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    • Abstract: Response to BaselCommittee on BankingSupervisionConsultative proposals to strengthen the resilienceof the banking sector16 April 2010  Summary

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Response to Basel
Committee on Banking
Supervision
Consultative proposals to strengthen the resilience
of the banking sector
16 April 2010
 
Summary
Contents
1 Summary 2
2 Quality, consistency and transparency of capital 7
3 Leverage ratio 10
4 Accounting considerations 12
5 Procyclicality 16
6 Capital conservation 20
7 Counterparty credit risk 22
8 Liquidity 28
9 Systemic effects 33
10 Contacts 33
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Summary
1 Summary
1.1 Introduction
In this section we provide overarching comments and summarise our key observations and recommendations.
Our detailed comments in the following sections deal particularly with the capital proposals, with separate sections
devoted to other selected key aspects. We also comment on accounting considerations and the proposals on liquidity. In
the section on counterparty credit risk we also provide observations on the trading book amendments which were agreed
last year and that interact with the current proposals.
1.2 Overarching comments
We discuss the main aspects below and would like to make the following introductory comments:
 When taken separately, a good case can be made for each proposal. However, when we look at the package of
proposals as a whole we believe that the combined effect of the proposed higher requirements and the proliferation
of buffers are overly conservative and lack transparency.
 Underlying this, there is no discussion of what constitutes an appropriate level of capital in the financial system.
Basel II aimed to leave the overall level of capital at the level of Basel I, but at that time there was no explicit review
to establish whether this level was correct. The new proposals provide an opportunity to conduct a fundamental re-
appraisal of the overall required level of capital and we believe this opportunity should not be missed. Without such
a review, there is a general sense that more capital is required in the system as a whole but there is no supporting
research as to what the limit should be, above which inefficiencies result for banks, customers and the wider
economy.
 Capital is expensive and needs to be adequately compensated for investors to invest. This must be recognised
explicitly in the Committee’s deliberations and proposals. At the same time that returns on capital are being
reduced significantly through, for example, higher capital requirements together with higher liquidity requirements,
charges for deposit protection insurance and resolution funds, the industry is being asked to either de-lever or raise
more capital.
 The macroeconomic consequences of the proposals need to be carefully evaluated as does their calibration. As we
note at various points in our responses below, there are various issues where the risk of unintended consequences
needs to be carefully considered. We also question whether it is possible to carry out a ‘comprehensive impact
assessment’ in the first half of 2010, as suggested in the paper. The current QIS is gathering information to support
calibration. In some cases this can be done (e.g. definition of capital and market risk) as the proposals are concrete
– in others this is not yet the case as the rules are yet to be finalised.
 We are concerned about the current timescales for transition envisaged by the Committee. We believe it could be
potentially damaging to the economy to implement at speed given the direct effects of the proposals on, for
example, lending capacity to finance growth of the economy. While we believe that while it may be possible by
2012 to have developed consensus on potential changes and their calibration, successful implementation is likely
to be best accomplished over an extended period.
 The differing objectives of financial and regulatory reporting lead us to question whether one set of standards can
satisfy the requirements of shareholders and regulators. The Committee wishes to harmonise regulation with
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Summary
accounting standards but the differing objectives of financial statements, produced on a “going concern” primarily
for shareholders, and regulatory returns, which consider a “gone concern” basis will be challenging to reconcile.
The proposals need to reflect these points of principle.
1.3 Quality, consistency and transparency of capital
We agree that the existing definition of capital is flawed. In principle we support the strengthening of eligibility criteria for
Tier 1, the simplification of Tier 2 and the elimination of Tier 3. We also agree that the current ’8% total capital, or which at
least half Tier 1‘ should be replaced with explicit minima for core Tier 1, total Tier 1 and total capital.
We believe it is debatable whether all deductions from capital should be made from common equity as this contradicts the
distinction between going concern and gone concern. For example, certain items, such as deferred tax assets, can have
considerable value to an organisation as long as it is a going concern. Indeed accounting standards require an
assessment of recoverability before such assets can be recognised. On the other hand, we agree that items that are
constructs of consolidated accounts (such as goodwill) should be deducted.
