant opportunities are opening up for strategic buyers with excess liquidity and an appetite for growth.

For more information please contact: Stuart King Partner KPMG in Spain T: +34 682 384 793 E: stuartking@kpmg.com Nick Colman Associate Director KPMG in Germany T: +49 17 3541 8596 E: ncolman@kpmg.com Jonathan Hunt Associate Director KPMG in the UK T: +44 77 4870 1509 E: jonathan.hunt@kpmg.com

1. Global Debt Sales, Portfolio Solutions Group, KPMG 2011

Market feedback also indicates that ‘cherry picking’, especially in relation to larger corporate debt, continued to be a feature of many deals in 2010.

For further information on loan portfolio activity across the world, please refer to KPMG’s first edition of ‘Global Debt Sales’, which can be found at kpmg.com. In this semi-annual publication series, KPMG’s Portfolio Solutions Group examines recent debt portfolio activity in key banking markets across Europe, the Americas and Asia-Pacific. They look at all types of debt sales, including non-core performing and non-performing loans from around the globe, and provide high-level insights into past trends, recent transactions, new opportunities and a view to the future.

Frontiers in Finance / April 2011 / 11 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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The global economic crisis caused a collapse in the value of real estate assets in developed economies, and seriously damaged their attractiveness to investors. In recent months, however, especially in Asia and emerging markets, the question of asset bubbles and inflation is back on commentators’ minds. In many countries, real estate investment performance statistics for 2010 showed activity on the increase and values recovering across the globe. Are investors rethinking the role that they want real estate to play in a diversified investment portfolio? The answer will be different for different types of investors, but the challenge to the industry is to provide the investment product that meets the risk-return needs of investors.

12 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Real estate as an asset class: Is it core to an investment portfolio?

Jonathan Thompson

Raymond G. Milnes

It is clear that in the years leading up to the crisis, real estate values became significantly detached from fundamentals, leading to asset bubbles in many markets. Values became far more sensitive to capital flows than to the underlying operating performance of the assets. The core characteristics of real estate, such as a reliable income stream and close correlation to GDP, were eclipsed in the majority of developed economies by speculation on liquidity and leverage-fueled re-pricing of the asset class. The legacy of the crisis continues to impact on the industry; its effects are likely to be felt for some time given the lack of an imminent solution for plugging the debt liquidity shortfall in Europe and North America. One direct consequence is that institutional investors have become increasingly risk averse, refocusing on underlying asset-fundamentals, and perhaps becoming more sophisticated in their consideration of volatility, risk and return. This topic has featured on the agenda of nearly every industry event in the second half of 2010, and remains high on the agenda of CIOs across the industry. Some forward-thinking research departments are already well advanced in defining new approaches to assessing real estate risk, return and portfolio volatility. We expect

Andrew Weir

that communication between fund managers and investors will increasingly include this type of information. Funds adopting investment strategies and performance reporting based on this may well be the winners in attracting new investment into the sector. Real estate needs to compete effectively with both the mainstream asset classes of equities and bonds as well as with the alternatives such as private equity, hedge funds and infrastructure. Those more experienced

Real estate needs to compete effectively with both the mainstream asset classes of equities and bonds as well as with the alternatives such as private equity, hedge funds and infrastructure. investors are demanding far greater disclosure of the risks faced from the markets within which the underlying assets operate, through to specific property risks and the portfolio mitigating effect. At one level the challenge is one of communication. Fund managers need to learn to communicate using familiar investment language and terms, rather than the real estate language of ‘core’, ‘core plus’, ‘yields’, ‘ERVs’, etc. In short, Frontiers in Finance / April 2011 / 13

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


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Investors are reconsidering their asset allocation strategy. One public example is that of the California Public Employees’ Retirement System (CalPERS) which recently announced its realignment of assets into five major groups on the basis of their function in high- or low-growth markets and the prevailing inflation environment.

investors want to understand, for a real estate portfolio, the expected return range and its risk profile. Investors are reconsidering their asset allocation strategy. One public example is that of the California Public Employees’ Retirement System (CalPERS) which recently announced its realignment of assets into five major groups on the basis of their function in high- or low-growth markets and the prevailing inflation environment. CalPERS publicly noted in their statement that they had in the past, “focused on assets and returns, but not enough on the risk of our allocations”. The re-categorisation is said to be aimed at providing a better way to look at risk, the performance of the markets and the fundamentals of the assets. To this end CalPERS has separated its various investments into, ‘Real’, ‘Growth’, ‘Income’, ‘Inflation’, and ‘Liquidity’ assets, with each group expected to contribute to the overall success of the pension fund. Real estate sits within the ‘Real’ group, together with infrastructure and forestry assets. These assets are expected to provide long-term income returns that are less sensitive to inflation risk. A fund manager looking to attract their capital would need an investment policy directed to meet these specific aims.

With the large pension funds looking to shore up their income streams there is competition for the right types of assets. However, not all investors are looking for the same risk/return profiles. For example, the opportunity funds will have an important role in recapitalizing the secondary and tertiary markets and generating high returns to compensate the higher risk. In essence the funds compete with private equity and hedge funds for investment capital. Continued uncertainty, arising from difficult debt markets and the uncertain impact of new regulation, may foster further caution in the capital markets of the developed economies. The impact of this sustained caution will depend on how investors approach their allocations and whether they are making decisions based on short, medium, or long-term strategies. Throughout the developed economies we expect there to be a move towards portfolios designed to achieve absolute risk-adjusted returns, rather than capital flowing into the sector chasing a cyclical relative return. As a result, we expect real estate will continue to play a significant role in investment portfolios, whether the investor is a high-return opportunity fund or a pension fund. However, in order to attract the capital flows,

investment managers will need to clearly communicate their investment strategy and their ability to identify, manage and mitigate risk, while also committing to additional reporting in order to satisfy investors’ increasing information requirements. Asian markets enjoy healthy levels of investment but still carry significant risks In Asia the story is a little different. Although there has been some distress in the real estate markets, the effects of the financial crisis have not been significant enough to cause a stepchange in approach, reflecting lower levels of gearing and continuing liquidity in the debt and capital markers. The result, combined with the ‘China effect,’ is that for many investors in the Asian property market it is ‘business as usual’. At present the Asian markets are enjoying healthy levels of local investment. Access to local equity sources, such as RMB capital in China, combined with access to dept capital, in particular from local based banks, has supported liquidity. Low interest rates in the region, particularly in Hong Kong and Singapore, have boosted real estate’s profile as an attractive investment to many who want a return for their surplus cash, even at very low yields.

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Low interest rates in the region, particularly in Hong Kong and Singapore, have boosted real estate’s profile as an attractive investment to many who want a return for their surplus cash, even at very low yields.

As a result, the private, high net worth individual has a significant influence on real estate investment. Some investors are looking to real estate to give them access to specific countries, such as China, with the investment acting as an inflationary hedge. Property investment in China in particular has another dimension – it is also a foreign exchange (FOREX) play, as most commentators expect continued appreciation of the RMB. Certain countries, including China, have been taking action to dampen demand in a bid to prevent a local ‘bubble’. However, for Western investors the Asian markets still carry significant risks and while allocations to the region have increased, investors remain cautious.

For more information please contact: Jonathan Thompson Global Chair Building, Construction and Real Estate KPMG in the UK T: +44 20 7311 4183 E: jonathan.thompson@kpmg.co.uk Raymond G. Milnes Head of Real Estate Americas Building, Construction and Real Estate KPMG in the US T: +1 312 665 5023 E: rgmilnes@kpmg.com Andrew Weir Head of Real Estate Asia Pacific Building, Construction and Real Estate KPMG in China T: +852 2826 7243 E: andrew.weir@kpmg.com.hk

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Patchwork: Bank taxes and levies Many of the major developed economies – but not all – are introducing taxes or levies on banks in the aftermath of the financial crisis.1 The motivations are clear in broad terms, but differ in detail between jurisdictions. The notion of a coordinated global approach was probably never realistic: the patchwork of different levies now being introduced reflects individual national priorities and also different emphases in the case for such levies in the first place.

