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Basel 3 June 2012



Basel iii Compliance Professionals Association (BiiiCPA) ...

Basel iii Compliance Professionals Association (BiiiCPA)

The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.

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Basel 3 June 2012 Basel 3 June 2012 Document Transcript

  • 1Basel iii Compliance ProfessionalsAssociation (BiiiCPA)1200G Street NW Suite800Washington, DC 20005-6705USA Tel:202-449-9750Web: www.basel-iii-association.comDear Member,Stresstestingisthemost important challengethismonth.PressReleasesBoard of Governorsof the Federal ReserveSystemFederal Deposit InsuranceCorporationOffice of the Comptroller of the CurrencyFor Immediate Release May 14, 2012Agencies Finalize Large Bank StressTesting GuidanceThe Federal ReserveBoard, the Office of the Comptroller of the Currency, and theFederal Deposit InsuranceCorporation on Monday issued final supervisory guidanceregardingstress-testingpractices at banking organizationswith total consolidatedassetsof more than $10billion.The guidance highlightsthe importance of stresstesting at banking organizationsasan ongoing risk management practicethat supports a banking organizationsforward-looking assessmentof its risks and better equips it to addressa range ofadverse outcomes.The recent financial crisisunderscored the need for banking organizationstoincorporate stresstesting into their risk management practices, demonstrating thatBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 2banking organizationsunprepared for particularly adverseeventsand circumstancescan suffer acute threats to their financial condition and viability.This guidance buildsupon previously issued supervisory guidance that discussestheusesand meritsof stresstesting in specific areasof risk management.The guidance outlinesgeneral principles for a satisfactorystresstesting frameworkand describesvariousstresstesting approaches and how stresstesting should be usedat variouslevelswithin an organization.The guidance alsodiscussesthe importance of stresstesting in capital and liquidityplanning and the importanceof strong internal governance and controlsaspart of aneffective stress-testingframework.The guidance does not implement the stresstesting requirements in the Dodd-FrankWall Street Reform and Consumer Protection Act (Dodd-Frank Act) or in the FederalReserveBoards capital plan rule that apply to certain companies, asthoserequirementshave been or are being implemented through separate proposals by therespective agencies.However, the agenciesexpect that banking organizationswith total consolidatedassetsof morethan$10billion would follow theprinciplesset forth in theguidance--aswell asother relevant supervisory guidance--whenconducting stresstesting inaccordancewith the Dodd-Frank Act, the capital plan rule, and other statutory orregulatoryrequirements.DEPARTMENT OF THE TREASURYOffice of the Comptroller of the CurrencyFEDERAL RESERVE SYSTEMFEDERAL DEPOSIT INSURANCE CORPORATIONSupervisory Guidance on StressTesting for BankingOrganizations with More Than $10Billion In TotalConsolidated AssetsAGENCIES: Board of Governorsof the Federal ReserveSystem (―Board‖ or―Federal Reserve‖);Federal Deposit InsuranceCorporation (―FDIC‖); Office of theComptroller of the Currency, Treasury(―OCC‖).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 3ACTION: Final supervisory guidance.SUMMARY: The Board, FDIC and OCC, (collectively, the ―agencies‖) areissuing this guidance, which outlines high-level principles for stresstesting practices,applicable to all Federal Reserve-supervised, FDIC-supervised, and OCC-supervisedbanking organizationswith more than $10billion in total consolidated assets.The guidance highlightsthe importance of stresstesting asan ongoing riskmanagement practice that supports a banking organization‘s forward-lookingassessment of itsrisks and better equips the organization to addressa rangeofadverse outcomes.DATES: This guidance will becomeeffective on July 23, 2012.I. BackgroundOn June 15, 2011, the agencies requested public comment on joint proposed guidanceon the useof stresstesting asan ongoing risk management practiceby bankingorganizationswith more than $10billion in total consolidated assets(the proposedguidance).The public comment period on the proposedguidance closed on July 29,2011.The agencies areadopting the guidance in final form with certain modificationsthatarediscussedbelow (the final guidance).Asdescribed below, this guidance does not apply to banking organizationswithconsolidated assetsof $10billion or less.All banking organizations should have the capacityto understand their risks and thepotential impact of stressful eventsand circumstances ontheir financial condition.The agencieshavepreviously highlighted theuseof stresstesting asameansto betterunderstand the range of a banking organization‘s potential risk exposures.The 2007- 2009financial crisisfurtherunderscoredtheneedfor banking organizationsto incorporate stresstesting into their risk management, asbanking organizationsunprepared for stressful eventsand circumstancescan suffer acutethreatsto theirfinancial condition and viability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 4The final guidanceisintendedto beconsistent with soundindustrypracticesandwithinternational supervisory standards.Building upon previously issued supervisory guidance that discussesthe usesandmeritsof stresstesting in specific areasof risk management, the final guidanceprovides principles that a banking organization should follow when conducting itsstresstesting activities.The guidance outlinesbroad principles for a satisfactorystresstestingframework and describesthe manner in which stresstesting should be employed asan integral component of riskmanagementthat isapplicable at variouslevels ofaggregation within a banking organization and that contributes to capital andliquidity planning.While the guidance is not intended to provide detailed instructionsfor conductingstresstesting for any particular risk or businessarea, the guidance describes severaltypesof stresstesting activitiesand how they may be most appropriately used bybanking organizationssubject to this guidance.The final guidance does not implement the stresstesting requirementsimposed bythe Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)onfinancial companies regulated by theOCC, FDIC, orBoardwithtotal consolidatedassetsof morethan $10billion or bytheBoard‘scapital plan rule on U.S. bank holdingcompanieswith total consolidated assetsequal to or greater than $50billion.The Dodd-Frank Act‘s stresstesting requirementsarebeing implemented throughseparatenoticesof proposedrulemaking by the respective agencies.The Board issued the final capital plan rule on November 22, 2011.In light of theserecent rulemaking efforts on stresstesting, the guidance providesbanking organizationswith principles for conducting their stresstesting activities to,among other things, ensure that thoseactivitiesare adequately integratedinto overallrisk management.The agencies expectsuch companies would follow the principles set forth in theguidance – aswell asother relevant supervisory guidance – when conducting stresstesting in accordance with statutory or regulatory requirements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 5II. Discussion of Comments on the Proposed GuidanceThe agencies received 17comment letterson the proposedguidance.Commentersincludedfinancial tradeassociations,bank holding companies, financialadvisory firms, and individuals. Commentersgenerally expressed support for theproposedguidance.However, several commentersrecommended changesto, or clarification of, certainprovisionsof the proposed guidance, asdiscussedbelow.In response to these comments, the agencies have clarified the principles set forth inthe guidance and modified the proposed guidance in certain respectsasdescribed inthis section.A. Scope of applicationThe proposed guidance would have applied to all banking organizationssupervised by the agencieswith more than $10billion in total consolidated assets.Specifically,- with respectto the OCC, thesebanking organizations would have includednational banking associationsand federal branchesand agencies;- with respect to the Board, these banking organizations would have included statemember banks, bank holding companies, and all other institutions for which theBoard is the primary federal supervisor;- with respectto the FDIC, thesebanking organizations would have included statenonmember banks and all other institutionsfor which the FDIC is the primaryfederal supervisor.The proposed guidance indicated that a banking organization shoulddevelop and implement itsstresstesting framework in a manner commensurate withitssize, complexity, business activities, and overall risk profile.Somecommenterssupported the total consolidated asset threshold (i.e., more than$10billion), but othersnoted the importance and value of stresstesting for smallerbanking organizations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 6Consistent with the proposed guidance, no supervised banking organization with $10billion or lessin total consolidated assetsis subject to this final guidance.The agencies believe that $10billion is the appropriate threshold for the guidancebasedon the general complexity of firmsabove this size.However, the agencies note that previously issued supervisory guidance applicable toall supervised institutions discussesthe useof stresstesting asa tool in certain aspectsof risk management—such as for commercial real estate concentrations, liquidity riskmanagement, and interest-rate risk management.The agencies receivedtwo commentssuggesting that the $10billion totalconsolidated asset threshold be measuredover a four quarter period in order tominimize thelikelihood that temporaryasset fluctuationswould trigger application ofthe guidance.The agencies donot establish an asset calculation methodology in the final guidance;however, banking organizationswith assetsnear the threshold should usereasonablejudgment and consider, in conjunction with their primary federal supervisor asappropriate, whether they should consider preparing to follow the guidance.Threecommentersexpressedconcern that foreign banking organizations (FBOs) arerequired to follow stresstesting guidelines established by their home countrysupervisorsand suggestedthat theagenciesgive consideration to thoserequirements.When developing the guidance, the agenciessought to ensurethat it would notintroduce inconsistencieswith internationally agreedsupervisory standards.The agencies recognize that an FBO‘s U.S. operations are part of the FBO‘s globalenterprisesubject to requirementsof itshome country.The agencies provided sufficient flexibility in the proposedguidance sothat theguidance could apply to varioustypes of organizations.In this final guidance, the agencies clarify that certain aspectsof the guidance maynot apply to U.S. branchesand agencies of FBOs (such asthe portionsrelatedtocapital stresstesting) or may apply differently (such asportionsrelated to governanceand controls).Supervisorswill take theseissuesinto consideration when evaluating the ability ofU.S. offices of FBOs to meet the principles in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 7Twocommentersexpressedconcern regarding the application of the proposedguidance to savingsand loan holding companies(SLHCs).They suggestedthat the Board issue separate guidance for SLHCs, astheseinstitutions would face adifferent set of stresstestingassumptionsand scenariosthanbanking organizations.The Board believes that the guidance is instructive to SLHCsto the samedegreeit isfor bank holding companies.The Federal Reserve became the primary federal supervisor for SLHCson July 21,2011, after the agencies published the proposed guidance for public comment butbefore the end of the comment period.While the Board recognizes that certain differencesdo exist betweenbank holdingcompanies and SLHCs, the Board believes the guidance containsflexibility adequateto accommodatethevariationsin size, complexity, businessactivities,and overall riskprofile of all banking organizationsthat meet the asset threshold.Thus, the guidance anticipatesthat each banking organization, including eachSLHC, would implement stresstesting in a manner consistent with itsown businessand risk profile.Similarly, one commenter advocated that the OCC proposeseparate guidance onstresstesting specifically tailored to savingsassociations.The OCC becamethe primary federal supervisor for federal savingsassociationsonJuly 21, 2011.While the OCC recognizesthat certain differencesdo exist betweennational banksand federal savings associations,the OCC notes that the final guidance containsflexibilityadequate to accommodate the variationsin size, complexity, businessactivities, and overall risk profile of all banking organizationsthat meet the assetthreshold.Thus, it is alsoexpectedthat eachfederal savingsassociation would implement theguidance consistent with itsown businessand risk profile.Several commentersrequestedclarification on the linkage between the stresstestingguidanceand the stresstesting requirementsin the Dodd-Frank Act.