Incidentally, in evaluating the impact of changes to capital ratios it will be important to present the comparisons
consistently in terms of ’old capital currency‘ and ’new capital currency‘. A 1% increase in the core Tier 1 ratio under
’Basel III‘ definitions is worth a lot more than a 1% increase under existing definitions.
As regards capital buffers, the proposals suffer from layered conservatism and propose a complex mechanistic approach.
On top of stricter rules for risk-weights, higher minimum capital ratios and a greater focus on core equity, the proposals
call for four buffers: (i) a counter-cyclical capital buffer; (ii) buffer ranges in which certain restrictions on capital
distributions will apply; (iii) additional buffers under the ‘macro prudential approach’ to be detailed later this year; and (iv)
possible additional capital buffers for ‘systemically relevant, cross-border institutions’.
We believe that a simpler approach should be developed that reflects higher minimum capital ratios and higher risk
weights for certain assets (as are proposed) as well as the factors mentioned above, but adopts a less ruthlessly additive
philosophy and leaves more room for regulator discretion.
We agree that there should be minimum Core Tier 1, Total Tier 1 and overall capital ratios for all banks. Each bank,
together with its supervisor, as part of its Pillar 2 assessment, should ascertain what additional capital level it requires to
cover a combination of:
(i) Planned business development, growth and distribution policy;
(ii) Normal market cycles; and
(iii) Stress.
and express this as a minimum capital ratio to be held over the cycle and a buffer which can be used to absorb stress
(this could be expressed as a capital ratio range).
In doing this the supervisor would clearly need to have regard to macro-prudential supervision and business cycle effects,
applied top down to systemically important banks, not embedded in a layered capital mechanism applied by every bank.
The supervisor’s focus in macro-prudential supervision should be on the quality of its own macro judgments and the wide
array of tools it at its disposal, not just implementing a complex capital buffer mechanism at a bank level.
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Summary
We believe that these capital buffers need to be institution-specific (via Pillar 2), not one-size-fits-all. Not only are all
institutions different (through, for example differences in business models, balance sheet structures, market contexts, risk
appetite, corporate organisation and governance), we believe that imposing a one-size-fits-all approach could have
adverse unintended consequences.
If buffers are set sufficiently high to cover the most risky institutions, a one-size approach would penalise low-risk
institutions and effectively force them to become more risky to get the required return on their capital. If set at a lower
level, then opportunities for arbitrage across different business models and markets can (and will) be exploited.
1.4 Leverage ratio
We agree in principle with the introduction of a leverage ratio, and we note that one of the probable causes of the recent
financial crisis was the relaxation of the leverage ratio for US broker-dealers (but not for banks) in 2004.
For many banks the leverage ratio (as proposed) could become the limiting constraint (as opposed to the target capital
ratios). In turn this could trigger de-leveraging that could have a significant macroeconomic impact. Therefore the
definition of the leverage ratio, its calibration and its interaction with accounting standards are vital issues to address.
Leverage ratios also need to be calibrated within the context of accounting standards (e.g. US GAAP and IFRS) and
business models (e.g. trading activities and retail banking).
There is also an important interaction with the higher levels of liquid assets to be held, which can inflate the leverage ratio
calculation for no good reason. We recommend that liquid assets be excluded from the calculation of the leverage ratio.
1.5 Accounting considerations
There is a very important interaction between the Committee’s proposals and changes being debated to accounting
standards. The accounting and prudential frameworks have different objectives. While accounting standards are aimed
at providing a ‘fairly presents’ view of the financial status of a institution, primarily in the eyes of the shareholders, i.e. an
objective assessment of a current situation on a going-concern basis, prudential regulators are concerned with the
stability of a financial institution and the financial system as a whole, plus increasingly the systemic risk posed by an
institution poses in the event of its failure.
As such, there is a natural conflict between accounting and regulatory world-views, specifically in the areas of
provisioning and asset valuation. The Committee needs to recognise openly the differing objectives and audiences of the
financial statements and the regulatory returns and rationalise similarities and differences of approach. We believe that it
is questionable whether one set of standards could meet both sets of objectives.