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Victor Mendoza

Arguments for a bank tax At the Pittsburgh summit in September 2009, in the immediate aftermath of the financial crisis, the G20 asked the International Monetary Fund to: “prepare a report for our next meeting [June 2010] with regard to the range of options countries have adopted or are considering as to how the financial sector could make a fair and substantial contribution toward paying for any burden associated with government interventions to repair the banking system.” The final IMF response in June 2010 also reflected a request, made in response to an interim report, to undertake further work on: “options to ensure domestic financial institutions bear the burden of any extraordinary government interventions where they occur, address their excessive risk taking and help promote a level playing field, taking into consideration individual country’s circumstances.” At the subsequent Toronto summit, the notion of a global tax, which had always seemed unlikely to be implemented, was officially declared to be no longer on the table. Instead, the G20 encouraged individual countries to implement a levy on financial institutions. A number of leading G20 members have been working since then to formulate and implement such a levy (or tax), among them the US, and France, Germany and the UK in Europe. However, this range of separate initiatives is responding to individual national agendas which are not necessarily consistent. They also reflect differing emphases over the fundamental purpose of such a levy.

Extending the case The initial case for a levy was couched in relation to requiring financial institutions to defray (some of) the costs borne by governments in bailing out the financial sector at the height of the crisis. The IMF noted that although the final net cost of government interventions may turn out to be relatively modest, fiscal exposures during the crisis averaged nearly 3 percent of GDP for G20 countries, and up to twice this level in the most affected countries. Amounts pledged during the crisis, including guarantees and other contingent liabilities, averaged 25 percent of GDP. In addition, government debt in advanced G20 countries is projected to rise by almost 40 percentage points of GDP during 2008–2015. However, the purpose of a bank levy was subsequently extended in two ways. The first was, in effect, to require banks to contribute in some way to providing for the costs of future government interventions. The second was to act as a disincentive to engage in future excessive risk-taking, thereby making the need for future government actions less likely. In addition, a number of national governments, facing severe fiscal and budgetary strains, have implicitly welcomed a new source of tax revenues, whatever its explicit rationale. Concern over the level and structure of bankers’ remuneration, and its potential role in driving excessively risky behavior, has stimulated proposals for ‘bonus taxes’. And a desire simply to punish the banks for their role in creating the crisis has also clearly played a part.

Peter Carville

Barry Larking

25% 40% Amounts pledged during the crisis, including guarantees and other contingent liabilities, averaged 25 percent of GDP.

Government debt in advanced G20 countries is projected to rise by almost 40 percentage points of GDP during 2008–2015.

Not open-and-shut But the case for bank levies is by no means open-and-shut. A number of governments are driven by competition concerns, and are reluctant to impose additional costs on their own financial services institutions, particularly when these compete internationally. Other leading G20 countries, for example Canada, may reasonably argue that their banks played little or no role in creating the crisis, remain stable and well financed and should not be penalized by suffering additional tax burdens. In the face of such diversity of motivations and priorities, it is not surprising that a coordinated and coherent international response is proving difficult to formulate. The IMF noted that unilateral actions by governments would risk being Frontiers in Finance / April 2011 / 17

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Figure 1 Bank levies: scope for double taxation under domestic rules

Austria

France

Germany

Hungary

Portugal

Sweden

UK

US

Foreign subsidiaries

N

Y

N

N

N

N

Y

Y

Domestic branches of EU banks

Y

N

N

Y

N

N

Y

Y

Domestic branches of non-EU banks

Y

Y*

Y

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Y

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Y

Y

* unless reciprocity

undermined by tax and regulatory arbitrage. Effective cooperation, short of full uniformity, would promote a level playing field and greatly facilitate the resolution of cross-border institutions when needed. Unfortunately, it increasingly looks as if the risks which most concerned the IMF will become reality as individual governments follow their separate paths. For example, the major EU governments are leading the way in implementing bank levies, responding as much to internal political dynamics in the Union as to the G20 encouragement. France, Germany and the UK all had measures in place as at 1 January 2011. By contrast, the Obama administration’s Financial Crisis Responsibility Fee has received a mixed reception, and prospects for its eventual implementation are far from certain. Issues and challenges Clearly, a patchwork of unilateral bank taxes, specific to individual jurisdictions and not imposed in many, has the potential to raise significant challenges for fiscal authorities: fiscal arbitrage: with some major economies highly unlikely to introduce bank levies, then the new taxes being brought into force, especially in the key EU countries, create a significant incentive to relocate headquarters and, for non-UK groups, to relocate business activity; Asian territories, for example, show no sign of introducing bank levies. double taxation: clearly, double taxation arrangements will need to be revised and updated to reflect

differences in individual countries’ regimes; this will take time and until the process is complete, banks and others caught by levies will remain unclear about the final impact; within Europe, it would be appropriate for the EU Arbitration Convention to be extended to include bank levies. A more fundamental challenge will be how to assess the impact of these new levies. We have seen how the rationale for their introduction has been stretched beyond its origins. Will they raise sufficient funds to offset the cost of government intervention in the crisis to provide funds to cover future government intervention? How can

A more fundamental challenge will be how to assess the impact of these new levies.

Can banks themselves do anything to mitigate the impact of these levies and/or to ensure they are implemented reasonably fairly? We think the prospects are limited: as we have seen, the major imperatives behind the imposition of banks levies are political and cases are relatively immune to rational argument. Nevertheless, banks and their representative organizations can still play a role through lobbying and communication. They are best placed to ensure that regulatory bodies understand the global competitive landscape and hazards of putting their own financial institutions at a disadvantage. Constructive engagement would be enhanced by the suggestion of alternative solutions. In the meantime, it is inevitable that some investment decisions may be postponed until the position is clarified.

For more information please contact:

these figures be estimated? Will they push banks into less ‘risky’ areas of business in future? Or will they simply result in distorted asset allocations – different but no less risky balances in the business model? National and international political imperatives have been the prime drivers behind the introduction of these new bank levies. Key jurisdictions now have them in place, but the next challenge is for them to determine precisely how they should work in practice, and, recognizing the IMF’s distinction between effective cooperation and full uniformity, how far international coordination can go in creating a reasonably level playing field.

Victor Mendoza Partner KPMG in Spain T: +34 9 1456 3488 E: vmendoza@kpmg.es Peter Carville Associate Partner KPMG in the UK T: +44 20 73115529 E: peter.carville@kpmg.co.uk Barry Larking Head of Knowledge Management, EU Tax Centre KPMG in the Netherlands T: +31 2 0656 1465 E: Larking.Barry@kpmg.nl 1. This article is based on KPMG’s detailed analysis of proposals for bank taxes and levies: Proposed bank levies – comparison of certain jurisdictions Edition V, KPMG International, February 2011

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AUDIT


Special feature: Challenges of Regulatory Change

Setting the pace on the regulatory agenda KPMG’s Financial Services Regulatory Centers of Excellence

Simon Topping

Giles Williams

Jim Low

Jon D. Greenlee

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Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

The shape of the new regulatory landscape is becoming clearer; but significant uncertainty remains of course. While progress on financial reforms was made at the G20 summit in Seoul, diverging national approaches are becoming evident. Nevertheless, the Basel Committee has finalized new principles for capital and liquidity in banking. In the insurance sector, significant change has already started with Solvency II, and with the IAIS adoption of a new strategic plan 2011–2015 setting out high level goals and strategies to strengthen overall insurance supervision. The United States has passed the Dodd-Frank Act, which touches on virtually every aspect of its financial sector. Proposals have been put forward by global, regional and national policy-setting bodies which will change the structure, supervision and governance of financial services. In 2010 we saw the regulatory framework being established, and in 2011 we will see these new regulations start to be implemented. The scope of change is going to have an impact on every aspect of financial services. One of the most far-reaching follows the strong new focus on financial stability and systemic risk, with the Financial Stability Oversight Council in the US and the European Systemic Risk Board both developing proposals for macroprudential oversight. As the breadth of regulatory reach widens, so does

the number and range of supervisory bodies, especially in the area of financial conduct: the US administration has created the Consumer Financial Protection Bureau (CFPB), Office of Financial Reporting (OFR) and the Federal Insurance Office (FIO); in the EU there is a new European Securities and Markets Authority; in the UK, the Financial Conduct Authority. What do all these changes mean for large financial institutions globally? The primary impact is that regulation is now driving the strategic agenda. Most senior executives of financial services organizations will now have regulation, and interaction with their regulators, in the top one to two issues that they face on an on-going basis. They are struggling with a number of key issues including: How will the competitive environment and strategic opportunities change as a result of individual firms being designated as either globally or nationally systemically important? How will additional requirements on capital affect the cost of doing business, and change the business model? How will developments around the world from the G20, Basel 3, Solvency II, other EU initiatives on governance, MiFID 2 and the DoddFrank Act resolve themselves into a coherent regulatory framework which multinational companies can work within effectively? One of the key uncertainties is the extent of global consistency that will

The scope of change is going to have an impact on every aspect of financial services.