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 8In devising the guidance, the agenciesendeavored to ensure that the proposedandfinal guidance is consistent with the stresstesting requirementsunder theDodd-Frank Act and believe that the principles set forth in the final guidance areuseful when conducting the stresstestsrequired under theAct.Notably, the final guidance was framed broadly to inform a banking organization‘suse of stresstesting in overall risk management, not just stresstests required underthe Dodd-Frank Act.Dodd-F rank stress tes ts would generally be con sidered part o f anorgan ization‘s overall stresstesting framework asdescribed in thestresstesting guidance.B. StressTesting PrinciplesAsnoted above, the proposed guidance identified and included a discussion of fourkeyprinciples for a banking organization‘s stresstesting framework and relatedstresstest results, namely that:(1)Abanking organization‘s stresstesting framework should include activitiesandexercises that are tailored to and sufficiently capture the banking organization‘sexposures, activities, and risks;(2)An effective stresstesting framework employs multiple conceptually sound stresstesting activities and approaches;(3) An effective stresstesting framework is forward-looking and flexible; and(4)Stresstest resultsshould be clear, actionable, well supported, and informdecision-making.In the final guidance, the agencieshave incorporated a fifth principle specifying thatan organization‘s stresstesting framework should include strong governance andeffective internal controls.The elementsof the fifth principle had been set forth in sectionVI of the proposedguidance, and the fifth principle doesnot expand on this aspect of the proposedguidance.Rather, the agencies reorganized this discussion into a fifth principleBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 9in order to underscorethe importance of governance and controls asa key element ina banking organization‘sstresstesting framework.Asnoted above, commentersweresupportive of the principles-based approachandthe notion that a banking organization‘s stresstesting framework should beimplemented in amanner commensurate with factorssuchasthecomplexityand sizeof the organization.With more specific regard to the proposed principles, commenterssuggested that thefinal guidance addressthe standardization of stresstesting through the inclusion ofcommoncoefficients, models, or benchmarks.Thesecommentersexpressedconcernsthat banking organizationswould implementthe principles inconsistently and that standardization would help regulatorsconductcomparative analysesacrossfirms.Another commenter suggested that the agencies prescribe more detailed andintegrated stresstesting between different entities or businessunitswithin anorganization.The agencies did not modify the guidance in responseto thesecomments.Akey aspectof theguidanceis to provide organizationsflexibilityon how theydesigntheir individual stresstesting frameworks.Thus, each banking organization should design a specific stresstesting framework tocapturerisksrelevant to the organization.The agenciesbelieve that prescribingstandardized stresstestsin this guidancewouldhave its own inherent limitations and may not appropriately cover a bankingorganization‘s material risks and activities.In addition, commenterssuggested that the agenciesmandate public releaseofstresstesting resultsthrough the guidance.The agencies haveconsideredthesecomments, but do not believe the final guidanceis the appropriate place for such a requirement given itsbroader focus on bankingorganizations‘overall stresstesting frameworks.The agencies note, however, that banking organizationsmay be required to discloseinformation about their stresstests pursuant to other statutory, regulatory, orsupervisory requirements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 10Afew commentersstated that a banking organization should explain and justify thestresstesting methodologies it utilizes to itsprimary federal supervisor.The agencies note that supervisorswill examinefirms‘stresstesting methodologiesthrough the supervisory process.One commenter noted that the guidance should explicitly indicate that liabilitiesshould be part of a banking organization‘s stresstesting activities; the agenciesintended that stresstesting activities would takean organization‘s liabilities intoaccount and have clarifiedthis in the final guidance.Threecommenterssuggestedthat operational risk be specifically referencedin theguidance.In response,the agencieshave clarified in the final guidance that operational riskshouldbe among the risksconsideredby an organization‘s stresstestingframework.Another commenter expressed concern that the frequency of stresstesting andcommunication of resultsmight eventually desensitize senior management to them.The agenciesbelieve that regular review of stresstest resultsis useful – both duringperiodsof economic downturn and benign periods– and have clarified that suchreview can help a banking organization track over time the impact of ongoingbusinessactivities, changesin exposures, varying economic conditions, and marketmovementson itsfinancialcondition.Aside from the inclusion of a fifth principle asdescribedabove, the agencies haveotherwiseadopted the proposed principles in the final guidance with only minoradditional refinements.C. Stresstesting approachesand applicationsThe proposed guidance describedcertain stresstesting approaches andapplications– scenario analysis, sensitivity analysis, enterprise-wide testing, andreversestresstesting – that a banking organization could consider using within itsstresstesting framework, asappropriate.The proposed guidance provided that each banking organization should apply theseapproaches and applicationscommensurate with itssize, complexity, and businessprofile, and may not need to incorporate all of the details described in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 11Somecommentersquestioned the appropriatenumber and typesof stresstestapproaches an organization should utilize.The agencies donot believe that specifying a number or particular typesofapproaches–including thenumberof scenarios–isappropriatein theguidancegiventhe wide range of stresstesting activities that different banking organizationsmayundertake.Abanking organization should choosethe approaches that appropriatelyconsider theunique characteristics of that particular organization and the relevant risksit faces.The agencies expectthat stresstesting methodologies will evolve over time asbanking organizationsdevelop approaches that best capture their individual riskprofiles.In addition, the proposed guidance described reversestresstesting asa tool thatwould allow a banking organization to assumea known adverse outcome, such assuffering a credit lossthat causesit to breach a minimum regulatory capital ratio orsuffering severe liquidity constraintsmaking it unable to meet its obligations, andthen deduce the typesof eventsthat could lead to such an outcome.This type of stresstesting may help a banking organization to consider scenariosbeyond itsnormal businessexpectationsand seetheimpact of severesystemic effectson the banking organization.It also would allow a banking organization to challengecommon assumptionsaboutitsperformanceand expected mitigation strategies.Three commenters expressed doubts regarding the effectiveness of reverse stresstesting, as the approach could produce resultsof questionable value and capturesunlikely, ―extreme‖ scenarios.The agencies reiterate the value of reversestresstesting, asit helpsa bankingorganization evaluate the combined effect of several typesof extremeeventsandcircumstancesthat might threaten the survival of the banking organization, even if inisolation eachof the effects might be manageable.Another commenter expressedconcern that the resultsof severescenariosused forreversestresstesting would directly lead to a supervisory requirement to raise capitalif the resultsof the approach were unfavorable to the organization.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 12In addition, some commenterssought clarification that resultswould not be used byregulatorsto criticize banking organizations.As stated in the proposed guidance, a given stress test result will not necessarily leadto immediate action by a firm, and in some casesstress test results – including thosefrom reversestresstests – aremost useful for the additional information they provide.In termsof supervisory responsesto an organization‘s stresstesting activities, theagencies expectto consider a banking organization‘s stresstest resultsand theappropriatenessof itsoverall stresstesting framework, along with all other relevantinformation, in assessingabanking organization‘s riskmanagement practices, aswellasitscapital and liquidity adequacy.The guidance setsforth supervisory expectationsfor prudent risk managementpractices and a firms decision not to follow the principles in this guidance will beexaminedaspart of the supervisory processand maybe cited asevidence of unsafeand unsound practices.D. Stresstesting for assessing adequacy of capital and liquidityGiven the importance of capital and liquidity to a banking organization‘sviability,stresstesting should be applied to thesetwo areason a regular basis.Stresstesting for capital and liquidity adequacyshould be conducted in coordinationwith a banking organization‘s overall businessstrategy and annual planning cycles.Resultsshould be refreshedin theevent of major strategic decisions, or other changesthat can materially impact capital or liquidity.An effective stresstesting framework should explorethe potential for capital andliquidity problemsto ariseat the sametime or exacerbateone another.Abanking organization‘sliquidity stressanalysis should explore situationsin whichthe banking organization maybe operating with a capital position that exceedsregulatoryminimums, but is nonethelessviewed within thefinancial marketsor by itscounterpartiesasbeing of questionable viability.For itscapital and liquidity stresstests, a banking organization should articulateclearlyitsobjectivesfor apost-stressoutcome, forinstanceto remain aviablefinancialmarket participant that is able to meet itsexisting and prospective obligationsandcommitments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 13In responseto comments received on the planning horizon for stresstests, theagencies clarifiedthat whilecapital stresstestsshould generally be conducted with ahorizon of at least two years, organizationsshould recognize that the effectsof certainstressconditionscould extend beyond that horizon.The agencies havealsoclarified, in responseto comments, that consolidated stresstests should account for the fact that certain legal entities within the consolidatedorganization arerequired to meet regulatorycapital requirements.Acommenter requested clarification on whether capital and liquidity stresstestingshould be evaluated in unified or separate stresstests.The proposed guidance did not specify the precisemanner in which capital andliquidity stresstestsshould be performed.The final guidance notes that assessing the potential interaction of capital andliquidity can be challenging and maynot be possible within a single stresstest, soabanking organization should explore several avenuesto assessthat interaction.In any case, the agenciesbelievethat stresstesting for both liquidity and capitaladequacyshould be an integral part of a banking organization‘s stresstestingframework.E. Governance and controlsAsnoted under the new fifth principle of the final guidance, a bankingorganization‘s stresstesting framework will be effective only if it issubject to stronggovernanceand controlsto ensure that the framework functionsasintended.Strong governance and controls alsohelp ensure that the framework contains coreelements, from clearly defined stresstesting objectives to recommended actions.Importantly, strong governance provides critical review of elementsof the stresstesting framework, especially regarding key assumptions, uncertainties, andlimitations.Abanking organization should ensurethat thestresstesting framework isnot isolatedwithin a banking organization‘s risk management function, but is firmly integratedintobusiness lines, capital and asset-liabilitycommittees, and other decision-makingbodies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 14Aspart of their overall responsibilities, a banking organization‘s board and seniormanagementshould establish acomprehensive, integratedand effective stresstestingframework that fits into the broader risk management of the banking organization.Stresstesting resultsshould be used to inform the board about alignment of thebanking organization‘s risk profile with the board‘s chosen risk appetite, aswell asinform operating and strategic decisions.Stresstesting resultsshould be considered directly by the board and seniormanagement for decisions relating to capital and liquidity adequacy.Senior management, in consultation with the board, should ensure that the stresstesting framework includesa sufficient rangeof stresstesting activities applied at theappropriatelevels of thebanking organization (i.e., not just oneenterprise-widestresstest).Several commentersraised concernsregarding the proposedresponsibilities of abanking organization‘s board of directorswith respectto stresstests and theframework.One commenter believed that the board of directorsshould not review all stresstestresults, but rather only thosethat wereexpected to have a material impact on theoverall organization.Another commenter expressed the belief that the board of directorsshould beinvolved in providing direction and oversight regarding the banking organization‘sstresstesting framework, but that the board of directorsshould not be expectedto beinvolved directly in more operational aspectsof the framework.The agencies havemodified the final guidance to clarify that senior management, notthe board of directors, should have the primary responsibilityfor stresstestingimplementation and technical design.However, the agenciesemphasize that a banking organization‘s board of directorsshould be provided with information from senior management on stresstestingdevelopments(including the processto design tests and develop scenarios) and onstresstesting results(including from individual tests, wherematerial).Asa general matter, the board of directorsis alsoresponsible for monitoringeffectiveness of the overall framework, and using the resultsto inform their decisionmaking process.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 15In addition, the final guidance specifiesthat senior management should, inconsultation with the board of directors, review stresstesting activities and resultswith an appropriately critical eye to ensure that thereis objective review and that thestresstesting framework includesa sufficient range of stresstesting activitiesappliedat the appropriate levels of the banking organization.Finally, in responseto comments, the agencies have clarified that a bankingorganization‘s minimum annual review and assessmentof the effectivenessof theirstresstesting framework should ensure that stresstesting coverage is comprehensive,tests are relevant and current, methodologies aresound, and resultsare properlyconsidered.IV. Administrative Law MattersA. Paperwork ReductionAct AnalysisIn accordance with the Paperwork Reduction Act (―PRA‖) of 1995 the agenciesreviewed the final guidance. The agencies may not conduct or sponsor, and anorganization is not required to respond to, an information collection unless theinformation collection displays a currently valid OMB control number.While the guidance is not being adopted asa rule, the agenciesdetermined thatcertain aspectsof the guidance may constitute a collection of information and,therefore, believed it washelpful to publish a burden estimate with the guidance.In particular, the aspectsof the guidance that mayconstitute an informationcollection are the provisions that state a banking organization should(i)Havea stresstesting framework that includesclearly defined objectives,well-designedscenarios tailored to the banking organization‘s businessand risks,well-documentedassumptions, conceptually sound methodologies to assesspotentialimpact on the banking organization‘s financial condition, informative managementreports, and recommendedactionsbased on stresstest results;and(ii)Havepolicies and proceduresfor a stresstesting framework.The agenciesestimated that the above-described information collectionsincluded inthe guidance would takerespondents, on average, 260hourseach year.The frequency of information collection is estimatedto be annual. Respondentsarebanking organizationswith more than $10billion in total consolidated assets, asdefined in the guidance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 16The agencies receivedthree comment lettersregarding the paperwork burden of theguidance, stating that implementation will require a multiple of the 260estimatedhours.The agencies emphasize that the guidance doesnot implement the stresstestingrequirementsimposedby the Dodd-Frank Act or the Board‘s capital plan rule, anddoesnot otherwiseimposemandatorystresstesting requirements.The burden of information collections associatedwith mandatory stresstestswill beaccountedfor in the respective rules that implement thoserequirements.In addition, the agenciesbelieve that in somerespects, the information collectionelements of this guidance augment certain expectationsthat already are in placerelative to certain existing supervisory guidance.The burden estimatesfor this guidance take into consideration only thosecollectionsof information, such asdocumentation of policiesand proceduresand relevantreports, that are specific to this guidance.Basedon these factors, the agencies believe the burden estimatesincluded in theproposedguidance continue to be appropriate.V. Final supervisory guidanceThe text of the final supervisory guidance is asfollows:Office of the Comptroller of the CurrencyFederal ReserveSystemFederal Deposit InsuranceCorporationGuidance on StressTesting for Banking Organizations withTotal Consolidated Assets of More Than $10BillionI. IntroductionAll banking organizations should have the capacityto understand fully their risksandthepotential impactof stressfuleventsand circumstancesontheirfinancial condition.The U.S. federal banking agencies have previously highlighted the useof stresstesting asa meansto better understand the rangeof a banking organization‘spotential risk exposures.