We recommend that the Committee and accounting standards bodies should seek to eliminate or minimize the effect of
any inconsistencies in their guidance except where necessary to reflect different objectives and audiences.
1.6 Procyclicality
Procyclicality cannot be eliminated from banks’ capital requirements, as this is neither possible nor desirable under a risk-
sensitive capital regime. Each bank is likely to take amore prudent line when markets are vulnerable, and even with
efforts to bring in more countercyclical measures we expect procyclical effects to remain. Countercyclical adjustments are
difficult to calibrate given the requirement for long runs of data to do so. We believe that it is essential to determine the
true impact of the procyclicality of minimum capital requirements via an ongoing study.
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In the meantime, any necessary adjustments could be undertaken under a potentially-reinforced Pillar 2 framework (as is
already the case in some jurisdictions).
This would also be in line with the recommendation of the Committee of European Banking Supervisors to include any
forward-looking capital buffers within the boundaries of the existing Pillar 2 framework;1, in particular it allows for flexibility
of application of the supervisory tools to take into account differences in individual institutions’ business models and the
sophistication and quality of their risk management frameworks.
1.7 Capital conservation
We do not favour a mechanical approach to setting capital conservation buffers. Where appropriate we recommend that
the supervisory evaluation of ICAAPs should be strengthened and the role of Pillar 2 given greater importance rather than
introducing formulaic rules. In particular, supervisors may wish to augment their current approach to Pillar 2 with
additional considerations regarding distributions. In addition, supervisors need to factor macro-prudential risks into their
Pillar 2 assessments for systemically important banks.
1.8 Counterparty credit risk
We support the Committee’s overall goal of improving transparency and orderly functioning of the derivatives markets in
order to mitigate the risks that banks can absorb in times of economic and/or market stress. However, we have
reservations regarding the severity of some of the proposals as well as the speed proposed for their implementation.
We believe that firms should continue to enjoy sufficient flexibility in developing and applying tools for managing risks that
are commensurate with their business profile rather than “fixing” industry-wide requirements that might also endanger a
level playing-field and could have unintended negative consequences for the end-users in the wider economy.
There are several aspects to the proposed framework that we believe require careful consideration prior to adoption of
the rules given (i) potentially ”excessive” capital buffering resulting from the combination of rules related to individual
areas and (ii) the need for further clarifications in the proposed methodology including the elimination of gaps.
We see many benefits in encouraging the use of central counterparties (CCPs). However, this creates a significant
concentration of risk in the industry: banks and regulators will have to deal with all the "monoculture" dangers that then
arise. Enhanced supervision of the CCPs and increased capital and liquidity requirements have a role to play, but the
wider risks around the CCP need very careful consideration. As others have commented, lender of last resort and implied
government support issues arise and these should be made transparent to the users and the governments.
In relation to the trading book, we recommend that BCBS emphasise in its guidance to supervisors that risk sensitivity
should be retained as a guiding principle and recognise that over-conservative capital allocations are potentially as
damaging to the future effectiveness of the prudential framework as under-measurement of risk.
We also recommend a detailed impact assessment of the combined capital and liquidity impact of the full suite of reforms
and proposals, specifically for trading book activity, and impact on financial markets.
1 Committee of European Banking Supervisors, Position paper on a countercyclical capital buffer, July 2009
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Summary
1.9 Liquidity
We see it as a high priority to complement the proposed quantitative liquidity requirements with efforts to harmonise the
international liquidity risk regulatory and supervisory frameworks.
We suggest that the quantitative measures be incorporated within the BIS ‘Principles for Sound Liquidity Risk
Management and Supervision’ so that the qualitative and quantitative requirements are both understood and applied
coherently. There is a risk that there will be a return to a ‘tick the box’ approach (both by banks and supervisors) if the
quantitative measures takes precedence over broader liquidity risk management principles. In addition, an overly
prescriptive approach has the potential to create systemic risk if it is applied uniformly. We believe that it is essential to
develop clear Pillar 2 liquidity requirements to address these issues.