1

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emerge. The European position is especially interesting. In other territories there will be local national responses to what the G20 is pushing for. But in Europe, the Commission will play a key role in driving this process. Some difficult tensions are likely to emerge between some of the countries whose views on the current policy response differ from those of others. Implementation and compliance with the Dodd-Frank Act in the US

Implementation and compliance with the Dodd-Frank Act in the US means significant operational redesign for many financial institutions which will most certainly result in divestitures and consolidation in the market place, and requires liaison with new and reconfigured regulatory entities.

means significant operational redesign for many financial institutions which will most certainly result in divestitures and consolidation in the market place, and requires liaison with new and reconfigured regulatory entities. Coordinating the local requirements with global initiatives such as Basel 3, the IAIS Core Principles and the FSB policies on recovery and resolution plans will be a challenge for global financial institutions. In Asia Pacific (ASPAC), most large financial institutions already have strong capital and liquidity positions, their business models haven’t been destroyed by the crisis, and they still have stronger reputations than in other regions. However, while the diversity of the countries in the region means that there is still work to be done to develop the infrastructure, governance, risk management and solvency requirements for firms, the financial institutions in the region are now focusing on how they can turn this to their advantage. To address these major issues for our firms’ clients, KPMG has created three regional Financial Services Regulatory Centers of Excellence – one each in Asia Pacific, Europe and the Americas – to draw together our regulatory expertise and focus it on supporting our clients. As they face the challenges of the new environment, financial services firms are needing to have relationships with multiple regulators. The supervisory approach is changing dramatically, and particularly impacts organizations with cross-border activities. They are changing business models to meet new prudential requirements. They need to reconcile global policy statements with local application. They are implementing complex changes required over extended timescales. Our experts are at the forefront of these developments, globally and locally. This is not simply a matter of applying analysis and understanding to current developments. The more far-sighted companies realize that responding to regulatory change in a way that makes sense for their business has enormous potential for strategic opportunity and competitive advantage.

The timelines may seem generous – but in practice will be challenging. Market pressures and implementation complexity will add pressure. Some institutions, particularly large ones, must be compliant much earlier – due to a combination of market and supervisory pressure. But others will struggle to meet deadlines and may be victims of industry restructuring as many financial institutions and business models become unattractive to providers of capital. In this special feature, Setting the pace on the regulatory agenda, leading experts from our Financial Services Regulatory Centers of Excellence review specific aspects of these developments and discuss the implications they will have for the industry.

For more information please contact: Simon Topping Principal, Financial Services Regulatory Center of Excellence, ASPAC region KPMG in China T: +852 2826 7283 E: simon.topping@kpmg.com.hk Jim Low Partner, Financial Services Regulatory Center of Excellence, Americas region KPMG in the US T: +1 212 872 3205 E: jhlow@kpmg.com Giles Williams Partner, Financial Services Regulatory Center of Excellence, EMA region KPMG in the UK T: +44 20 7311 5434 E: giles.williams@kpmg.co.uk Jon D Greenlee Managing Director, Financial Services Regulatory Center of Excellence, Americas region KPMG in the US T: +1 703 286 8032 E: jdgreenlee@kpmg.com

For more insight into the regulatory issues facing the financial services industry, visit www.kpmg.com/ regulatorychallenges

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Special feature: Challenges of Regulatory Change

Too big to fail? Recovery and resolution planning in the US

The US regulatory authorities are moving to require large banks and other financial companies to prepare and submit ‘recovery and resolution plans’ – commonly referred to as ‘living wills’. This may look like just another regulatory burden, another hoop for companies to jump through, but the implications are profound, and large banks and systemically important non-banks need to start considering them now.

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Jon D Greenlee

Too big to fail A series of critical events at the height of the financial crisis graphically illustrated how inadequate the US and global supervisory authorities’ tools were for effectively dealing with the resolution of a systemically important financial institution (SIFI). The lack of adequate tools was highlighted by the different paths taken to deal with troubled SIFIs. These include the decision to rescue Bear Stearns, to place Fannie Mae and Freddie Mac into conservatorship, followed by the decision to allow Lehman Brothers to fail, yet save AIG. In the words of the Financial Crisis Inquiry Commission: “Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be ‘too big to fail,’ caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession… The government’s inconsistent handling of major financial institutions during the crisis… increased uncertainty and panic in the market.”1 As a result, one of the major thrusts of regulatory reform since the crisis, driven by the G20 and the Financial Stability Board, has been to ensure that governments are never faced with the same dilemmas again and have available tools that allow for the orderly resolution of a SIFI. While this is a theme of many proposals across the developed world, the US Government made this a cornerstone of the DoddFrank Act by passing legislation that

outlines a framework for the FDIC to have Orderly Resolution Authority (OLA). The Federal Reserve and FDIC are both charged under this law with drafting regulations that implement the OLA. The FDIC has approved a notice of proposed rulemaking asking for public comments, and the Federal Reserve Board is expected to approve it shortly. The timeline outlined in the notice of proposed rulemaking will result in final rules becoming effective no later than 21 January 2012. Both globally and in the US, meeting the policy challenge involves two different yet complementary approaches: reducing the risk that a SIFI might fail developing a mechanism to allow a SIFI to fail by reducing the collateral and systemic damage of that failure. The first of these is the province of recovery planning, the second of resolution planning: recovery: when the firm encounters capital or liquidity stress, its board and management activate a strategy to prevent escalation to failure; this may involve restructuring, sale of assets and certain non-core business lines, raising new capital from the market or through convertible securities (eg, CoCos), and other activities that may reduce the overall risk in the organization. resolution: if failure cannot be avoided, the regulatory authorities need a mechanism to take control of the situation to eventually resolve the organization by implementing a pre-determined strategy that

addresses key internal and external dependencies and economic functions, counterparty exposures, and core operations to minimize the harm and cost to creditors and public funds.

A major thrust of regulatory reform since the crisis, driven by the G20 and the Financial Stability Board, has been to ensure that governments are never faced with the same dilemmas again. Together, recovery and resolution planning have the potential to reduce the riskiness of the US financial system by helping to limit moral hazard and allowing a SIFI to eventually fail. Although the proposed regulations are not yet finalized, banks should not assume that this is simply a technical issue, to be left to the risk or regulatory relations department to manage. All the indications are that it could well lead to profound changes to the core of business models. Already, some organizations are undertaking efforts to rationalize legal entity structures, change the way they manage capital and liquidity, simplify shared services models, and consider the impacts on corporate strategy. Bank boards of directors and senior management need to start engaging on this topic now and identify the implications of recovery and resolution planning, and capitalize on potential opportunities to streamline legal entities and reduce costs, develop new business models, and maximize shareholder returns. Frontiers in Finance / April 2011 / 25

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

Regulatory response: the ‘living will’ Under the Dodd-Frank Act, the largest bank and systemically important non-bank holding companies will be required to submit to the FDIC and to the Federal Reserve recovery and resolution plans – so-called ‘living wills’ – that will facilitate a rapid and orderly resolution of the company. This requirement will apply to: large interconnected bank holding companies with at least $50 billion in consolidated assets; any other company predominantly engaged in financial activities that the Financial Stability Oversight Council (FSOC) has determined is a SIFI and that could pose a threat to the financial stability of the US because of its size, scale, concentration, interconnectedness or mix of activities or as a result of a material financial distress at the company. The preparation of a ‘living will’ will be an extension of existing processes for capital and liquidity scenario planning, stress testing and crisis management plans. These will need to be extended to include the collection of detailed data on assets, liabilities, contractual relationships, systems and processes etc. in each of the company’s businesses and operations. These will form the foundation of detailed plans to deal with future crises. Where