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 17The 2007-2009 financial crisis underscored the need for banking organizationstoincorporate stresstesting into their risk management practices, demonstrating thatbanking organizationsunprepared for stressful eventsand circumstancescan sufferacutethreatsto their financial condition and viability.The Federal Reserve, the Office of the Comptroller of the Currency, and the FederalDeposit InsuranceCorporation (collectively, the ―agencies‖) are issuing thisguidance to emphasize the importanceof stresstesting asan ongoing riskmanagement practice that supports banking organizations‘forward-lookingassessment of risksand better equips them to addressa range of adverseoutcomes.This joint guidance is applicable toall institutionssupervised by the agencies withmore than $10billion in total consolidated assets.Specifically, with respect to the OCC, thesebanking organizationsinclude nationalbanking associations, federal savings associations,and federal branchesandagencies;with respectto the Board, these banking organizationsinclude statemember banks, bank holding companies, savings and loan holding companies, andall other institutionsfor which the Federal Reserveis the primaryfederal supervisor;with respectto the FDIC, these banking organizations include state nonmemberbanks, state savings associationsand insured branches of foreign banks.The guidance doesnot apply to any supervisedinstitution below the designated assetthreshold.Certain other existing supervisoryguidance that applies to all supervised institutionsdiscussestheuseof stresstesting asa tool in certain aspects of risk management,such asfor commercial real estate concentrations, liquidity risk management, andinterest-rate risk management.However, noinstitution at orbelow $10billion in total consolidatedassetsis subjecttothis final guidance.Building upon previously issued supervisory guidance that discussesthe usesandmeritsof stresstesting in specific areasof risk management, this guidance providesbroad principles a banking organization should follow in conducting its stresstestingactivities, such asensuring that thoseactivitiesfit into the organization‘soverall riskmanagement program.The guidanceoutlinesbroadprinciplesfor a satisfactorystresstesting framework anddescribesthe manner in which stresstesting should be employed asan integralcomponent of risk management that isapplicable at variouslevelsof aggregationBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 18within a banking organization, aswell asfor contributing to capital and liquidityplanning.While the guidance is not intended to provide detailed instructionsfor conductingstresstesting for any particular risk or businessarea, the document describes severaltypesof stresstesting activitiesand how they maybe most appropriately used bybanking organizations.II. Overview of StressTesting FrameworkFor purposesof this guidance, stresstesting refersto exercisesused to conduct aforward looking assessment of the potential impact of variousadverse eventsandcircumstances ona banking organization.Stresstesting occursat variouslevelsof aggregation, including on an enterprise-widebasis.Asoutlined in section IV, thereare several approachesand applicationsfor stresstesting and a banking organization should consider the useof eachin itsstresstesting framework.An effective stresstesting framework provides a comprehensive, integrated, andforwardlooking set of activities for a banking organization to employalong with otherpractices in order to assist in the identification and measurement of its material risksand vulnerabilities, including thosethat maymanifest themselves during stressfuleconomic or financial environments, or arise from firm-specificadverseevents.Sucha framework should supplement other quantitative risk management practices,suchasthosethat rely primarily on statistical estimatesof risk or lossestimatesbasedon historical data, aswell asqualitative practices.Inthismanner, stresstestingcanassist in highlighting unidentified orunder-assessedrisk concentrationsand interrelationships and their potential impact on the bankingorganization during timesof stress.Abanking organization should develop and implement itsstresstesting framework ina manner commensurate with its size, complexity, businessactivities, and overall riskprofile.Its stresstesting framework should include clearly defined objectives, well-designedscenarios tailored to the banking organization‘s businessand risks, well-documentedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 19assumptions, sound methodologies to assesspotential impact on the bankingorganization‘s financial condition, informative management reports, ongoing andeffective review of stresstesting processes,and recommendedactionsbasedon stresstest results.Stresstesting should incorporate the useof high-quality data and appropriateassumptionsabout the performance of the institution under stressto ensure that theoutputsarecredible and can be used to support decision-making.Importantly, a banking organization should have a sound governanceand controlinfrastructure with objective, critical review to ensurethe stresstesting framework isfunctioning asintended.Astresstestingframework shouldallow abanking organizationto conduct consistent,repeatable exercisesthat focus on its material exposures, activities, risks, andstrategies, and alsoconduct ad hoc scenariosasneeded.The framework should consider the impact of both firm specificand systemic stresseventsand circumstancesthat arebased on historical experience aswell asonhypothetical occurrencesthat could have an adverseimpact on a bankingorganization‘s operations and financial condition.Banking organizationssubject to this guidance should develop policies on reviewingand assessing the effectivenessof their stresstesting frameworks,and usethosepolicies at leastannually to assessthe effectivenessof their frameworks.Suchassessmentsshould help to ensure that stresstesting coverageiscomprehensive, tests are relevant and current, methodologies are sound, and resultsareproperly considered.III. General StressTesting PrinciplesAbanking organization should develop and implement an effective stresstestingframework aspart of its broader risk management and governance processes.The framework should include severalactivitiesand exercises, and not just relyonanysingle test or type of test, since every stresstest haslimitations and relieson certainassumptions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 20The usesof a banking organization‘s stresstesting framework should include, but arenot limited to,- augmenting risk identification and measurement;- estimating businessline revenuesand lossesand informing businesslinestrategies;- identifying vulnerabilities, assessing the potential impact from thosevulnerabilities, and identifying appropriate actions;- assessing capital adequacyand enhancing capital planning; assessing liquidityadequacyand informing contingency funding plans;- contributing to strategic planning;- enabling senior management to better integrate strategy, risk management, andcapital and liquidity planning decisions; and assistingwith recoveryandresolutionplanning.This section describes general principles that a banking organization should apply inimplementing such a framework.Principle 1:A banking organization‘s stress testing framework should include activities andexercises that are tailored to and sufficiently capture the banking organization‘sexposures, activities, and risks.An effective stresstesting framework coversa banking organization‘s full set ofmaterial exposures, activities, and risks, whether on or off the balancesheet, basedoneffective enterprise-widerisk identification and assessment.Risksaddressedin a firm‘s stresstesting framework mayinclude (but are not limitedto) credit, market, operational, interest-rate, liquidity, country, and strategic risk.The framework should also addressnon-contractual sourcesof risks, such asthoserelated to a banking organization‘s reputation.Appropriate coverage is important asstresstesting resultscould give a false senseofcomfort if certain portfolios, exposures, liabilities, or businessline activitiesare notincluded.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 21Stresstesting exercisesshould be part of a banking organization‘s regular riskidentification and measurementactivities.For example, in assessingcredit risk a banking organization should evaluate thepotential impact of adverseoutcomes, such asan economic downturn or decliningasset values, on the condition of its borrowersand counterparties, and on the value ofany supporting collateral.Asanother example, in assessing interest-raterisk, banking organizations shouldanalyze the effects of significant interest rate shocks or other yield-curve movements.An effective stresstesting framework should be applied at variouslevelsin thebanking organization, such asbusinessline, portfolio, and risk type, aswell ason anenterprise-wide basis.In many cases, stresstesting may be moreeffectiveat businessline and portfoliolevels, asa higher level of aggregation may cloud or underestimate the potentialimpact of adverse outcomeson a banking organization‘s financial condition.In somecases,stresstesting can also be applied to individual exposuresorinstruments.Eachstresstest should be tailored to the relevant level of aggregation, capturingcritical risk drivers, internal and external influences,and other key considerationsatthe relevant level.Stresstesting should capturethe interplay among different exposures, activities, andrisksand their combined effects.While stresstesting several typesof risks or business linessimultaneously may proveoperationally challenging, abanking organization should aim to identify commonriskdrivers acrossrisk types and businesslines that can adverselyaffect itsfinancialcondition.Accordingly, stresstests should provide a banking organization with the ability toidentify potential concentrations – including thosethat may not be readily observableduring benign periodsand whose sensitivity to a common set of factorsis apparentonly during timesof stress– and to assessthe impact of identified concentrations ofexposures, activities, and riskswithin and acrossportfoliosand businesslinesand onthe organization asa whole.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 22Stresstesting should be tailored to the banking organization‘s idiosyncrasies andspecificbusinessmix and include all major business linesand significant individualcounterparties.For example, a banking organization that isgeographically concentrated maydetermine that a certain segment of itsbusiness maybe more adverselyaffectedbyshocksto economic activity at the state or local level than by a severe nationalrecession.On the other hand, if the banking organization hassignificant global operations, itshould consider scenariosthat have an international component and stressconditionsthat could affect the different aspectsof itsoperations in different ways, aswell asconditionsthat could adverselyaffect all of its operations at the sametime.A banking organization should use its stress testing framework to determine whetherexposures, activities, and risks under normal and stressed conditionsare aligned withthe banking organization‘s risk appetite.Abanking organization can usestresstesting to help inform decisions about itsstrategic direction and/ or risk appetite by better understanding the risksfrom itsexposuresorof engaging in certain businesspractices.For example, if a banking organization pursuesa businessstrategyfor a new ormodified product, and the banking organization doesnot have long-standingexperience with that product or lacks extensivedata,the banking organization can usestresstesting to identify the product‘s potentialdownsides and unanticipated risks.Scenarios used in a banking organization‘s stresstestsshould be relevant to thedirection and strategy set by itsboard of directors, aswell assufficiently severe to becredible to internal and external stakeholders.Principle 2:An effective stresstesting framework employsmultiple conceptually sound stresstesting activities and approaches.All measuresof risk, including stresstests, have an elementof uncertaintydue toassumptions, limitations, and other factorsassociatedwith using past performancemeasuresand forward-looking estimates.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 23Banking organizationsshould, therefore, usemultiple stresstesting activities andapproaches (consistent with section IV), and ensure that eachis conceptually sound.Stresstestsusually varyin design and complexity, including the number of factorsemployed and the degreeof stressapplied.Abanking organization should ensure that the complexity of any given test doesnotundermine itsintegrity, usefulness, or clarity.In somecases, relativelysimple testscan be very useful and informative. Additionally,effective stresstesting relies on high-quality input data and informationto produce credible outcomes.A banking organization should ensure that it hasreadily available data and otherinformation for the types of stress tests it uses, including key variables that driveperformance.In addition, a banking organization should have appropriate managementinformation systems(MIS) and data processesthat enable it to collect, sort,aggregate, and update data and other information efficiently and reliably withinbusinesslines and acrossthe banking organization for usein stresstesting.If certain data and information are not current or not available, or if proxies are used, abanking organization should analyze the stresstest outputs with an understanding ofthosedata limitations.Abanking organization should alsodocument the assumptionsused in itsstresstestsand note the degreeof uncertainty that maybe incorporated into the tools used forstresstesting.In somecases, it maybe appropriate to present and analyze test resultsnot just intermsof point estimates,but also including the potential margin of error or statisticaluncertaintyaround the estimates.Furthermore, almost all stresstests, including well-developed quantitative testssupported by high-quality data, employ a certain amount of expert or businessjudgment, and the role and impact of such judgment should be clearly documented.In somecases,when credible data are lacking and more quantitative tests areoperationally challenging or in the early stagesof development, a bankingBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 24organization may choose to employ more qualitatively based tests, provided that thetests are properly documented and their assumptionsaretransparent.Regardlessof the type of stresstests used, a banking organization should understandand clearly document all assumptions, uncertainties, and limitations, and provide thatinformation to usersof the stresstesting results.Principle 3:An effective stresstesting framework is forward-looking and flexible.Astresstesting framework should be sufficiently dynamic and flexible to incorporatechangesin a banking organization‘s on- and off-balance-sheet activities, portfoliocomposition, asset quality, operating environment, businessstrategy, and other risksthat mayariseover time from firm-specificevents, macroeconomic and financialmarket developments, or some combination of theseevents.Abanking organization should also ensure that itsMISare capable of incorporatingrelatively rapid changesin exposures, activities, and risks.While stresstesting should utilize available historical information, a bankingorganization should look beyond assumptionsbased only on historical data andchallengeconventional assumptions.Abanking organization should ensure that it is not constrained by past experienceand that it considersmultiple scenarios, even scenarios that have not occurredin therecent past or during the banking organization‘shistory.For example, a banking organization should not assumethat if it hassuffered no orminimal lossesin a certain businessline or product that such a pattern will continue.Structural changesin customer, product, and financial marketscanpresentunprecedented situations for a banking organization.Abanking organization with any type of significant concentration can be particularlyvulnerable to rapid changesin economic and financial conditionsand should trytoidentify and better understand the impact of thosevulnerabilitiesin advance.For example, the risksrelated to residential mortgageswere underestimatedfor anumber of yearsleading up to the 2007-2009financial crisis by a large number ofbanking organizations, and thoserisks eventually affectedthe banking organizationsin a variety of ways.