1.10 Systemic effects
The present proposals focus on a bottom-up assessment of the capital and liquidity levels of individual banks rather than
considering the stability of the system as a whole in a structured way. There needs to be a move away from such a focus
on a mechanical capital regime and formulaic liquidity requirements and towards the use of a more balanced range of
regulatory tools. Raising capital levels should be a final option, not the first: more capital is usually not the answer, and it
may be a very expensive option for the local and global economies as well as the banks themselves.
Given that the overall aim of the proposals is to prevent systemic financial crises, the focus on the micro perspective
needs to be complemented with a clear view from the Committee of what is required from a macro perspective. We
suggest that the macro perspective should be considered from a number of angles including:
• Use of systemic tools;
• Oversight of market-wide macroeconomic indicators; and,
• Awareness of market distortions caused by regulation.
As an example of the use of the right tools, we would take the question of excessive credit growth. Here we support the
need to identify appropriate macro indicators and to take timely action. We recommend that the emphasis should be on
timely preventive action, not necessarily more capital buffers. We suggest that actions such as requiring the tightening of
underwriting standards and liquidity supervision would be a lot more effective than using the blunt and expensive
insurance of capital.
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Quality, consistency and transparency of capital
2 Quality, consistency and
transparency of capital
2.1 Introduction
We agree with the basis of your diagnosis, namely that the existing definition of capital is flawed in that regulatory
adjustments generally are not applied to common equity and that there is no harmonised and consistently defined list of
regulatory adjustments. We also agree with the concept of splitting capital into ‘going concern’ and ‘gone concern’ capital;
indeed, balance sheet and credit managers in the industry have been aware of this for many years.
In principle we support the strengthening of eligibility criteria for Tier 1, the simplification of Tier 2 and the elimination of
Tier 3. We agree that on a going concern basis it is only common equity that can absorb losses. We also agree that the
current “8% total capital, or which at least half Tier 1” should be replaced with explicit minima for core Tier 1, total Tier 1
and total capital. That is how the rating agencies and most prudent bankers look at capital ratios.
In evaluating the impact of changes to capital ratios it will be important to present the comparisons consistently in terms of
“old capital currency” and “new capital currency”. A 1% increase in the core Tier1 ratio under the “Basel III” definitions is a
worth a lot more than a 1% increase under existing definitions.
We believe it open for debate whether all deductions from capital should be made from common equity (para 73). This in
fact contradicts the efforts to make a clear distinction between going concern and gone concern. Particularly in the case
of assets that are deducted, it is relevant to assess whether the asset has any value in a ‘going concern’ context as
opposed to a ‘gone concern’ context. Certain items – such as deferred tax assets – can have considerable value to an
organisation as long as it is a going concern, as the term ‘going concern’ means that there is an expectation of a return to
profitability against which past tax losses can be offset. Indeed accounting standards require an assessment of
recoverability before such assets can be recognised. On the other hand, we do agree that items that are constructs of
consolidated accounts (such as goodwill, but subject to eliminating the relevant underlying RWAs) should be deducted.
2.2 Detailed comments and recommendations
Our views on the specific items listed are:
Stock surplus (§94) Agree, as this closes an existing loophole
Minority interest (§95) Agree that this is not available to support risks outside the subsidiary to which it relates. However, total
exclusion would be a significant and unwarranted barrier to banks opening up in territories where local
equity involvement is required or advantageous. As a result it should be clear that the proportion of RWAs
in the subsidiary in question should also be excluded from the capital adequacy computation.
Unrealised gains and losses (§96) We do not agree that these should never be adjusted for. Unrealised gains only exhibit loss-absorbing
characteristics against losses on the instruments to which they relate (e.g. an unrealised gain on an equity
cannot be used to absorb a credit loss, unless the equity can be sold to realise the gain – this is
appropriate only for liquid, trading positions).
We suggest that the inclusion of unrealised gains be limited to the capital required to be held against the
same items; losses should be fully deducted. We suggest that any unrealised gains on assets that are not
readily realisable should be excluded from capital. This would only apply to such items not held in the
trading book but available for sale.
This would only apply to items not held in the trading book or available for sale, as these are (1) marked to
market and (2) can be sold at any time.