“If [banks] can’t show they can be resolved in a bankruptcy-like process... then they should be downsized now… There is no reason in the world why they should get some special treatment backstop that other businesses in this country don’t have.” Sheila Bair Chairman of the Federal Deposit Insurance Corp. (FDIC)

bankruptcy is unavoidable, the plans need to set out the necessary data and analysis to underpin the action the FDIC should take to manage the dissolution process. And since these plans may need to be acted on at short notice, the ‘living will’ has to be updated regularly, at least once per year. Fundamental implications So far, the requirement to prepare and submit recovery and resolution plans may largely seem a matter of additional bureaucracy overlaid onto sensible contingency planning. But the implications are far greater. The FDIC will have the responsibility to review and approve recovery and resolution plans along with the Federal Reserve and potentially other prudential regulators. If a company cannot submit a credible resolution plan, the statute permits increasingly stringent requirements to be imposed that, ultimately, can lead to divestiture of assets or operations to remove impediments that impede an orderly resolution of the organization. It is clear that the US authorities are planning to use these permissions, where appropriate, to drive fundamental change in banks’ structure, strategy and operations to eliminate impediments to resolution of a SIFI. In February 2011, FDIC Chairman Sheila Bair reiterated her intention to eliminate the category of organizations ‘too big to fail’: “If [banks] can’t show they can be resolved in a bankruptcy-like process... then they should be downsized now… There is no reason in the world why they should get some special treatment backstop that other businesses in this country don’t have,” she said.2 Bair went on to suggest that large multinational banks with complex legal structures could be forced to simplify themselves: “The burden [will be] on them to show us that they don’t think they need subsidiarization. They need to give us a plan on how they can be resolved on an international basis without it.” Fundamental changes to business models could be required: “Far too many of them manage their businesses along business line as opposed to legal entity,” she said.3 Such proposals reach to the heart of the strategy and structure of

major financial services companies, and impact directly on the core responsibilities of boards of directors and senior management. They involve immensely sensitive issues of business models, corporate strategy, key economic functions, and internal and external dependencies. This process will impose much greater transparency on legal entity structures, costs, profitability and competitive advantage. The significance of recovery and resolution planning should not be under-estimated. Fundamental decisions and trade-offs will be required to meet strategic business objectives and regulatory expectations. The regulation on living wills becomes effective no later than 21 January 2012. Therefore, Boards of directors, chief executives, and the senior management of major banks and financial services companies all have the obligation now to engage with the issues raised by ‘living wills’ and lead the preparation of their organization’s response. While it may be tempting to wait until final details are determined, this could be a mistake. The reality is that, as in other areas of regulatory change, requirements will continue to evolve. The benefit of engagement now is that the well-prepared institution can be well placed to move quickly to comply with these new requirements and have key strategic decisions in place that will result in potentially significant competitive advantage gained over their less prepared rivals.

For more information please contact: Jon D Greenlee Managing Director, Financial Services Regulatory Center of Excellence, Americas region KPMG in the US T: +1 703 286 8032 E: jdgreenlee@kpmg.com

1. The Financial Crisis Inquiry Report: Final report of the national commission on the causes of the financial and economic crisis in the United States, January 2011 2. Speaking at the Reuters Future Face of Finance Summit, 28 February 2011 3. Speaking at the Reuters Future Face of Finance Summit, 28 February 2011

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© 2011 KPMG International Cooperative (“KPMG International”). KPMG International provides no client services and is a Swiss entity with which the independent member firms of the KPMG network are affiliated. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG. © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

The US Foreign Account Tax Compliance Act (FATCA) is likely to pose significant challenges for the banking sector. 28 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


FATCA: A looming challenge The US Foreign Account Tax Compliance Act (FATCA) is likely to pose significant challenges for the banking sector. The principal purpose of the Act is to compel foreign entities (over which the US does not generally have jurisdiction) to report information about foreign accounts held by US persons to the IRS. Gathering and reporting the large amounts of information required will be challenging. Also, because there are potentially hundreds of thousands of companies that will be subject to these new requirements, the impact will be truly global.

Laurie Hatten-Boyd

Iain Hebbard

The background According to the US Treasury, total foreign holdings of US securities have grown rapidly in the last few years1. Total US source income – income where the activity for which the payment is being made is in the US – was $139.6 million in tax year 2000 and $646.5 million in tax year 2007, an increase of 363 percent. This growth is of interest to the Internal Revenue Service (IRS) for two reasons: US taxpayers avoiding taxation by shielding their identity using foreign accounts; and foreign citizens benefiting from reduced rate of withholding that they may not be entitled to (US1441 regulations are in place to manage the latter). The Foreign Account Tax Compliance Act (FATCA) is an initiative to tighten sanctions against such offshore abuse by US taxpayers.2 FATCA is estimated to generate $800m annually, from global income earned by US taxpayers with undeclared accounts. The FATCA legislation is lengthy and complex and introduces an entirely new set of concepts in relation to US withholding and information reporting. The statute has provided the US Treasury Secretary with broad authority to relax or waive the FATCA requirements in certain instances. The detailed regulations, Frontiers in Finance / April 2011 / 29

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

According to the US Treasury, total foreign holdings of US securities have grown rapidly in the last few years.

that have not yet been published, are expected to define how widely the Treasury Secretary will exercise this authority; however, the IRS has released priority guidance setting forth the general framework to follow when implementing a FATCA-compliant business. The core principle of the Act is that ‘foreign financial institutions’ (FFIs) will need to identify the direct and indirect owners of their accounts to determine whether they are ‘US accounts’. To the extent they are, the FFI must disclose them to the IRS. FFIs that do not agree to do this will suffer a 30 percent withholding tax on all US withholdable payments, including gross sales proceeds. Specifically, to avoid the penal withholding, the FFI will have to enter into an agreement with the IRS to identify all US accounts held by it or its affiliates and report annually on each account. Further, the FFI will have to comply with any request for additional information regarding each account, as well as attempt to obtain from each account holder a waiver of any bank secrecy law that would otherwise prevent disclosure. If this proves impossible, the legislation provides that the account must be closed. The IRS could utilize the information collected under FATCA to identify potential instances of underreporting or fraud by US persons. FATCA broadens the definition of an FFI beyond the traditional view, to include hedge funds, private equity funds, and other collective investment vehicles, insurance companies that issue cash value products. The Challenge FATCA will come into force on 1 January 2013. While it may appear that this leaves ample time for preparation, timing is actually a significant concern for potentially impacted entities. Based on our conversations with USFIs and FFIs that intend to become participating

FFIs, most agree that it will take between 18 to 24 months to become FATCA-compliant. Estimates of the number of FFIs that will need to enter into disclosure agreements vary tremendously, with estimates anywhere between 100,000 and 700,000 entities. The question such institutions must ask themselves is whether they have the requisite information available for their account holders to determine their status under FATCA. Since all group companies must be included within the assessment, this initial review of the information available on account holders could take several months to complete, as institutions draw together data from disparate systems, and assess its quality and completeness. In order to be FATCA-compliant, companies will have to identify US persons that hold affected accounts or financial instruments on a direct and indirect basis – across the global business. Identifying and providing the relevant information to the IRS will pose a major challenge for the banking sector. Non-participation with the FATCA regime will be expensive and customer relationships will be at risk if clients who are not acting illegally are unnecessarily subject to withholding or have confidential account information inappropriately provided to the IRS. The challenge is greater for the ‘non-traditional’ entities brought within the FATCA framework. Many of these entities are not currently subject to the same regulatory requirements to obtain documentation under their local know-your-customer or anti-moneylaundering rules. As a result, the starting point for these entities is that all accounts are undocumented. They need to start gathering the information and developing the systems they will need to obtain, retain, and report the required information now. Looking ahead, institutions will need to adapt their customer on-boarding processes to ensure that the requisite information is collected at the outset

30 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


FATCA is estimated to generate $800m annually, from global income earned by US taxpayers with undeclared accounts. 1 1

Total US source income

363% $139.6m $646.5m increase from 2000–2007.

in tax year 2000.

in tax year 2007.

for all new customers, and that necessary systems changes are implemented to capture and present this information in a format that can be used to meet the future FATCA reporting requirements. The systems and operations implications may represent a significant undertaking for any institution with multiple customer platforms and legacy systems in place. Underpinning all of this will be a need for education programs for both customers and staff, ensuring that everyone is aware of what FATCA means and how it will impact them. The account identification, withholding, and reporting requirements under FATCA will impact several disciplines and processes, from IT and operations to the tax and regulatory departments. Allocating adequate resources to planning now can help lower the risks inherent in implementing the processes required to comply with the new law. Conclusion FATCA compliance will be a significant challenge for affected institutions over the next two years and beyond. This challenge is exacerbated given the estimated time it will take impacted entities to become FATCA-compliant (18–24 months) and the fact that proposed regulations are not anticipated until late 2011, with final regulations some time after that. Given this, it is

Internal Revenue Service FY 2012 Budget Re Passed as part of The Hiring Incentives to Re

imperative that potentially affected institutions begin now to analyze the impact of new laws, for example by conducting an impact analysis and developing plans to address the necessary changes to systems and processes so they will be in a position to comply with the new laws by 1 January 2013.