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 25Effective stresstesting can help a banking organization identify any suchconcentrationsand help understand the potential impact of several key aspectsof thebusinessbeing exposedto common drivers.Stresstesting should be conducted over various relevant time horizonsto adequatelycapture both conditionsthat may materialize in the near term and adverse situationsthat take longer to develop.For example, when a banking organization stresstests a portfolio for market andcredit risks simultaneously, it should consider that certain credit risk lossesmay takelonger to materialize than market risk losses, and alsothat the severity and speed ofmark-to-market lossesmay createsignificant vulnerabilitiesfor the firm, even if amore fundamental analysis of how realized lossesmay play out over time seemstoshow lessthreatening results.Abanking organization should carefully consider the incremental and cumulativeeffectsof stressconditions, particularly with respectto potential interactionsamongexposures, activities, and risksand possible second-order or ―knock-on‖ effects.In addition to conducting formal, routine stresstests, a banking organization shouldhavetheflexibility to conduct new or ad hoc stresstestsin a timely mannerto addressrapidly emerging risks.Theselessroutine tests usually can be conducted in a short amount of time and maybe simpler and lessextensivethan a banking organization‘s more formal, regulartests.However, for its ad hoc tests a banking organization should still have the capacitytobring together approximated information on risks, exposures, and activities andassesstheir impact.More broadly, a banking organization should continue updating and maintaining itsstresstesting framework in light of new risks, better understanding of the bankingorganization‘s exposuresand activities, new stresstestingtechniques, and anychangesin itsoperating structureand environment.Abanking organization‘sstresstesting development should beiterative, with ongoingadjustmentsand refinementsto better calibratethe tests to provide current andrelevant information.Banking organizationsshould document the ongoing development of their stresstesting practices.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 26Principle 4:Stresstest resultsshould be clear, actionable, well supported, and informdecision-making.Stresstesting should incorporate measuresthat adequately and effectively conveyresultsof the impact of adverse outcomes.Suchmeasuresmayinclude, for example, changesto asset values, accounting andeconomic profit and loss, revenue streams, liquidity levels, cash flows, regulatorycapital, risk-weightedassets,the loan lossallowance, internal capital estimates, levelsof problem assets, breachesin covenantsor keytrigger levels, or other relevantmeasures.Stresstest measuresshould be tailored to the type of test and the particular level atwhich the test isapplied (for example, at the businessline or risk level). Some stresstests mayrequire using a range of measuresto evaluate the full impact of certainevents, such asa severesystemic event.In addition, all stresstest resultsshould be accompanied by descriptive andqualitative information (such askey assumptionsand limitations) to allow userstointerpret the exercisesin context.The analysis and the processshould be well documented sothat stresstestingprocessescan be replicatedif need be.Abanking organization should regularly communicate stresstest resultstoappropriate levels within the banking organization to foster dialogue around stresstesting, keep the board of directors,management, and staff apprised, and to informstresstesting approaches, results, and decisions in other areasof the bankingorganization.Abanking organization should maintain an internal summaryof test resultstodocument at a high level therangeof itsstresstesting activitiesand outcomes, aswellasproposedfollow-up actions.Regular review of stresstest resultscan be an important part of a bankingorganization‘s ability over time to track the impact of ongoing businessactivities,changesin exposures, varying economic conditions, and market movementson itsfinancial condition.In addition, management should review stresstesting activities on a regular basis todetermine, among other things, the validity of the assumptions, the severityof tests,Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 27the robustnessof the estimates, the performanceof any underlying models, and thestability and reasonablenessof the results.Stresstest resultsshould inform analysis and decision-making related to businessstrategies, limits, risk profile, and other aspectsof risk management, consistent withthe banking organization‘s established risk appetite.Abanking organization should review the resultsof itsvariousstresstests with thestrengthsand limitationsof each test in mind (consistent with Principle 2),determines which resultsshould be given greater or lesser weight, analyze thecombined impact of its tests, and then evaluate potential coursesof action based onthat analysis.Abanking organization may decide to maintain itscurrent coursebased on testresults;indeed, the resultsof highly severe stresstests need not alwaysindicate thatimmediateactionhas to be taken.Wherever possible, benchmarking or other comparative analysis should be used toevaluatethe stresstesting resultsrelative to other tools and measures– both internaland external to the banking organization – to provide proper context and a check onresults.Principle 5:An organization‘s stresstesting framework should include strong governance andeffective internal controls.Similar to other aspectsof itsrisk management, a banking organization‘sstresstesting framework will be effective only if it is subject to strong governance andeffective internal controls to ensure the framework is functioning asintended. Stronggovernanceand effective internal controls help ensure that the framework containscoreelements, from clearly defined stresstesting objectives to recommendedactions.Importantly, strong governance providescritical review of elementsof the stresstesting framework, especially regarding key assumptions, uncertainties, andlimitations.Abanking organization should ensurethat thestresstesting framework isnot isolatedwithin a banking organization‘s risk management function, but is firmly integratedintobusiness lines, capital and asset-liability committees, and other decision makingbodies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 28Along thoselines, theboard of directorsand senior managementshould play keyrolesin ensuring strong governance and controls.The extent and sophistication of a banking organization‘s governance over its stresstesting framework should align with the extent and sophisticationof that framework.Additional details regarding governance and controls of an organization‘s stresstesting framework areoutlined in section VI.IV. StressTesting ApproachesandApplicationsThis section discussessomegeneral typesof stresstesting approaches andapplications.For any type of stresstest, banking organizationsshould indicate thespecific purposeand the focus of the test.Defining the scopeof a given stresstest isalsoimportant, whether it applies at theportfolio, businessline, risk type, or enterprise-wide level, or even just for anindividual exposureor counterparty.Basedon the purposeand scope of the test, different stresstesting techniques aremost useful.Thus, a banking organization should employ several approaches andapplications;these might include scenario analysis, sensitivity analysis,enterprise-wide stresstesting, and reversestresstesting.Consistent with Principle 1, banking organizations should apply thesecommensuratewith their size, complexity, and businessprofile, and may not need to incorporate allof the details describedbelow.Consistent with Principle 3, banking organizations should also recognizethat stresstesting approaches will evolve over time and they should update their practices asneeded.ScenarioAnalysisScenario analysis refersto a type of stresstesting in which a banking organizationapplies historical or hypothetical scenariosto assessthe impact of various eventsandcircumstances, including extremeones.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 29Scenarios usually involve somekind of coherent, logical narrativeor ―story‖ asto whycertain eventsand circumstances canoccur and in which combination and order,such asa severe recession, failureof a major counterparty, lossof major clients,natural or man-made disaster, localized economic downturn, disruptionsin fundingor capital markets,or a sudden change in interestratesbrought about by unfavorableinflation developments.Scenario analysis can be applied at various levels of the banking organization, such aswithin individual businesslinesto help identify factorsthat could harm thosebusinesslinesmost.Stressscenariosshould reflect a banking organization‘s unique vulnerabilitiestofactorsthat affect itsexposures, activities, and risks.Forexample,if abanking organization is concentratedin aparticularlineof business,such ascommercial real estateor residential mortgage lending, it would beappropriate to explorethe impact of a downturn in thoseparticular market segments.Similarly, a banking organization with lending concentrations to oil and gascompaniesshould include scenariosrelated to the energysector.Other relevant factorsto be considered in scenario analysis relateto operational,reputational and legal risksto a banking organization, such assignificant eventsoffraud or litigation, or a situation when a banking organization feels compelled toprovide support to an affiliate or provide other types of non-contractual support toavoid reputational damage.Scenarios should be internally consistent and portray realistic outcomesbased onunderlying relationshipsamong variables, and should include only thosemitigatingdevelopmentsthat areconsistent with the scenario.Additionally, a banking organization should consider the best manner to try tocapturecombinationsof stressful eventsand circumstances, including second-orderand ―knock-on‖ effects.Ultimately, a banking organization should select and design multiple scenariosthatarerelevant to itsprofile and make intuitive sense, use enough scenariosto explorethe range of potential outcomes, and ensure that the scenarioscontinue to be timelyand relevant.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 30Abanking organization may apply scenario analysis within the context of itsexistingrisk measurement tools (e.g., the impact of a severedeclinein market prices on abanking organization‘s value-at-risk (VaR) measure) or useit asan alternative,supplemental measure.Forinstance, abanking organization mayusescenario analysis to measuretheimpactof a severe financial market disturbance and comparethoseresultsto what isproduced by its VaR or other measures.This type of scenario analysis should account for known shortcomingsof other riskmeasurementpractices.For example, market risk VaR models generally assumeliquid marketswith known prices.Scenario analysis could shed light on the effects of a breakdown in liquidity and ofvaluation difficulties.Oneof the keychallengeswith scenario analysisis to translatea scenariointobalancesheet impact, changesin risk measures, potential losses, or other measuresofadversefinancial impact, which would vary depending on the test design and the type ofscenario used.For someaspectsof scenario analysis, banking organizationsmayuseeconometric orsimilartypesof analysis to estimatea relationship betweensomeunderlying factorsordrivers and risk estimatesor lossprojectionsbased on a given data set, and thenextrapolateto seethe impact of more severeinputs.Careshould be taken not to make assumptionsthat relationshipsfrom benign ormildly adversetimeswill hold during more severe timesor that estimatingsuchrelationshipsis relativelystraightforward.For example, linear relationships betweenrisk drivers and lossesmaybecomenonlinear during timesof stress.In addition, organizations should recognize that therecan be multiple permutationsof outcomesfrom just a few key risk drivers.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 31Sensitivity AnalysisSensitivityanalysis refersto a banking organization‘s assessment of itsexposures,activities, and risks when certain variables, parameters,and inputsare―stressed‖ or―shocked.‖Akey goal of sensitivity analysis is to test the impact of assumptionson outcomes.Generally, sensitivity analysis differsfrom scenario analysis in that it involveschanging variables, parameters,or inputs without an explicit underlying reasonornarrative, in order to explorewhat occursunder a range of inputsand at extremeorhighly adverselevels.In this type of analysis a banking organization may realize, for example, that a givenrelationship is much more difficult to estimate at extremelevels.Abanking organization may apply sensitivity analysis at variouslevelsof aggregationto estimate the impact from a change in one or more key variables.The resultsmayhelp abanking organization better understand therangeof outcomesfrom some of its models, such asdeveloping a distribution of output based on avarietyof extremeinputs.For example, a banking organization may chooseto calculatea range of changesto astructured security‘s overall value using a range of different assumptions about theperformanceand linkageof underlying cash flows.Sensitivityanalysis should be conducted periodically due to potential changesin abanking organization‘s exposures, activities, operating environment, or therelationship of variables to one another.Sensitivityanalysis can also help to assessa combined impact on a bankingorganization of several variables, parameters,factors, or drivers.For example, a banking organization could better understand the impact on itscreditlossesfrom a combined increase in default ratesand a decrease in collateral values.Abanking organization could also explore the impact of highly adversecapitalizationrates, declines in net operating income, and reductionsin collateral when evaluatingitsrisks from commercial real estateexposures.