Goodwill and intangibles (§97) Agree. Goodwill exists usually only at the consolidated level, whereas in periods of stress it is the legal
entity which matters. At the legal entity level, goodwill is usually a component of investment in
subsidiaries. Where the regulated entity is looked at on a consolidated basis, the goodwill should be
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Quality, consistency and transparency of capital
deducted. Where the regulated entity is looked at on a standalone basis, the component of investment in
subsidiaries which exceeds the book value of the subsidiaries’ tangible net assets at acquisition (i.e. the
proportion which is treated as goodwill in the consolidated accounts) should be deducted from core equity,
as is the practice of many supervisors today.
“Other intangibles” is too broad and needs to be clarified. For example, some jurisdictions have taken this
to include mortgage servicing rights, which are a purchased form of future cash flows (not dissimilar to
many other financial products). In other cases the embedded values of life policies are treated as
intangible. The Committee should be more specific as to what other intangibles covers. These could be
treated as RWAs, if necessary at a 1250% risk weight (or whatever percentage is commensurate with the
final decision on minimum capital levels), as this is cleaner and more transparent (see below).
Deferred tax assets (DTAs)(§98-99) While we agree that DTAs (except those that arise merely from timing differences) may not be recoverable
if a bank continues to make losses, full deduction from common equity is too severe, as it implies that
DTAs are not recoverable in a bank which is still a going concern. This is a typical example of a ‘gone
concern’ item, as DTAs will only be worthless if the bank goes into bankruptcy.
Treasury stock (§100) Agree – this does not represent capital
Unconsolidated investments in Agree with the “corresponding deduction approach”. This implies that for the standalone capital adequacy
financial entities (§101) assessment, any investment in excess of the net assets of the subsidiary (which is recognised as goodwill
in the consolidated accounts) should be deducted from core Tier 1.
Expected loss shortfall (§102-103) We agree that any shortfall should be deducted from equity, as this is where the expected losses will be
absorbed when they materialise. However, the Committee needs to ensure that the proposed approach is
aligned with possible accounting changes. We also note that under the current accounting proposals the
definition of EL is not the same as under Basel II. Most notably, the accounting proposals cover cumulative
EL whereas Basel II only includes one year’s EL. The Committee should clarify whether the existing EL
definition will remain at one year, or whether it will be aligned with the accounting rules when they change.
It is also not clear what will happen in the meantime for banks under the Standardised Approach for credit
risk, as these banks do not compute EL. The Committee could require banks to compute EL irrespective of
whether they are IRB banks. The basis for doing this would need careful consideration. Implementation in
less sophisticated banks could be by way of percentages set by the BCBS based on actual data from
relevant IRB banks in relevant economies, with an appropriate level of conservatism.
Cash flow hedge reserve (§104) While we can understand the logic of this, there may be an unintended consequence in that it may
discourage hedging, which is not to be recommended. However, this will need to be reconsidered to the
extent the accounting standard setters revise hedge accounting in the future.
Own liabilities (§105) Agree
Defined pension funds (§106) This area requires further clarification. A full pension fund obligation risk (i.e. effectively marking the fund
to market and adjusting the available capital for any surplus/shortfall) would lead to possibly unnecessary
and counter-productive pro-cyclical volatility in capital ratios. Supervisors could be required to adjust for
this in the Pillar 2 assessment.
The Committee should also clarify the treatment of liabilities. As written, the paper suggests that unfunded
pension fund liabilities should not be adjusted.
Remaining 50:50 deductions (§107) Agree that these should be removed and treated as 1250% risk-weighted assets instead – it makes
everything much neater.
However, the percentage may need to change, as 1250% reflects a minimum capital requirement of 8% -
to maintain the ‘dollar for dollar’ equivalence the percentage used here, and elsewhere in the existing
Basel II rules.