For more information please contact: Laurie Hatten-Boyd Principal, Tax KPMG in the US T: +1 206 913 4489 E: lhattenboyd@kpmg.com Iain Hebbard Senior Manager, Corporate Tax KPMG in the UK T: +44 11 7905 4163 E: Iain.hebbard@kpmg.co.uk

1. Internal Revenue Service FY 2012 Budget Request February 14, 2011 2. Passed as part of The Hiring Incentives to Restore Employment (HIRE) Act, 18 March 2011

Frontiers in Finance / April 2011 / 31 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

Rob Curtis

David Sherwood

Martin Noble

Evolving Insurance Regulation: On the move The insurance industry does not benefit from a single regulatory framework with the weight which the Basel Accords carry in the banking sector. However, the International Association of Insurance Supervisors issues global principles, standards and guidance papers which are moving in a parallel direction. Later this year, the Association will publish a new suite of Insurance Core Principles. Over the next few years, a wide range of new requirements will be introduced to tackle issues such as capital adequacy and risk management.

32 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Insurers coped relatively well with the financial crisis. A small number of global insurers and reinsurers encountered substantial difficulties through their participation in noninsurance activities, such as with their trading in structured credit products like collateralized debt obligations (CDOs) and credit default swaps. Monoline credit and bond guarantee insurers, which have a different business model from other insurers, also experienced significant losses from the general downturn in the economy and from their exposures to residential mortgagebacked securities and CDOs. For the life insurance sector, falls in the sale of unit-linked and single premium life insurance products were accompanied by average reductions in shareholder

capital of between 30–40 percent, with some companies suffering declines of up to 70 percent. Nevertheless, there were few institutional failures and little direct regulatory intervention, unlike in the banking sector. However, the crisis has nonetheless influenced the continuing process of regulatory reform. It has reinforced the need for renewed dialogue between regulators and the industry over effective regulation, supervision that delivers a risk-based approach to solvency, enhanced group supervision and greater cooperation among regulators. Greater harmonization of insurance regulation can already be seen. The International Association of Insurance Supervisors (IAIS) will introduce from October 2011 a new

70%

For the life insurance sector, falls in the sale of unitlinked and single premium life insurance products were accompanied by average reductions in shareholder capital of between 30–40 percent, with some companies suffering declines of up to 70 percent.

Frontiers in Finance / April 2011 / 33 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

The IAIS principles, standards and guidance apply to individual insurance supervisors who are members of the IAIS. National regulators are expected to implement the ICPs produced by the IAIS. The International Monetary Fund (IMF) is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.

suite of Insurance Core Principles (ICPs), which will have a significant impact on the form and extent of regulation globally. In Evolving Insurance Regulation, our insurance experts from the Regulatory Centers of Excellence examine the implications this will have for the future of the industry.1 Regulatory action and the IAIS Since the financial crisis, groups like the G20, Financial Stability Board (FSB) and Joint Forum have been active in reviewing the regulatory framework for banks, and such analysis has invariably flowed across to the insurance sector. The IAIS was established in 1994 with the broad aim of harmonizing international insurance regulatory requirements. It acts as a forum for insurance supervisors to discuss developments in the insurance sector and topics affecting insurance regulation. The IAIS has now grown to represent 190 insurance supervisory jurisdictions, and is the world-standard setter for insurance. The IAIS issues insurance principles, standards and guidance papers which apply to all member supervisory authorities. The IAIS also works closely with other standard setters such as the Basel Committee on Banking

Supervision and the International Accounting Standards Board; its core principles are endorsed by the International Monetary Fund and the World Bank. The IAIS principles, standards and guidance apply to individual insurance supervisors who are members of the IAIS. National regulators are expected to implement the ICPs produced by the IAIS. Lessons from the crisis A number of key lessons have been learned regarding existing inadequacies in solvency assessment. These include: regulatory focus being too concentrated at the microeconomic level and not enough being undertaken at a macro-level; lack of oversight and monitoring of non-regulated subsidiaries/activities; legal and legislative limitations on insurance group supervision; limitations in the quality and content of both regulatory structure and supervisory practice; lack of coordination of responsibilities/established coordination mechanisms between supervisors; and lack of effective tools to minimize regulatory arbitrage on a cross sector and cross border basis.

The IAIS has responded to the need for reform by accelerating their plans to promote common regulatory standards and cooperation. Common themes emerging from current international regulatory developments are: the move towards more risk-based approaches to capital and solvency measurement; a greater focus on risk management and governance; increased use of stress and scenario testing; and group supervision. Insurance supervisors are looking to harmonize these regulatory approaches by increasing cooperation and coordination of their activities by formal mechanisms, such as memorandums of understanding between one another and the development of a project within the IAIS to build a common framework for the supervision of internationally active insurance groups (IAIGs). Such initiatives at the international level complement the significant efforts by many jurisdictions in further strengthening their own local requirements. In Europe, Solvency II is driving further regulatory harmonization, and this could eventually be extended to non-EU countries, which is relevant

34 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


to the region’s insurance market through the concept of ‘equivalence’. However, in the short-term, broader cross-border mutual recognition of regimes is likely to remain limited, as few regions share the same degree of economic and political union. Countries such as the US are mindful of the changes and have commenced their own reforms such as the Solvency Modernization Initiative (SMI) where developments are more aligned to the IAIS’s new ICPs concerning solvency and group supervision mechanisms. In Asia Pacific, an area of significant focus for inward investment by many international insurance groups, regulators are very much aware of developments in risk and capital management in Europe and by the IAIS; most have already effected or are considering significant change. The crisis once again highlighted capital adequacy as a key concern for all regulators, and a renewed push for reform commenced. Globally, it is expected that supervisors will increasingly move to ensure insurers are adequately capitalized with riskbased capital requirements, will require valuations of assets and liabilities on a consistent and economic basis, and will increasingly allow the use of internal models. These will be subject to stringent standards and prior supervisory approval and will enable regulatory capital requirements to be calculated using insurers’ own internal models, which are a better reflection of their risks than a common standard formula. What are the implications? The introduction of the new IAIS ICPs in October 2011 will herald a significant new step in achieving international convergence and consistency in regulatory requirements. Covering

capital adequacy and internal models, enterprise risk management, investments, systems and controls and group supervision, they will have a profound impact on both insurance supervisors and the insurance industry. All supervisors will have to enact the requirements into their local supervisory frameworks. If they don’t, the relevant territory risks receiving an adverse finding from the IMF/World Bank who conduct the Financial Sector Assessment Program (FSAP) reviews. So, understanding the changing regulatory landscape has never been more important. Firms that are aware of such changes and actively involved in shaping the new reforms stand to gain a competitive advantage and will be best prepared to meet the new challenges ahead. Above all, the substantial regulatory changes now being implemented will further reinforce the underlying structural changes insurers are making to their business models, particularly in regards to: cultural change; improved and enhanced sophistication of tools being used for effective risk and capital management; enhancing the quality and timeliness of making better business decisions; and demonstrating the underlying value proposition to investors thereby attracting greater investment.

For more information please contact: Rob Curtis Director, Insurance Financial Services Regulatory Center of Excellence, EMA region KPMG in the UK T: +44 20 7694 8818 E: rob.curtis@kpmg.co.uk David Sherwood US Head of Insurance Regulatory Financial Services Regulatory Center of Excellence, Americas region KPMG in the US T: +1 212 954 5861 E: davidsherwood@kpmg.com Martin Noble Senior Manager, Insurance Financial Services Regulatory Center of Excellence, ASPAC region KPMG in China T: +852 2685 7817 E: martin.noble@kpmg.com 1. Evolving Insurance Regulation – On the move, KPMG International, March 2011

For more insight into the direction regulation is headed in, see KPMG International’s latest thought leadership on Evolving Insurance Regulation at www.kpmg.com

Regulation is clearly on the move: the challenge has been laid down to the sector as a whole. Understanding the changing regulatory landscape has never been more important. Firms that are aware of such changes and actively involved in shaping the new reforms stand to gain a competitive advantage and will be best prepared to meet the new challenges ahead.