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 32Sensitivityanalysis canbe especially useful becauseit is not necessarily accompaniedby a particular narrative or scenario; that is, sensitivity analysis can provide bankingorganizationsmoreflexibility to explore the impact of potential stressesthat theymaynot be able to capturein designed scenarios.Furthermore, banking organizationsmay decide to conduct sensitivity analysis oftheir scenarios, i.e., choosing different levels or paths of variables to understand thesensitivities of choices made during scenario design.For instance, banking organizationsmay decide to apply a few different interest-ratepathsfor a given scenario.Enterprise-Wide StressTestingEnterprise-widestresstestingisanapplication ofstresstestingthatinvolves assessingthe impact of certain specified scenarioson the banking organization asa whole,particularly with regard to capital and liquidity.Asis the casewith scenario analysis moregenerally, enterprise wide stresstestinginvolves robust scenario design and effective translation of scenarios into measuresofimpact.Enterprise-widestresstests canhelp abanking organization in itseffortsto assesstheimpact of its full set of risks under adverse eventsand circumstances, but should besupplementedwith other stresstests and other risk measurementtools given inherentlimitations in capturing all risksand all adverseoutcomesin one test.Scenario design for enterprise-wide stresstesting involvesdeveloping scenariosthataffect the banking organization asa whole that stem from macroeconomic,market-wide, and/or firm-specificevents.Thesescenariosshould incorporate the potential simultaneousoccurrenceof bothfirm-specific and macroeconomic and market-wide events, considering system-wideinteractionsand feedback effects.For example, price shocks may lead to significant portfolio losses, rising fundinggaps, a ratings downgrade, and diminished accessto funding.In general, it is a good practiceto consult with a large set of individualswithin thebanking organization – in variousbusiness lines, researchand risk areas– to gain awide perspectiveon how enterprisewide scenarios should be designed and to ensureBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 33that the scenarioscapturethe relevant aspectsof the banking organization‘s businessand risks.Banking organizations should alsoconduct scenariosof varying severityto gauge therelative impact.At least somescenarios should be of sufficient severityto challengethe viability of thebanking organization, and should include instantaneousmarket shocksand stressfulperiodsof extended duration (e.g., not just a one or two-quarter shock after whichconditionsreturn to normal).Selectionof scenario variables is important for enterprise-wide tests, because thesevariables generally serveasthe link betweenthe overall narrative of the scenario andtangible impact on the banking organization asa whole.For instance, in aiming to capture the combined impact of a severe recession and afinancial marketdownturn, abanking organizationmaychoosea set of variables suchaschangesin grossdomesticproduct(GDP), unemployment rate,interestrates,stockmarket levels, or home price levels.However, particularly when assessing the impact on the whole banking organization,usingalargenumber of variables can makea test morecumbersomeand complicated– soa banking organization mayalsobenefit from simpler scenarios or from thosewith fewervariables.Banking organizations should balance the comprehensivenessof contributingvariables and tractability of the exercise.Aswith scenario analysis generally, translating scenariosinto tangible effectson thebanking organization asa whole presentscertain challenges.Abanking organization should identify appropriate and meaningful mechanismsfortranslating scenariosinto relevant internal risk parametersthat provide a firm-wideview of risks and understanding of how these risksaretranslated into lossestimates.Not all businessareasare equally affected by a given scenario, and problemsin onebusinessareacan have effects on other units.However, for anenterprise-widetest, assumptionsacrossbusinesslinesand riskareasshould remain constant for the chosen scenario, since the objective is to seehow thebanking organization asa whole will be affectedby a common scenario.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 34Reverse StressTestingReversestresstesting is a tool that allows a banking organization to assumea knownadverseoutcome, suchassuffering a credit lossthat breachesregulatorycapital ratiosor suffering severeliquidity constraintsthat render it unable to meet its obligations,and then deduce the typesof eventsthat could lead to such an outcome.This type of stresstesting may help a banking organization to consider scenariosbeyond itsnormal businessexpectationsand seetheimpactof severesystemic effectson the banking organization.It also allows a banking organization to challenge common assumptionsabout itsperformanceand expected mitigation strategies.Reversestresstesting helps to explore so-called ―break the bank‖ situations, allowinga banking organization to set aside the issue of estimating the likelihood of severeeventsand to focus more on what kinds of eventscould threaten the viability of thebanking organization.This type of stress testing also helps a banking organization evaluate the combinedeffect of several types of extreme events and circumstances that might threaten thesurvival of the banking organization, even if in isolation each of the effects might bemanageable.For instance, reversestresstesting may help a banking organization recognize that acertain level of unemployment would have a severe impact on credit losses,that amarket disturbance could createadditional lossesand result in rising funding costs,and that a firm-specificcaseof fraud would causeeven furtherlossesand reputationalimpact that could threaten a banking organization‘s viability.In somecases, reversestresstestscould reveal to a banking organization that―breaking the bank‖ isnot asremote an outcome asoriginally thought.Given the numerouspotential threats to a banking organization‘s viability, theorganization should ensurethat it focusesfirston thosescenariosthat havethelargestfirm-wide impact, such asinsolvency or illiquidity, but also on thosethat seemmostimminent given the current environment.Focusing on the most prominent vulnerabilitieshelpsa banking organizationprioritize its choice of scenariosfor reversestresstesting.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 35However, a banking organization should alsoconsider a widerrange of possiblescenarios that could jeopardize the viability of the banking organization, exploringwhat could representpotential blind spots.Reversestresstesting can highlight previously unacknowledgedsourcesof risk thatcould be mitigated through enhanced risk management.V. StressTesting for Assessing theAdequacy of Capital andLiquidityThere are many usesof stresstesting within banking organizations.Prominent amongthesearestresstestsdesignedto assesstheadequacyof capital andliquidity.Given the importance of capital and liquidity to a banking organization‘sviability,stresstesting should be applied in thesetwo areasin particular, including anevaluation of theinteractionbetweencapital and liquidity and thepotential for both tobecomeimpaired at the same time.Depletionsand shortagesof capital or liquidity can causea banking organization tono longer perform effectively asa financial intermediary, be viewed by itscounterpartiesasno longer viable, becomeinsolvent, or diminish itscapacity to meetlegal and financial obligations.Abanking organization‘scapital and liquidity stresstesting should consider howlosses, earnings,cashflows, capital, and liquidity wouldbeaffectedin anenvironmentin whichmultiple risksmanifest themselvesatthesametime,for example,anincreasein credit lossesduring an adverseinterest-rate environment.Additionally, banking organizationsshould recognize that at the end of the timehorizon consideredby a given stresstest, they may still have substantial residual risksor problem exposuresthat may continue to pressurecapital and liquidity resources.Stresstesting for capital and liquidity adequacy should be conducted in coordinationwith a banking organization‘s overall strategyand annual planning cycles.Resultsshould be refreshedin the event of major strategic decisions, or otherdecisions that can materially impact capital or liquidity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 36Banking organizationsshould conduct stresstesting for capital and liquidityadequacyperiodically.Capital StressTestingCapital stresstesting resultscan serveasa useful tool to support a bankingorganization‘s capital planning and corporate governance.They may help a banking organization better understand itsvulnerabilities andevaluatethe impact of adverse outcomeson itscapital position and ensurethat thebanking organization holdsadequate capital given itsbusiness model, including thecomplexity of its activitiesand itsrisk profile.Capital stresstesting complementsa banking organization‘s regulatory capitalanalysis by providing a forward-looking assessmentof capital adequacy, usually witha forecasthorizon of at least two years(with the recognition that the effects of certainstressconditionscould extend beyond two yearsfor some stresstests), andhighlighting the potential adverse effects on capital levels and ratiosfrom risks notfully captured in regulatory capital requirements.It should also be used to help a banking organization assessthe quality andcomposition of capital and itsability to absorb losses.Stresstesting can aid capital contingency planning by helping management identifyexposuresor risksin advancethat would needto be reducedand actionsthat could betaken to bolster capital levels or otherwisemaintain capital adequacy, aswell asactionsthat in timesof stressmight not be possible – such asraising capital.Capital stresstesting should include exercisesthat analyze the potential for changesin earnings, losses, reserves, and other potential effects on capital under a variety ofstressful circumstances.Suchtesting should alsocaptureany potential change in risk-weighted assets, theability of capital to absorb losses, and any resulting impact on the bankingorganization‘s capital ratios.It should include all relevant risk typesand other factorsthat have a potential to affectcapital adequacy, whetherdirectly or indirectly, including firm-specificones.A banking organization should also explore the potential for possible balance sheetexpansion to put pressure on capital ratios and consider risk mitigation and capitalpreservationoptions, other than simply shrinking the balance sheet.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 37Capital stresstesting should assessthepotential impact of a banking organization‘smaterial subsidiaries suffering capital problemson their own – such asbeing unableto meet local country capital requirements– even if the consolidated bankingorganization is not encountering problems.Wherematerial relative to the banking organizations capital, counterparty exposuresshould alsobe included in capital stresstesting.Enterprise-widestresstesting, asdescribedin sectionIV, should beanintegral part ofa banking organization‘scapital stresstesting.Suchenterprise-wide testing should include proforma estimatesof not only potentiallossesand resourcesavailable toabsorb losses, but also potential planned capitalactions(such asdividends or sharerepurchases)that would affect the bankingorganization‘s capital position, including regulatoryand other capital ratios.There should alsobe consideration of the impact on the banking organization‘sallowancefor loan and leaselossesand other relevant financial metrics.Even with very effective enterprise-wide tests, banking organizationsshould usecapital stresstesting in conjunction with other internal approaches (in addition toregulatorymeasures) for assessing capital adequacy, such asthosethat rely primarilyon statistical estimatesof risk or lossestimates based on historical data.Liquidity stresstestingAbanking organization should alsoconduct stresstesting for liquidity adequacy.Through such stresstesting a banking organization can work to identifyvulnerabilitiesrelated to liquidity adequacy in light of both firm-specificandmarket-wide stressevents and circumstances.Effective stresstesting helpsa banking organization identify and quantify the depth,source, and degreeof potential liquidity and funding strain and to analyze possibleimpactson itscash flows, liquidity position, profitability, and other aspectsof itsfinancial condition over varioustime horizons.For example, stresstesting can be used to explorepotential funding shortfalls,shortagesin liquid assets, the inability to issue debt, exposure to possible depositoutflows, volatility in short-term brokered deposits, sensitivity of funding to a ratingsdowngrade, and the impact of reducedcollateral values on borrowing capacity at theFederal Home Loan Banks, the Federal Reservediscount window, or other securedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 38wholesale funding sources.Liquidity stresstesting should explore the potential impact of adverse developmentsthat mayaffect market and asset liquidity, including the freezing up of credit andfunding markets, and the corresponding impact on the banking organization.Suchtestscan also help identify the conditions under which balance sheets mightexpand, thus creatingadditional funding needs (e.g., through accelerateddrawdownson unfunded commitments).Thesetests alsohelp determine whether the banking organization has a sufficientliquidity buffer to meet varioustypesof future liquidity demandsunder stressfulconditions.In this regard, liquidity stresstesting should be an integral part of the developmentand maintenanceof a banking organization‘s contingency funding planning.Liquidity stresstesting should include enterprise wide tests as discussed in section IV,but should also be applied, as appropriate, at lower levels of the banking organization,and in particular should account for regulatoryor supervisory restrictionsoninter-affiliate funding and asset transfers.Aswith capital stresstesting, banking organizationsmay need to conduct liquiditystresstests at both the consolidated and subsidiary level.In undertaking enterprise-wide liquidity tests banking organizationsshould makerealisticassumptionsasto the implicationsof liquidity stressesin one part of thebanking organization on other parts.An effective stresstesting framework should explorethe potential for capital andliquidity problemsto ariseat the sametime or exacerbate oneanother.For example, a banking organization in a stressedliquidity position is often requiredto takeactionsthat have a negative direct or indirect capital impact (e.g., sellingassetsat a loss or incurring funding costsat above market ratesto meet fundingneeds).Abanking organization‘sliquidity stressanalysis should explore