“Other” category of RWAs (Additional We also recommend that a fourth category of RWAs be added to the existing credit, market and
point not covered in the consultation operational risks. Currently, the ‘credit’ category includes all of the non-credit obligation assets such as
paper) fixed assets) which are not actually credit risk. These could be moved to a fourth category, “other”. The
1250% (or other percentage – see above) risk weighted assets for securitisation, equity exposures and
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Quality, consistency and transparency of capital
non-payment/delivery on non-DVP transactions would be included in credit RWAs, and the significant
investments in commercial entities in the ‘other’ category
Contingent capital (§91) We support the interest in the industry and of supervisors in the concept of contingent capital. However,
there is a risk here that a broad principles-based approach such as was previously adopted for hybrid
equity may lead (again) to a proliferation of different instruments. More fundamentally, it is not yet known
whether these new instruments will operate as designed in a future crisis, nor whether they will become
more attractively priced by the markets as more are issued. Some argue, for example, that as a bank
approaches the trigger level, this could have a destabilising effect on the share price, funding costs and
the bank’s ability to source new debt. This topic will benefit from ongoing monitoring and requires further
evaluation as to how contingent capital should be treated in a bank’s capital base.
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Leverage ratio
3 Leverage ratio
3.1 Introduction
We agree in principle with the introduction of a leverage ratio, and we note that one of (many) the probable causes of the
recent financial crisis was the relaxation of the leverage ratio for US broker-dealers (but not for banks) in 2004.
For many banks the leverage ratio (as proposed) could become the limiting constraint (as opposed to the target capital
ratios). It could thus impact business expansion plans for banks and in turn trigger de-leveraging that could have a
significant macroeconomic impact.
3.2 Comments
Repos and netting
We agree that repos are a form of borrowing (§§220-221), and that they should not be netted for the purposes of
determining the leverage ratio. However, we would point out that the current US leverage ratio follows the US accounting
treatment, which generally allows for netting of repos and derivative contracts with the same counterparty. The rules
under International Accounting Standards are different. When determining the actual percentage of the leverage ratio this
important distinction should be taken into account, as without netting the US ratio would need to be higher than it is today.
We note that any move to not allowing netting for the leverage ratio would tend to discourage banks from putting in place
netting agreements, where the leverage ratio is a binding constraint.
Derivatives
On derivatives, we do not believe the future value should be factored into the leverage ratio (§228). The leverage ratio is
by definition a non-risk-adjusted measure of current assets versus current borrowing. If adjustments for potential future
changes in value are to be included, there is no clear line between the present and the future, and risk assessments start
to work their way into the ratio. Banks should be free to take whatever measures they need to take to maintain their
current leverage ratios and not be arbitrarily penalised for assessments of future risks.
Off-balance-sheet items
We have a similar view on the 100% conversion factor for off-balance-sheet (OBS) items such as letters of credit and the
value of credit protection sold (§§230-235), as this does not take into account the practice only a small proportion of these
will become deliverable in the future. We agree that some limitation on OBS exposures is needed to prevent unwanted
leverage building up in this way (we note that the current US regime only reflects on balance sheet items), using a 100%
conversion factor is too severe and should be re-considered. As the leverage ratio is likely to become one of the most
important constraints on banks capital levels, adopting a 100% conversion factor makes these items identical to on-
balance sheet items, and this could have potential negative macro-economic effects as banks will effectively have to
charge their customers the same for a guarantee as they would, say, for an outright loan (as both will consume equal
amounts of capital).
Undrawn commitments
The proposed aggressive treatment of undrawn lending commitments would have a similar effect, particularly on the
ability of banks to provide corporates with the degree of potential borrowing capacity that they need. In addition, treating
unsettled and failed trades in the normal course of settlement with a 100% factor would have a major effect for brokerage
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Leverage ratio
firms. We recommend that for normal (i.e. short term) settlement periods these should be excluded. There are important
level-playing field issues between banks with and without trading books as the application of the same ratio to a trading
book with gross assets and liabilities appears impossible. Given Basel will not just be implemented for globally active
banks in most territories this issue needs to be considered by the Committee.
3.3 Recommendations
We recommend that the definition of the leverage ratio, its calibration and its interaction with accounting standards are
vitally important issues to be addressed before ratios are imposed.
There is an important interaction of the leverage ratio with the higher levels of liquid assets to be held, which can inflate
the ratio calculation. We recommend that liquid assets be defined (as in the liquidity proposals) and excluded.
We also question whether an identical leverage ratio level can be used for fundamentally different business models. For
example, there are clear differences between fully securitising mortgages and having them off balance sheet and a model
of funding them with mortgage-backed bonds but leaving them on balance sheet. We r


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