Understanding the changing regulatory landscape has never been more important. Frontiers in Finance / April 2011 / 35 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

Basel 3 Time for banks to engage In response to the crisis, the Basel Committee on Banking Supervision’s new proposals (Basel 3) for strengthening capital and liquidity and ensuring a more resilient banking sector were endorsed by the G20 in Seoul. Much remains to be done to translate these measures into concrete legislation and regulation at a national level, and significant territorial differences are emerging. Nevertheless, all G20 nations have committed themselves to adopting Basel 3 by the end of 2011. All banks need to consider what the implications might be. 36 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-Ă -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Jane Leach

The G20 endorsed the new Basel 3 capital and liquidity requirements at its November 2010 Summit in Seoul. There are many areas of detail needing further development, and worldwide debate and lobbying will inevitably continue. However, the core principles are agreed, and banks need to start planning their responses.1 The key changes involve: improving the quality and transparency of banks’ capital base and tightening the definitions of Tier 1 and Tier 2 capital; improving resilience and reducing risk by specific measures on counter-party exposures; restricting dangerous levels of leverage; reducing procyclicality and encouraging the creation of counter-cyclical capital buffers; introducing a minimum liquidity standard. The enhanced capital ratios prescribed by Basel 3 will place increased pressure on compliance. The capital ratio requirement will increase; the eligibility of capital will be tightened, so reducing the amount of capital firms have to meet the required ratio; and the calculation of risk weighted assets (RWA) will change, leading to an increase for many organizations. It is difficult to estimate the precise impact on individual firms, but (Figure 1) shows the estimated possible percentage range of increases to the RWA arising from three of the key

Klaus Ott

Steven Hall

capital changes in Basel 3, together with some estimate of the percentage range of mitigation of the potential RWA increase that many believe might occur due to firm-wide actions. In addition, firms may face shortfalls in their long-term funding needs of up to 50 percent as a result of the new Net Stable Funding Ratio (NSFR) liquidity proposals. Despite a lack of absolute clarity over how these measures will be

Hugh Kelly

implemented locally, there is no time to waste. Experience from Basel II proved that early analysis, strategic evaluation and robust planning are all crucial to success. Firms must also remain flexible to adapt to subsequent changes and developments, with a number of other parallel policy initiatives being put in place, notably Recovery and Resolution Plans, enhanced college of regulator arrangements and continuing uncertainty over tax.

There are many areas of detail needing further development, and worldwide debate and lobbying will inevitably continue. However, the core principles are agreed, and banks need to start planning their responses.

Figure 1 Range of potential increases to RWAs and the possible range of mitigation to the RWA increases Mitigation Securitisation CVA/Counterparty Credit Risk Market Risk 0%

25%

50%

75%

100%

Source: KPMG International, 2010.

Frontiers in Finance / April 2011 / 37 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

Chief Officers: Issues to consider

Capital management Carry out appropriate scenario planning and impact assessments to ensure the development of a successful capital strategy. Identify which businesses have the most attractive fundamentals under Basel 3 – which businesses in your portfolio should you be considering exiting, growing or diverting? Ensure management is adequately incentivized to optimize use of capital. Define consistent, quantified capital objectives to apply throughout the group. Identify what levers can be pulled if needed to fine-tune/ lower capital consumption. Ensure your organization is geared up to deliver measurement and management of your capital position and requirements on a sufficiently timely basis. Consider how to address the pricing implications arising from changes in the capital requirements for certain products. Review whether the same business models continue under a different structure, minimizing capital penalties (e.g. branch versus subsidiary).

Liquidity management

General capital planning

Ensure you understand your current liquidity position in sufficient detail and know where the stress points are – e.g. how sticky are your retail and wholesale deposits?

Ensure you understand and charge businesses correctly for the capital costs of the business that they are doing, focusing your business model on ‘capital-light’ areas.

Ensure management is sufficiently incentivized to optimize use of liquidity. Are transfer pricing or other incentives in place?

Ensure that Basel 3 capital implications are taken into account for new business and consider how existing long-dated business can be revisited.

Consider the impact of new liquidity rules on profitability and whether it has been factored into key business processes and pricing. Check that liquidity planning, governance and modeling are in line with leading industry practice. Determine an appropriate series of liquidity stress tests and how these will change over time. Gain awareness of the likely implementation timetable for different elements of the global and national frameworks being proposed. Assess your liquidity strategy in light of the existing legal and regulatory structure of your organization and identify whether the systems, data and management reporting are adequate to meet the requirements.

Examine how non-core businesses, insurance subsidiaries and other financial institutions can be sold or restructured. Consider the introduction of external capital into specialist structure models to mitigate the capital impacts arising. Focus on Basel II implications as well as Basel 3, given that Basel 3 amplifies any increases in RWAs arising from Basel II. Examine the performance of your existing assessment methodologies (eg. IRB models). Review your existing data quality – are you missing out on the benefits from collateral information or improved re-rating of obligors due to inappropriate processes.

Prepare to be able to meet more accelerated implementation timescales if required.

In the medium term, many firms will be capital- and liquidity-constrained and so will need to focus on capital management, product and business pricing, capital inefficiencies that hang over from Basel II, and the structure of their liabilities. 38 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


What should banks be doing to mitigate the impacts? While these are early days, firms are hoping to be able to mitigate the impact on capital ratios through a variety of measures including: Improving the performance of existing assessment methodologies in internal ratings-based credit risk approaches and internal models market risk approaches: The increased capital ratios in Basel 3 will amplify any inefficiency in existing internal modeling approaches to determining credit risk and market risk RWAs. Firms will therefore benefit from a thorough review of current methods and any associated conservatism, together with a review of the data, inputs and systems that are used to populate such models. Legal entity reorganization to optimizes impact of capital deductions: Changes to the treatment of minority interests and investments in financial institutions within the definition of capital may encourage firms to withdraw from certain entities, dispose of certain stakes or buy out minority interest positions to optimize the capital calculation. Active balance sheet management and hedging strategies: Pressure on bank capital will drive investment in active capital management and active portfolio management, as banks review existing trades and consider how external protection, restructuring into other entities, or development of structured vehicles with investment from external third party capital may help to minimize or hedge counterparty and market risk exposure. Redesign of business model and portfolio focus: Some types of business (particularly in the trading book) will see significant increases in RWAs and therefore capital. Firms need to continue to review portfolio strategy and exit or re-price certain areas of business which become unattractive on a returns basis.

For more information please contact: Jane Leach UK Head of Basel 3 KPMG in the UK T: +44 20 7694 2779 E: jane.leach@kpmg.co.uk Klaus Ott Partner, Financial Services KPMG in Germany T: +49 69 9587 2684 E: kott@kpmg.com Steven Hall Director, Financial Risk Management KPMG in the UK T: +44 20 7311 5883 E: steven.hall5@kpmg.co.uk

Firms should ensure they are engaging with Basel 3 as soon as possible to put themselves in the best competitive position in the new post-crisis financial risk and regulatory landscape. Implications In the medium term, many firms will be capital and liquidity constrained and so will need to focus on capital management, product and business pricing, capital inefficiencies that hang over from Basel II, and the structure of their liabilities. As we have seen above, given the rise in capital ratios under Basel 3, previous inefficiencies will be amplified. Now is the time to address this and other key issues. The Basel 3 framework introduces another paradigm shift in capital and liquidity standards. Many elements remain unfinished, and on the face of it the final implementation date looks a long way off. However, market pressure and competitor pressure is already driving considerable change at a range of organizations. Firms should ensure they are engaging with Basel 3 as soon as possible to put themselves in the best competitive position in the new post-crisis financial risk and regulatory landscape.

Hugh Kelly Principal KPMG in the US T: + 202 533 5200 E: hckelly@kpmg.com

1. This article draws on an important KPMG report: Basel 3: Pressure is building… , KPMG International, December 2010

For more insight, see KPMG International’s latest thought leadership on Basel 3: Pressure is building at www.kpmg.com

Frontiers in Finance / April 2011 / 39 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

Keeping ahead of the curve Solvency II and the new IFRS for insurance contracts

40 / Frontiers in Finance / April 2011 Š 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à -vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Danny Clark

Joachim Kölschbach

Mary Trussell

As regulators and accounting standards bodies work to finalise Solvency II and the new IFRS for insurance contracts, insurers face a radically different reporting environment.