situationsin whichthe banking organization maybe operating with a capital position that exceedsregulatoryminimums, but is nonethelessviewed within thefinancial marketsor by itscounterpartiesasbeing of questionable viability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 39Assessingthepotential interactionofcapital and liquiditycanbechallengingand maynot be possible within a single stresstest, soorganizationsshould explore severalavenuesto assessthat interaction.Aswith other applicationsof stresstesting, for itscapital and liquidity stresstests, it isbeneficial for a banking organization to articulate clearly itsobjectives for apost-stressoutcome, for instance to remain a viable financial market participant thatis able to meet itsexisting and prospective obligations and commitments.In such cases,banking organizationswould have to consider which measuresoffinancial condition would need to be met on a post-stressbasis to securetheconfidenceof counterpartiesand market participants.VI. Governance and ControlsAsnoted under Principle 5, a banking organization‘s stresstesting framework will beeffective only if it is subject to strong governance and controls to ensure theframework is functioning asintended.The extent and sophistication of a banking organization‘s governanceover its stresstesting framework should align with the extent and sophistication ofthat framework.Governanceover a banking organization‘s stresstesting framework restswith thebanking organization‘s board of directorsand senior management.Aspart of their overall responsibilities, a banking organization‘s board and seniormanagementshould establish acomprehensive, integratedand effective stresstestingframework that fits into the broader risk management of the banking organization.While the board is ultimately responsible for ensuring that the banking organizationhas an effective stresstesting framework, senior management generally hasresponsibilityfor implementing that framework.Senior management duties should include establishing adequate policiesandproceduresand ensuring compliance with those policies and procedures, assigningcompetent staff, overseeing stresstest development and implementation, evaluatingstresstest results, reviewing any findings relatedto the functioning of stresstestprocesses,and taking prompt remedial action wherenecessary.Senior management, directly and through relevant committees, also should beBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 40responsible for regularly reporting to the board on stresstesting developments(including the processto design tests and develop scenarios) and on stresstestingresults(including from individual tests, wherematerial), aswell ason compliancewith stresstesting policy.Board members should actively evaluate and discuss this information, ensuring thatthe stress testing framework is in line with the banking organization‘s risk appetite,overall strategy and business plans, and contingency plans, directing changes whereappropriate.Abanking organization should have writtenpolicies, approved and annually reviewedby the board, that direct and govern the implementation of the stresstestingframework in a comprehensivemanner.Policies, along with proceduresto implement them, should:Describe the overall purposeof stresstesting activities;Articulate consistent and sufficiently rigorousstresstesting practices acrosstheentirebanking organization;Indicate stresstesting roles and responsibilities, including controls over externalresourcesusedfor any part of stresstesting (such asvendorsand data providers);Describe the frequencyand priority with which stresstesting activitiesshould beconducted;Indicate how stresstest resultsareused, by whom, and outline instancesin whichremedial actionsshould be taken; andBereviewedand updated asnecessaryto ensurethat stresstesting practices remainappropriate and keepup to date with changesin market conditions, bankingorganization productsand strategies, banking organization exposuresand activities,the banking organization‘s established risk appetite, and industry stresstestingpractices.Astresstesting framework should incorporate validation or other type of independentreview to ensure the integrity of stresstesting processesand results, consistent withexistingsupervisory expectations.If a banking organization engagesa third party vendor to support some or all of itsstresstesting activities, thereshould be appropriate controls in place to ensure thatBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 41thoseexternally developed systemsand processesaresound, applied correctly, andappropriate for the banking organization‘s risks, activities, and exposures.Additionally, senior management should be mindful of any potential inconsistencies,contradictions, or gapsamong itsstresstests and assesswhat actions should be takenasa result.Internal audit should alsoprovide independent evaluation of the ongoingperformance, integrity, and reliabilityof the stresstesting framework.Abanking organization should ensure that itsstresstests are documentedappropriately, including a description of the typesof stresstests and methodologiesused, key assumptions, results, and suggestedactions.Senior management, in consultation with the board, should review stresstestingactivities and resultswith an appropriately critical eye and ensure that there isobjective review of all stresstesting processes.The resultsof stresstesting analysesshould facilitate decision-making by the boardand senior management.Stresstesting resultsshould be used to inform the board about alignment of thebanking organization‘s risk profile with the board‘s chosen risk appetite, aswell asinform operating and strategic decisions.Stresstesting resultsshould be considered directly by the board and seniormanagementfor decisionsrelatingto capital andliquidityadequacy, including capitalcontingency plans and contingency funding plans.Senior management, in consultation with the board, should ensure that the stresstesting framework includesa sufficient rangeof stresstesting activities applied at theappropriatelevels of thebanking organization (i.e., not just oneenterprise-widestresstest).Sound governance also includes using stresstesting to consider the effectivenessof abanking organization‘s risk mitigation techniquesfor variousrisk types over theirrespective time horizons, such asto explore what could occur if expected mitigationtechniques break down during stressful periods.VII. ConclusionAbanking organization should usethe principleslaid out in this guidance to develop,Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 42implement, and maintain an effective stresstesting framework.Sucha framework should be adequately tailored to the banking organization‘s size,complexity, risks, exposures, and activities.Akey purposeof stresstesting is to explore varioustypes of possible outcomes,including rareand extremeeventsand circumstances, assesstheir impact on thebanking organization, and then evaluate the boundaries up to which the bankingorganization plansto be able to withstand such outcomes.Stresstesting maybe particularly valuable during benign periodswhen othermeasuresmaynot indicate emerging risks.While stresstesting can provide valuable information regarding potential futureoutcomes, similar to any other risk management tool it haslimitations and cannotprovide absolutecertainty regarding the implicationsof assumedeventsand impacts.Furthermore, management should ensure that stress testing activities are notconstrained to reflect past experiences, but instead consider a broad range ofpossibilities.Nosingle stresstest can accuratelyestimate the impact of all stressful eventsandcircumstances;therefore, a banking organization should understand and account forstresstesting limitationsand uncertainties, and use stresstests in combination withother risk management tools to make informed risk management and businessdecisions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 43Guidelines on Stressed Value-At-Risk (Stressed VaR) and on theIncremental Default and Migration Risk Charge (IRC)16May 2012The EBApublished today twosets of Guidelines on Stressed Value-At-Risk (StressedVaR) and on the Incremental Default and Migration Risk Charge(IRC) modellingapproaches employed by credit institutionsusing the Internal Model Approach(IMA).TheseGuidelines are seen asan important meansof addressing weaknessesin theregulatorycapital framework and in the risk management of financial institutions.Their objective is to contribute to a level playing field and to enhanceconvergence ofsupervisory practices acrossthe EU.National competent authorities areexpected to implement the provisions set out inthe Guidelines within six monthsafter their publication.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.Guidelines on Stressed Value-At-Risk (Stressed VaR)TheseGuidelines include provisions on StressedVaR modelling by credit institutionsusing the Internal Model Approach for the calculationof the required capital formarket risk in the trading book.The main provisions of the Guidelines relateto:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 44-The identification and the review of the stressedperiod;- The Stressed VaR methodology;- The Usetest.Guidelines on the Incremental Default and Migration RiskCharge (IRC)TheseGuidelines include provisions on the IRC modelling approachesemployed bycredit institutionsusing the Internal Model Approach (‗IMA‘) for the calculation ofthe required capital for specific interest risk in the trading book.The incremental risk charge is intended to complement additional standardsbeingapplied to the value-at-risk (VaR) modelling framework in the trading book.The main provisions of the Guidelines relateto:- The scope of application; Individual modelling of all aspectsof the IRC approach- The interdependencebetweendefault and migration events;-The profit and losses(P&L) valuation including how ratingschangesimpact onmarket prices and on the computation of P&L;- The liquidity horizons;- The validation and use test for IRC models.Notes1) According to the amendmentsof the Capital RequirementsDirective by Directive2010/76/EU, entered into force on 31December 2011, the EBAis tasked withmonitoring the rangeof practices in theareaof StressedValue-at-Risk (StressedVaR)and Incremental Default and Migration Risk Charge (IRC) in the trading book.The EBAshall draw up guidelines in order to ensureconvergence of supervisorypractices.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 452) In accordancewithArticle 16(3) of the EBARegulation, Guidelines set out theEBA‘sview of appropriate supervisory practiceswithin the European System ofFinancial Supervision or of how Union law should be applied in a particular area.Competent authoritiesand financial market participantsmust make every effort tocomply with the guidelines.Beforethe deadlineindicated in the Guidelines, i.e 6 months from the date ofpublication, Competent authorities must notify the EBAasto whether theycomply orintendto comply with theseguidelines,orotherwisewithreasonsfor non-compliance.The notificationsshall be published on the EBAwebsite.EBAGuidelineson Stressed ValueAt Risk (Stressed VaR)16.05.2012I. Executive SummaryThe amendmentsto the Capital RequirementsDirective1 by Directive 2010/76/EU(CRD III) relate, among others, to StressedValue-at-Risk (Stressed VaR) in thetrading book.According to theseamendments, the predecessorof the EBA, the Committee ofEuropean Banking Supervisors(CEBS) is tasked with monitoring the range ofpractices in this areaand drawing up guidelinesin order to ensureconvergence ofsupervisory practices.The amendmentsto the Capital RequirementsDirective by Directive 2010/76/EU(CRD III) entered into force on 31December2011.Providing guidance on Stressed VaR modelling by credit institutions using theInternal ModelApproach (‗IMA‘) for the calculation of therequiredcapital for marketrisk in the trading book, is seenasan important meansof addressing weaknessesinthe regulatorycapital framework and in the risk management of financial institutionsthat contributed to the turmoil in global financial markets.It isalsoexpected to reducereliance on cyclical VaR-basedcapital estimatesaswellasto contribute to the development of a morerobust financial system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 46The first chapter, on ‗Identification and validation of the stressedperiod‘, elaborateson the value-at-risk model inputs calibratedto historical data from a continuous12-month period of significant financial stressrelevant to an institution‘s portfolioanddeals withi)The length of the stressedperiod,ii) The number of stressed periodsto usefor calibration,iii) The approach to identify the appropriate historical period andiv)The required documentation to support the approach used to identify the stressedperiod.The second chapter, on ‗Review of the stressed period‘ provides guidance on thefrequencyand monitoring of a stressed period.The third chapter on ‗StressedVaR methodology‘ deals withi) Consistencyissuesbetweenthe VaR and StressedVaR methodologies andii) The useand validation of proxies in Stressed VaR modelling.The fourth and final chapter, entitled ‗Use tests‘specifies use test requirements.The Guidelines on Stressed VaR are expected to contribute to a level playing fieldamong institutionsand to enhanceconvergence of supervisory practices among thecompetent authoritiesacrossthe EU.It isexpected that the national competent authorities around the EU will implementthe Guidelines by incorporating them within their supervisory procedures within sixmonthsafter publication of the final guidelines.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.II. Background and RationaleThe CRD III trading book amendments, including the requirement of Stressed Valueat Risk (VaR) modelling for the calculation of the regulatory capital for market risk inthe trading book, arethe result of widespread international (G20, Basel, FSF)Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 47recognition in 2008that further regulatoryreform wasneeded to addressweaknessesin the current regulatory capital framework and in the risk management of financialinstitutions that contributed to the turmoil in global financial markets.In January 2009, the Basel Committee on Banking Supervision (BCBS) proposedsupplementing the current VaR-based trading book framework with, among othermeasures, an incremental risk capital charge (IRC), which includesdefault risk aswell asmigration risk for unsecuritised credit productsand a stressed value-at-riskrequirement.Asobserved lossesin banks trading books during the financial crisis have beensignificantly higher than the minimum capital requirementsunder the Pillar 1marketrisk rules, the BCBSproposed to enhancethe framework through requiring banks tocalculate, in addition to the current VaR, a stressed VaR taking into account aone-year observation period relating to significant losses.The additional stressed VaR requirement is expected to help reduce thepro-cyclicality of the minimum capital requirementsfor market risk.In the processof refining capital requirementsfor market risk, the BCBSconducted aquantitative impact study.In thesummerof 2009, the Trading Book Group (TBG) investigated the impactof theprovisionsof the ‗Revisionsto the Basel II market risk framework‘ and of the‗Guidelines for computing capital for incremental risk in the trading book‘consultation paperspublished in January 2009, focusing (generally) on biginternationally-active banks with extensivetrading activities.The amendmentsto the Capital RequirementsDirective by Directive 2010/76/EU(CRD III) relatingto StressedVaRin thetradingbook areadirecttransposition of theproposalsfrom the BCBSin the EU context.The European BankingAuthority is requestedto monitor the rangeof practices inthis areaand to provide guidelines on Stressed VaR models.The objectives of these Guidelines on StressedVaR are:I. To achieve a common understanding among the competent authoritiesacrosstheEU on StressedVaR modelling in order to enhanceconvergence of supervisorypractices;Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 48II.To create more transparency for institutions when implementing Stressed VaR intothe calculation of the required capital for market risk in thetrading book and into theirrisk management practices;andIII. To create a level playing field among institutionsin this area.The guidelines presented in this paper do not aim to be a comprehensive set of rules,but rather to complement the new CRD provisionsrelating to Stressed VaR whereadditional guidance by the EBAwasdeemed necessaryor appropriate.Given that the Guidelinesdiscussedin this paper do not go beyond the provisions ofthe CRD but rather clarify how the rules are to be applied in practicea detailedassessment of the costsand benefitsassociatedwith them is not required.Thesecostsand benefits are unlikely to be incremental to thoseidentified in the EUCommission‘s ImpactAssessment accompanying itsCRDIII proposal.III. EBAGuidelines on Stressed VaRStatusof these Guidelines1.This document containsguidelinesissuedpursuant toArticle 16of Regulation(EU)No1093/2010of the European Parliamentand of the Council of 24November 2010establishing a European SupervisoryAuthority (European BankingAuthority),amending Decision No 716/2009/EC and repealingCommission Decision2009/78/EC (‗the EBARegulation‘).In accordancewithArticle 16(3) of the EBARegulation, competent authorities andfinancial market participants must make every effort to comply with the guidelines.2. Guidelines set out the EBA‘s view of appropriate supervisory practiceswithin theEuropean System of Financial Supervision or of how Unionlaw should beapplied in aparticular area.The EBAthereforeexpectsall competent authorities and financial marketparticipants to whom guidelines are addressed to comply.Competent authoritiesto whom guidelines apply should comply by incorporatingthem into their supervisory practices asappropriate (e.g. by amending their legalframework or their supervisory rules and/or guidance or supervisory processes),including whereparticular guidelines are directed primarily at institutions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 49Notification Requirements3.According toArticle 16(3) of the EBARegulation, competent authorities mustnotify the EBAasto whether they comply or intend to comply with theseguidelines,or otherwisewith reasonsfor non-compliance, by 16.07.2012.In the absence of any notification by this deadline, competent authoritieswill beconsidered by the EBAto be non-compliant.Notificationsshould be sent by submitting the form provided at Section V tocompliance@eba.europa.euwith the reference‗EBA/GL/2012/2‘. Notificationsshould be submitted by personswith appropriate authority to report complianceonbehalf of their competent authorities.4.The notification of competent authorities mentioned in the previous paragraphshall be published on the EBAwebsite, asper article 16 of EBARegulation.Title I – Subject matter, Scope and Definitions1. Subject matterTheseguidelines aim at achieving a common understanding among the competentauthoritiesacrosstheEU onStressedValue at Risk (VaR) modelsin orderto enhanceconvergence of supervisory practices in line withAnnex V of Directive 2006/49/EC,asamended by Directive 2010/76/EU.2. Scope and level of application1.Competent authoritiesshould requireinstitutionsto comply with theprovisionslaiddown in theseGuidelines on Stressed VaR.2.These guidelines should apply to institutions using an Internal Model Approach(IMA) for the purpose of calculating the capital requirement for market risk in thetrading book.3.The guidelinesapply to institutionsat the level (solo and/or consolidated) on whichthe model is authorised to be used by the relevant competent authority, unless statedotherwisein theseGuidelines.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 503. DefinitionsIn theseguidelines the following definitionsshould apply:a.The term institutionsshould mean credit institutionsand investment firmsassetout in Directives 2006/48/EC and 2006/49/EC.b.The term antithetic data under point 6 of theseGuidelines should mean pricemovementswhich areconsideredrelevant irrespective of their direction.c.The term de-meaning under point 10of theseGuidelines should mean aquantitative processto remove a trend from historical data.Depending on the positionsand the size of the trend, not removing the drift from thehistorical data to simulate the price variationscould generate mainly profitablescenarios and very few and limited losses.d.The term proxy under point 11of theseGuidelinesshould mean an observablevariable or price taken from a liquid market that isused to substitute a variable thatcannot be observed(or whose hypothetical pricedoes not reflect real transactionsfrom a deep two-waymarket) and thus cannot be accurately measured. Institutionsuseproxies both for valuation and risk measurementpurposes.From a theoretical perspective threetypes of proxies can be identified: thoseappliedin the valuation of instruments(which would affect the adequacyof VaR and StressedVaR ascapital measures);thoseused forVaR calculations(which would alsobe present in Stressed VaR metrics);and thoseaffecting solely the StressedVaR calculation.Title II – Requirements regarding institutions‘ Stressed VaRmodelling - A. Identification and validation of the stressedperiod4. Length of the stressed period1. The requirement set out in the CRD that the historical data used to calibrate theStressedVaRmeasurehave to cover acontinuous12-month period, appliesalsowhereBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 51institutions identify a period which isshorter than 12months but which isconsideredto be a significant stressevent relevant to an institution‘s portfolio.2. The approach to be applied to identify the stressedperiod in order to meet therequirementof Paragraph 10aof Annex 5 of Directive 2006/49/EC asamended byDirective 2010/76/EU, tocalculateaStressedVaRmeasurecalibratedtoacontinuous12-month period of financial stressrelevant to an institution‘s portfolio, is the mostmaterial element determining the output of the model and is thereforesubject toapproval by the competent authorities.5. Number of stressed periods to use for calibration1.For the purposesof approval of the choice of the stressed period by institutions, acompetent authority isthe competent authority responsible for the exerciseofsupervision on a consolidated basis of this EU institution and, in the caseof aninternal model alsorecognised at a subsidiary‘s level, the competent authorityresponsible for the exerciseof supervision of this EU institution‘s subsidiary.2.When the competent authoritiesapprove the stressedperiod defined at group levelaccording to Article 37(2) of Directive 2006/49/EC referring toArticle 129of Directive2006/48/EC, a single stressedperiod should only be required to be defined at grouplevel.3.Asan exception from the above, the competent authorities should requirean EUinstitution to determineadifferent stressedperiod at asubsidiary‘s levelif thestressedperiod defined for the group is not consideredrelevant to the subsidiary‘s portfolio.Wherea single group-wide stressed period is used in an institution that has asubsidiary with a locally approved VaR model, institutions should provide proof thatthis group-wide stressed period is relevant to the subsidiary‘s portfolio.6. The approach for identifying the appropriate historical period1.In order to choosea historical period for calibration purposes, institutionsshouldformulate a methodology for identifying a stressedperiod relevant to their currentportfolios, based on one of the following two ways:i. judgement-based approaches; orii. formulaic approaches.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 522.Ajudgement-based approach is one that doesnot usea detailed quantitativeanalysis to identify the preciseperiod to use for calibration, but ratherrelies on ahigh-level analysis of the risksinherent in an institution‘s current portfolio and pastperiodsof stressrelated to thoserisk factors.Wherethis judgement-based approach is used by institutions, it should includequantitative elementsof analysis.3.Aformulaic approachinstead is onethat applies, in addition to expert judgement, amore systematic quantitative analysis to identify the historical period representing asignificant stressfor an institution‘s current portfolio.This more systematic approachcould be employed in a number of ways:i.Arisk-factor based approach: an institution identifiesa restricted number of riskfactorswhich are consideredto be a relevant proxy for the movement in value of itsportfolio.The historical data for theserisk factorscan then be fully analysed to identify the moststressed period (for example, through identification of the period of highest volatilityof the risk factors), in the historical data window.ii.AVaR based approach:the historical period isidentified by running either the fullVaR model or an approximation over a historical period to identify the 12-monthperiod which producesthe highest resulting measurefor the current portfolio.4.This approach should be employed to determine a historical period that wouldprovide a conservative capital outcome rather than just selecting the period of highestvolatility.5.While either approach maybe used by institutions, the useof the formulaicapproach, wherepossible, should be preferredfor the identification of the historicalperiod.6.Institutionsmayalsocombinetheabove two approaches to limit the computationalburden of the formulaic approach.This can be done by using the judgement-based approachto restrict the historicaldataperiodsto be consideredin the formulaic approach.7.Irrespective of the approachused, institutionsshould provide evidence that thestressedperiod is relevant for their current portfolio and that they have considered arangeof potential historical periodsin their analyses.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 53The institutions should alsohave to prove that the portfolio on which theidentification of the stressedperiodsis based is representative of the institutions‘currentportfolio, e.g. by applying theapproachtoidentify thestressedperiod to othertypical or previous portfolios.Asan example, for many portfolios, a 12-month period relating to significant lossesin2007/2008 would adequately reflect a period of such stress,but, in addition to that,other periodsrelevant to the current portfolio should alsobe considered byinstitutions.8.In all casesno weightingof historical data should be applied when determining therelevant historical period or when calibratingthe Stressed VaR model, astheweightingof data in a stressedperiod would not result in a true reflection of thepotential stressedlossesthat could occur for an institution‘s portfolio.9.Finally, competent authorities mayrequireinstitutionsto useantithetic data whencalibrating the Stressed VaR model, especially wherean institution‘s portfolio ischaracterized by frequent position changes.7. Documentation to support the approach used to identify thestressed period1.Irrespective of the approachapplied, institutionsmust produce robustdocumentation justifying the choice of approach made.This should in all casesinclude quantitative assessmentsto support the currentchoiceof the historical period and its relevance for the current portfolio.This should alsoinclude documentation of the modelling of risk factors‘returns.2.Whereinstitutions apply a formulaic approach to identify the stressed period thefollowing issuesshould, asa minimum, be addressedin the relateddocumentation:i.Justification for the choice of risk factorsused if a risk-factor based approachisapplied and wherefewer than the modelled risk factorsareselected.ii.Justification of any simplificationswherea simplified VaR model is usedto identifythe historical period.3. Wherea formulaic approachis applied, which is based on a simplified VaR model,aninstitution should alsoprovide adequateevidencethat thesimplified measuregivesBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 54directionally the sameVaR results asthe full VaR model (and thereforeis accurate indetermining the most stressedperiod).This evidence should include empirical analysis.4. Wherea formulaic approachis applied, which aimsat identifying the most volatileperiod for a set of risk factors, an institution should provide adequate evidence that aperiod of high volatility isa suitable proxy for a period in which the VaR measurewould be high and that thelackof inclusion of correlationsor other factorsthat wouldbe reflectedin the VaR measuredoesnot result in rendering this proxy unsuitable.B. Review of the stressed period8. Frequency1.The requirement of the CRD, for the review of the identified 12-month period ofsignificant stressto be performed at least yearlyby institutions, meansthat differentcircumstances, including a very high turnover in the trading book or specific tradingstrategies, may require a review of the stressed period with a higher frequency.2.Any changes to the choice of the historical period following the outcome of thereview of the stressed period should be communicated to the competent authoritybefore the intended implementation date of the proposedchanges.9. Monitoring the stressed period1.In addition to the above-mentioned regular review, an institution should have inplace procedureswhich ensure, on an on-going basis, that the specified stressedperiod remains representative, including when ,market conditionsor portfoliocompositions have been subject to significant change.2.In order to put in placesound proceduresfor the ongoing monitoring of therelevanceof a stressed period, an institution should document the soundnessof theimplemented approach.Monitoring may be based on a variety of factorswhich may differ among institutions.Factorsto be considered include changesin market conditions, in trading strategiesor alsoin portfolio composition.