With the publication in summer 2010 of the Exposure Draft (ED) for a new IFRS for insurance contracts, the International Accounting Standards Board (IASB) took a major step forward in its journey to make insurers’ financial statements more comparable and transparent. Meanwhile, the European Commission and the European Insurance and Occupational Pensions Authority (EIOPA) are continuing to develop Solvency II, creating a single common framework for capital adequacy and risk management across the European Union (EU).

As early as 2004 the European Commission decided to use IFRS as the basis for the economic balance sheet under Solvency II. Together, Solvency II and IFRS represent a fundamental change in regulatory and financial reporting for insurance companies. And the challenge is not simply about compliance. The new metrics introduced by the regimes will transform the way insurers monitor and manage their business and communicate with their investors and other stakeholders. These changes provide a catalyst to implement a

comprehensive and more integrated financial and risk reporting framework. Achieving a consistent presentation of performance As early as 2004 the European Commission decided to use IFRS as the basis for the economic balance sheet under Solvency II.1 This aimed to reduce the burden of reporting and to provide greater comparability and transparency. Over time, the linkage between general purpose financial statements and capital adequacy has been weakened, partly because the respective timetables for Solvency II and the IASB’s Insurance Contracts standard have become decoupled and partly as the measurement of assets and liabilities for regulatory purposes has been refined. The links are still there however: many companies who took part in the European Commission’s Quantitative Impact Study 5 (QIS 5) found that there were few differences in principle other than in relation to capital instruments and technical provisions, which for current IFRS purposes may be measured on a very different basis from that tested under QIS 5. This gives encouragement to those companies hoping to integrate these measures in future. Reconciling the balance sheets produced under the two measures is in some ways the easy part. Arguably more useful is a rigorous understanding of how the two frameworks recognize

and report profits and losses. Perhaps surprisingly, the IASB’s proposed measurement model in the ED may lead to slower recognition of profit than for Solvency II because the proposals in the ED prohibit the recognition of day one gains on the inception of an insurance contract, whereas initial gains contribute immediately to own funds under Solvency II. A significant change for many insurers under the IASB’s proposal will be to move away from volume-based metrics (such as premiums and claims) towards an analysis of margins. Under this approach, the income statement is a bridge which reflects changes in value of assets and liabilities (typically, using current or market values) from one period to the next. Explanations will include the impact of discounting, the release of risk margins and changes in values arising from changes in markets. This more dynamic approach reflects a departure for financial reporting. A common feature shared by the IFRS proposals and Solvency II is increased volatility. This is in contrast with many existing financial reporting and regulatory frameworks where assumptions remain unchanged from period to period and prudential margins are held to buffer income statement volatility. Many insurers are finding navigating these unfamiliar and choppy waters unattractive: indeed some consider that these new measures Frontiers in Finance / April 2011 / 41

© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Special feature: Challenges of Regulatory Change

will place insurance reporting at the mercy of the ebb and flow of market movements and underwriting cycles, over which they have very limited control. It will be vital that management understand how their business responds in the face of market volatility and are able to explain this clearly to their stakeholders. Ultimately, this information should enhance the understanding of the risks the business faces and should act as an incentive to enhance ALM strategies and hedging programmes. Challenges in exploiting synergies As well as overlaps between Solvency II and IFRS Phase II in the measurement of technical provisions and other balances there are synergies in the models, systems, processes and test methods that are the foundation of both frameworks. At the heart of both lies the need to estimate the mean value of all future cash flows, a discount rate that reflects the time value of money and a risk adjustment that allows for uncertainties in the amount and timing of future cash flows. The similarities between the two regimes offer the promise of reporting systems and processes that have dual capability. Closer investigation reveals differences in detail that pose very real, and highly complex, practical and reporting challenges. These make it harder to exploit synergies when designing reporting processes to meet the demanding schedules imposed by Solvency II. In addition, both Solvency II and IFRS Phase II contain a number of areas which are still to be resolved that may increase or decrease their alignment. This includes fundamental issues such as the extent to which a consistent approach to the valuation of liabilities can be adopted for Solvency II and IFRS and how much of the proposed Phase II financial statement disclosures can be used as the basis for Solvency II reporting. Deadlines are approaching fast. While the detail of both frameworks is not yet set in stone, both are rapidly crystallizing.

Optimizing performance – the lessons for insurers Amid these challenges, one certainty is that both Solvency II and Phase II represent a radical departure from the status quo for insurers – and so reporting processes will be subject to significant change over the next few years. And these influences will be felt outside Europe. Many European headquartered groups have a global reach and many insurance regulators, including those outside Europe, are adopting a more dynamic and riskbased approach to supervision .

II and using this to generate their results under the new framework. Another useful exercise is to compare the results of QIS 5 – possibly updated for 2010 data – with results measured using the IFRS proposals – addressing, wherever possible, the direction of current tentative decisions on the likely outcome of a final standard. In this way insurers can achieve a good appreciation of the modelling issues and reporting requirements, as well as developing their understanding of the likely drivers of their future results. The impacts of Solvency II and IFRS Phase II will be many and varied, from staff incentives and training to control frameworks and internal reporting systems and processes. Depending on the final outcome of both regimes some insurers may even find the new rules driving fundamental changes to the structure and viability of product lines and aspects of their business model.

Many European headquartered groups have a global reach and many insurance regulators, including those outside Europe, are adopting a more dynamic and risk-based approach to supervision.

Optimizing performance – the lessons for regulators and standard-setters Insurers have juggled a confusing and varied array of financial and risk metrics for many years despite endeavors by some to arrange these into a balanced suite of metrics addressing profitability, value creation, cash generation and capital. There is a strong feeling in some companies that this complexity has increased their cost of capital and has made it hard to appeal to non-specialist investors. So is there more that standardsetters can do? We were struck by the words of the original Framework for Consultation: “In order to ensure convergence in financial and regulatory reporting, as well as to limit the administrative burden for supervised institutions, supervisory reporting should be compatible with accounting rules elaborated by the International Accounting Standards Board (IASB). This applies in particular to the techniques and methods used to calculate technical provisions (under Phase II of the IASB insurance project) … Disclosure requirements enhance market discipline and complement

There is no single right solution to project planning. A comprehensive implementation plan will be needed to manage dependencies and deliverables. The foundation is a review of existing systems, capabilities and competencies against known and emerging requirements in order to achieve clarity on the path to implementation, whether of Solvency II and IFRS, or of local developments. Having conducted such a review, some firms may go little further at the moment than developing detailed implementation plans and building their knowledge of the new regimes. Others may establish core systems and capabilities that will be needed whatever the detailed outcome – for example, some large firms are already building enhanced data collection and modeling systems required by Solvency

42 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


“Financial information is a vital part of the information that supervisors use to assess solvency and capital adequacy.To the extent that the same information can meet the common needs of supervisors and other users, it would be desirable for the information reported to supervisors to converge with the information reported in general purpose financial statements...”

requirements under Pillars I and II. The disclosure requirements should be in line with those elaborated by the IAIS and IASB in order to reduce the administrative burden for supervised institutions. They should also be compatible with disclosure requirements in the banking sector.” Of course, much water has flowed under the bridge since this was written in 2004. At the time the Framework was written, few knew that the global financial crisis was around the corner, although by late 2004 Nouriel Roubini had already started to write about a “nightmare hard landing scenario for the United States.”3 Solvency II has since been through many iterations as it has evolved to address the post global financial crisis world. Nevertheless, we believe that these axioms remain as valid in 2011, post-global financial crisis as they were in 2004. Perhaps even fewer commentators foresaw that Solvency II would leapfrog Phase II and overtake it. Nevertheless, the IASB also saw the benefits of a common approach to financial and risk reporting: “Financial information is a vital part of the information that supervisors use to assess solvency and capital adequacy. To the extent that the same information can meet the common needs of supervisors and other users, it would be desirable for the information reported to supervisors to converge with the information reported in general purpose financial statements …” In doing so, the Board will pay particular attention to the need for users of an insurer’s financial statements to receive relevant and reliable information, capable of preparation at a reasonable cost, as a basis for economic decisions. The information should enable users

to compare the financial position and financial performance of insurers within a country and in different countries. It should be comparable with information provided about similar transactions by entities that are not insurers.4 Again, we believe these principles remain valid today. As deliberations on the details of both Solvency II and Phase II enter their final phases we commend these sentiments to both the Board and EIOPA. An integrated and comprehensive approach to reporting that can deliver robust, credible and coherent output will be of immense value to management and other stakeholders – including the buyers of insurance. Insurance is an important social and economic benefit and to add to the cost of capital arguably disadvantages us all. Staying ahead of the curve – what is the most likely outcome? In practice the window for change to both regimes is now closing fast. Some insurers have been striving to develop a more coherent set of finance, risk and capital metrics within the constraints of diverse regulatory and reporting requirements for several years. Even if a fully integrated reporting and regulatory framework remains tantalisingly out of reach these steps will stand them in good stead as they plan for a future where reporting and supervisory frameworks, if not fully integrated, at least are more closely aligned. The changes introduced by Solvency II and the new insurance standard represent an opportunity to take stock and refresh the infrastructure on which their reporting is based. Leading companies are likely to want to develop an integrated reporting capability to address financial and risk

metrics under Solvency II and IFRS Phase II. This will give them an edge in decision-making, performance measurement and management and in delivering a credible story about the performance of and prospects for their business to regulators and investors. Excellence lies in analyzing the implications for how the business is run and, above all, identifying how these changes can be turned to competitive advantage.

For more information please contact: Danny Clark Associate Partner KPMG in the UK T: +44 20 7311 5684 E: danny.clark@kpmg.co.uk Joachim Kölschbach Partner KPMG in Germany T: +49 221 2073 6326 E: jkoelschbach@kpmg.com Mary Trussell Partner KPMG in China T: +852 2913 2563 E: mary.hm.trussell@kpmg.com

1. During 2004 and 2005, the Commission issued three waves of Calls for Advice to CEIOPS (the predecessor body to EIOPA), regarding different aspects of the new solvency system which was to become Solvency II. The Commission set out policy guidelines and principles to guide CEIOPS in its task in a document called the ‘Framework for Consultation’, which was published in July 2004. 2. See our recent publication Evolving Insurance Regulation – On the Move, March 2011 3. Nouriel Roubini’s seminal address to the IMF predicting a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession was made on 7 September 2006. (Source: Dr Doom by Stephen Mihm, The New York Times, 15 August 2008) 4. IASB Discussion Paper, Preliminary views on Insurance Contracts, May 2007

Frontiers in Finance / April 2011 / 43 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


/ Insights

Insights

KPMG member firms provide a wide-ranging offering of studies, analyses and insights on the financial services industry. For more information please go to www.kpmg.com/frontiersinfinance

Evolving Insurance Regulation March 2011 This global insurance thought leadership, developed by the Regulatory Centre of Excellence, takes a fresh look at the various regulatory reform initiatives in the insurance sector – what will the future regulatory landscape look like, and what implications does this have for insurance firms?

Benchmark survey on VAT/GST January 2011 KPMG International’s the Benchmark Survey on VAT/GST, shows that VAT/GST remains under-resourced, under-measured and undermanaged in most organizations. With this first-of-its-kind survey globally, VAT/GST performance can now be benchmarked globally based on real data obtained from over 100 global businesses.

Portfolio Investors – KPMG in India February 2011 On 28 February 2011 the Government of India presented the budget encompassing the revenue and expenditure in the strategic sectors for the upcoming financial year. This document focuses on the impact of key regulatory announcements, pertaining to the financial sector that were covered in the budget. It also summarizes the direct taxes, regulatory updates and developments across the financial services spectrum during the last fiscal year.

Delivering Australian Prosperity to 2020 December 2010 The way business and governments respond to challenges and emerging opportunities will determine Australia’s success, performance and future well-being. Working with clients across a diverse range of industry sectors and global economies means that KPMG is well placed to present ideas that could benefit the nation. In this publication, 12 of KPMG’s best thinkers came together to brainstorm the key issues challenging the countries’ ongoing economic well-being.

Evolving Banking Regulation: A marathon or a sprint? November 2010 KPMG International’s regulatory specialists investigate the changing regulatory landscape for banks, the challenges and implications of new developments and the future direction regulators are likely to take. This publication focuses on some of the key changes, including capital requirements, treatment of systemically important financial institutions, governance, supervision and remuneration.

Global Debt Sales – Portfolio Solution Group February 2011 The recent global credit crisis added new complexities and challenges for debt sales market participants as market dislocation reshaped the global status quo. This first edition of the report analyzes recent debt portfolio activity in a number of banking markets across Europe, Americas and APAC. It also looks at all types of debt sales and provides high-level insights into existing trends and new opportunities.

Staying Ahead of Public Policy and Regulatory Challenges – KPMG in the US February 2011 Within days of the November mid-term elections in the US, KPMG in the US launched a survey among C-class executives and board members to determine the impacts of today’s complex legislative and regulatory environment. A range of companies polled agreed that the pace and scale of change is not likely to diminish over the next 18 months. Read the full report to find out what changes companies are putting in place.

UK Banks: Performance Benchmarking Report, Full Year Results 2010 March 2011 This Report summarizes the 2010 annual results of Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland and Standard Chartered. It analyzes these results and identifies trends within the context of a changing political, regulatory and economic climate. It also offers insight as to what can be expected over the coming period.

44 / Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.


Foreword We spent much of the last issue of Frontiers in Finance trying to understand the potential impact of regulatory change, the impact of IFRS on insurance contracts and the banking sector and measures to tackle the critical issue of systemically important financial institutions (SIFIs). It will come as no surprise that regulation is once again one of our features. However, the emphasis is changing. As policymakers and regulators get to grips with the challenges – and dilemmas – of framing new controls for the global financial system, they are finding that it’s not as easy as it seems. On the other side of the fence, financial services firms are realizing that regulatory change will not only bring costs and burdens but also opportunity. As Jeremy Anderson argues in his keynote article, smart companies are already looking at how to strategically turn the new regulatory environment to their advantage and become best in class. KPMG firms pride ourselves on bringing clients market-leading analysis,

advice and service. To this end, we have created three regional Financial Services Regulatory Centers of Excellence – one each in Asia Pacific, Europe and the Americas – to draw together our regulatory expertise and focus it on supporting our firms’ clients. A note on this initiative kicks off our special regulatory feature in this issue, with other articles looking at the impact of FATCA, insurance regulation, Solvency II and Basel 3. We also update the SIFI debate with a view on recovery and resolution planning in the US. The theme for this edition is Your next move. We explore the key issues companies need to consider when embarking on major change. Debt sales and real estate investments are both asset classes whose attractiveness has been fundamentally upset by the crisis; we look at how they are faring now. I hope you find this issue of Frontiers of value.

insights /

Global financial services leadership team

Jeremy anderson Global chairman, financial services regional coordinating Partner EMA region KPMG in the UK t: +44 20 7311 5800 e: jeremy.anderson@kpmg.co.uk

S

ricardo anhesini souza regional coordinating Partner financial services Latin America region KPMG in Brazil t: +55 11 2183 3141 e: rsouza@kpmg.com.br

K t Kim Joint regional coordinating Partner financial services Aspac region KPMG in Korea t: +82 2 2112 0400 e: kkim1@kr.kpmg.com

David sayer Global sector Leader retail Banking KPMG in the UK t: +44 20 7311 5404 e: david.sayer@kpmg.co.uk

frank ellenbürger Global sector Leader insurance KPMG in Germany t: +49 89 9282 1867 e: fellenbuerger@kpmg.com

Alison Halsey Editor, Frontiers in Finance Partner, KPMG in the UK

Frontiers in Finance / April 2011 © 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG international. KPMG international provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG international have any such authority to obligate or bind any member firm. all rights reserved.

Bill Michael Head of financial services KPMG in the UK t: +44 20 7311 5292 e: bill.michael@kpmg.co.uk

Frontiers in Finance / April 2011 / 45 © 2011 KPMG International. KPMG international is a swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG international. KPMG international provides no client services. no member firm has any authority to obligate or bind KPMG international or any other member firm vis-à-vis third parties, nor does KPMG international have any such authority to obligate or bind any member firm. all rights reserved.


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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International. Produced by KPMG’s Global Financial Services Practice Designed by Mytton Williams Publication name: Frontiers in Finance Publication number: 314640 Publication date: April 2011 Printed on recycled material

April 2011

© 2011 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in the United Kingdom.


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