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 55Thesefactorsmay be analysed by comparing them to changesin the allocation ofmarket valuesor notionals, in risk factor loadings, in the level of VaR or sensitivities,in therepartitionof VaRor sensitivitiesover portfolios and riskcategories,in theP&Land back-testing resultsor alsoby the impact of newly approved products on the riskprofile.3.Inaddition totheabove-mentioned procedures, monitoring of StressedVaRrelativeto VaR should be performed on an on-going basis, because, while in theory, due todifferencesin parameterisation, StressedVaR can exceptionally be smaller than VaR,alsoat inception, this should not structurally be the case.The ratio betweenStressedVaR and VaR at the moment of identification of therelevant stressedperiod should be used asa referencevalue for ongoing monitoring.Significant decreasesin the ratio should be consideredasindicationsfor a potentialneed for review of a stressedperiod.Aratio betweenStressedVaR and VaR below one should be considered asa warningsignal triggering a review of the stressedperiod.C. Stressed VaR methodology10.Consistency with VaR methodology1.The Stressed VaR methodology should be based on the current VaR methodology,with specific techniques required, where applicable, in order to adjust the current VaRmodel into one that delivers a Stressed VaR measure. Any risk factor occurring in theVaR model should thereforebe reflected in the Stressed VaR model.2.With respectto standardsusedin both measures, and further to the onesprescribedby the Directive (e.g. the 99% confidence level), institutions mayconsider the useof‗squareroot of time‘scaling to calculatea 10-dayStressed VaR measure.Nevertheless,given some known limitationsof the scaling factor, an analysis todemonstrate that the assumptionsunderlying the useof the ‗square root of time‘ruleareappropriate, should form part of the internal model validation process.3.While the Stressed VaR model should sharesomeof the current VaR standards,othersmay diverge due to explicit Directive requirementsor to methodologicalincompatibilities related to the Stressed VaR concept.In particular, this is the casein the following areas:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 56(i) Lengthof thestressedPeriodGiven the length of the stressed period must be 12 months, any action to reduce orincrease the stated stressed period based on the need for consistency between VaRand Stressed VaR should not be permitted.(ii) Back-testingrequirementThe multiplication factor msused for capital requirementsshould be at least 3 and beincreasedby an addend between0 and 1depending on the VaR backtesting results.Nevertheless,backtestingis not a requirement in itself for determining the StressedVaR measure.(iii) Periodicity of theStressed VaR calculationAsthe CRD provides that the calculationof the Stressed VaR should be at leastweekly, institutionsmaychoose to compute the measuremore frequently, forinstance, daily, to coincide with the VaR periodicity.If, for example, institutionsdecide on a weekly StressedVaR computation, andassuming a one-day Stressed VaR scaled up to 10days, for the daily calculation ofcapital requirementsbased on internal models the following would apply:a)The sameStressed VaR number would be used for 5 subsequent businessdaysfollowing the running of the Stressed VaR model;b)With respectto the calculationof the average Stressed VaR numbersduring thepreceding sixty businessdays, institutionsshould usethe previous 12 Stressed VaRnumbersto compute that average;c)An institution should be able to prove that, on the day of the weekchosen forStressedVaR calculation, itsportfolio is representativeof theportfolio held during theweekand that the chosen portfolio doesnot lead to a systematical underestimation ofthe Stressed VaR numberswhen computed weekly.For example, proof that the VaR is not systematically lower on the day of the weekchosen for Stressed VaR calculation could be consideredsufficient.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 574.StressedVaR standardsmay diverge from VaR standardsin other circumstanceswheretherecould be methodological incompatibilities betweenthe current VaR andthe Stressed VaR model.One example includeschangesin the current VaR methodology that cannot betranslatedinto the StressedVaR measureand the useof local valuation (sensitivityanalysis/proxies) asopposed to full revaluation, which isthe preferredapproach forStressedVaR.5.As a general rule, changes in an institution‘s VaR model or VaR methodologyshould be reflected in changes to the model/methodology used to calculate theStressedVaR charge.6.Under exceptional circumstances, if an institution can demonstrate that it cannotincorporate enhancementsto the current VaR methodology in the StressedVaR, suchsituations should be documented and the institution should be able to demonstratethat the impact (for example, in termsof VaR or capital requirements) resulting fromthe current VaR developmentswhich are not implemented in the StressedVaRmeasureis limited.7.Where sensitivities rather than full revaluation are used within a VaR model, theinstitution concerned should demonstrate that this approach is still appropriate forStressedVaR wherelarger shocksareapplied.Asensitivity-based approach for StressedVaR may require that higher orderderivatives/convexity are factored in.8.Any revaluation laddersor spot/volatility matrices employedshould be reviewedand extended to include the wider shocks in risk factorsthat occur in stressfulscenarios.It ispreferable that full revaluation be used for Stressed VaR with shocksappliedsimultaneously to all risk factors.9.Intermsof calibrationto marketdata, theprocessof ‗de-meaning‘isnot considerednecessaryfor StressedVaR. If thereis a significant drift in market data, the useofantithetic data ispreferable to ‗de-meaning‘.10.The table below summarisesthe main issuesdescribedabove concerningthe levelof consistencybetweenthe methodological aspectsof the current VaR and StressedVaR measure.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 5811. Estimation of proxiesfor Stressed VaR1.Given that the data constraintsthat make necessarythe useof proxiesforVaR, becomeeven more relevant for Stressed VaR and that it isexpected that anyproxiesusedin VaRwill alsobenecessaryfor StressedVaR, while additional onesmayalsobeneeded, whereasanynew risk factor not presentin the historical data shouldnaturally requirethe useof a proxy for VaR calculation, but only on a ‗temporary‘basis (e.g. after one year therewould be enough real information to completea 12-month data series),thesameproxyshould bemore‗permanent‘for StressedVaRpurposes(dueto the more constant nature of the historical time series).2.If ariskfactorismissingin thestressedperiod becauseit wasnot observableduringthat period (for example for a newly listed equity) the institution mayuseanother riskfactor (in this example, another equity from the samesector and with a similar riskand businessprofile) for which thereis information available and for which a highlycorrelated behaviour with the factor that the institution is trying to capture can bedemonstrated.Wheretheseproxies are used, institutions should consider whether an assumption of100%correlation between the risk factor and itsproxy is appropriate.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 593.Institutionsmay alternatively map the missing factor to another one similar intermsof volatility (though not necessarily correlated). If this approach isused, institutions should demonstrate that it isconservative and appropriate.4.If aVaRmodel is enhancedbyincorporating arisk factor, an institution should alsoincorporate it into itsStressedVaR calculations.In certain cases, this may mean reviewing the historical data seriesfor the risk factorsand introducing an appropriate proxy.For example wherea new risk factor used for valuation purposesis incorporated intothe VaR model asrequired underAnnex V point 12first Paragraph of Directive2006/49/EC asamended by Directive 2010/76/EU.5.In all cases, the useof theseproxies, including simplificationsand any omissionsmade,will only beacceptableprovided theyarewell documentedandtheir limitationsaretaken into account and addressed in the institution‘s capital assessment.12.Validation of proxies1.Whereasvalidation of aproxyshould be broadly performedin thesamewayfor VaRand Stressed VaR, any proxyvalidated for the day-to-day VaR is not automaticallyacceptable for StressedVaR.Proxiesin use should be reviewedperiodically to assesstheir adequacyand ensurethat they provide a conservativeoutcome.2.Regarding those proxies which might be used for Stressed VaR purposes only (forinstance, due to lack of data in the selected period), an institution should ensure thatthe risk factor used asproxy is conservative.13.Validation of model inputs/outputs1.All qualitative standardsdefined for the control of consistency, accuracyandreliabilityof data sourcesof VaR alsoapply to StressedVaR.2.Underlyingsfor which institutions do not have a history of data complete enough tocover the reference period, should be shocked by approximation, using closely relatedunderlyings(samemarket, similar structure and characteristics).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 60Following the sameprocessthat has been approved for the institutions‘ internalmodels, in order to ensurethe qualityof historical data used for the referenceperiod,institutions should document the methodology followed for identifying and forproxying missing data.Institutionsshould also perform tests of the potential impact of the useof theseproxies.3.With aview to preserving arbitrageinequalities, institutionsmayneedto apply datacleaning for StressedVaR.Wherethis is the case, the removal of outliersfrom historical data seriesshould beappropriately justified and documented, asit should not end up decreasing themagnitude of extremeevents.4.As Stressed VaR entails, by definition, the application of highly stressed scenariosto current market parameters, which may lead to incoherent market conditions (e.g.negative forward rates) more frequently than within a VaR computation, institutionsshould monitor the calibration failuresthat may materialise.Institutionsusing full revaluation when estimating their Stressed VaR maybe morefrequently confronted with thosecalibrationfailuresthan institutionsnot using fullrevaluation, not because failureswill not happen, but becausetheir methodology willnot enable them to spot these calibration failureswhen they occur.D. Use test14.Use test1.The StressedVaRmodel should besubjectto ausetestthrough useof StressedVaRoutput in risk management decisions.StressedVaR output should be in place asa supplement to the risk managementanalysis based on the day-to-day output of a VaR model.The resultsof Stressed VaR should be monitored and reviewedperiodically by seniormanagement.2.WhereStressed VaR outputsreveal particular vulnerability to a given set ofcircumstances, prompt steps should be taken to manage thoserisks appropriately.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 61Title III – Final Provisionsand Implementation15.Date of applicationCompetent authoritiesshould implement theseGuidelines by incorporating themwithin their supervisory procedureswithin six monthsafter publication of the finalGuidelines.Thereafter, competent authoritiesshould ensure that institutionscomply with themeffectively.IV. Accompanying documentsa. Feedback on the public consultation and on the opinion ofthe BSG1.The European BankingAuthority (EBA) officially came into being on 1January2011and has taken over all existing and ongoing tasksand responsibilitiesfrom theCommittee of European Banking Supervisors(CEBS).2.On 16November 2011, the draft Guidelines on StressedVaR werepresentedto theEBA‘s Banking Stakeholder Group (BSG).The BSGprovided broad commentsand suggestions, to be considered by theEBA, when finalizing the Guidelines.3.On 30November 2011, theEBAsubmitted thedraft Guidelines onStressedValue atRisk (Stressed VaR) for public consultation.The consultation period ended on 15January 2012.Ten responseswerereceived.In addition, a public hearing washeld on 13December2011at the EBA‘s premisesinLondon, to allow interestedpartiesto sharetheir viewswith the EBA.4.The responses to the consultation paper weregenerally positive and supportive ofEBA‘s work and requiredonly someclarification; however,onsomeparagraphsin theBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 62consultation paper, the majority of the respondentsdisagreedor requestedsignificantclarification.5.Adetailed account of the comments received and the EBA s responsesto them isprovided in the feedback table below.The feedback table is divided between general remarksand specific commentsreceived from respondentsand includesa sectionwith EBA‘s point of view on themand the changesmade in the final guidelines to addressthem.6.In somecases,several respondentsmade similar comments.In such cases,the comments, and EBA‘s analysis of them are included in the sectionof the detailed part of this paper whereEBAconsidersthem most appropriate.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 63Models and tools for macroprudential analysisBCBS Working Papers No 21, May 2012The Basel Committees ResearchTask Force Transmission Channel project aimed atgenerating new researchon variousaspectsof the credit channel linkagesin themonetarytransmission mechanism.Under the credit channel view, financial intermediariesplay a critical role in theallocation of credit in the economy.They arethe primarysource of credit for consumersand businessesthat do not havedirect accessto capital markets.Among more traditional macroeconomic modelling approaches, the credit view isunique in its emphasis on the health of the financial sector asa critically importantdeterminant of the efficacyof monetarypolicy.The final products of the project are two working papersthat summarisethe findingsof the many individual research projects that wereundertaken and discussedin thecourseof the project.The first workingpaper, Basel Committee Working Paper No 20, "The policyimplicationsof transmission channelsbetweenthe financial system and the realeconomy", analysesthe link betweenthe real economyand the financial sector, andchannelsthrough which the financial system may transmitinstability to the realeconomy.The second working paper, Basel Committee Working Paper No 21, "Models andtools for macroprudential analysis", focuseson the methodological progressandmodelling advancementsaimed at improving financial stability monitoring and theidentification of systemic risk potential.Becauseboth working papersaresummaries, theytouch only briefly on the resultsand methodsof the individual researchpapersthat were developed during the courseof the project.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 64Eachworking paper includescomprehensivereferenceswith information that willallow the interested reader to contact any of the individual authorsand acquire themostup-to-date version of theresearchthat wassummarisedin eachof theseworkingpapers.The Research Task Force Transmission Channels ProjectThe Research Task Force Transmission Channel (RTF-TC) project wasconceivedbefore the onsetof the recent global financial crisis.From the beginning, RTF-TC wasintended to be a long-term project that wouldinvolve many RTF member institutions.The primarygoal wasto generate new researchon variousaspectsof the creditchannel linkages in the monetary transmission mechanism.Under the credit channel view, financial intermediariesplay a critical role in theallocation of credit in the economy.They arethe primarysource of credit for consumersand businessesthat do not havedirect accessto capital markets.Among more traditional macroeconomic modelling approaches, the credit view isunique in its emphasis on the health of the financial sector asa critically importantdeterminant of the efficacyof monetary policy.Subsequent to the start of the RTF-TC, the onset of the global financial crisisfocusedpolicymakers‘attention on the health of the financial sector.While the RTF-TC did not anticipate the financial crisis, itswork did progressasthefinancial crisis unfolded.Many of the researchpapersproduced in this project made useof new data andinsightsgained from the work that many RTF member institutionsundertook duringthe courseof the financial crisis.Six workshopshosted by the Bank of Italy, by the Bank of Franceand the FrenchPrudential SupervisoryAuthority, bytheUK Financial ServicesAuthority, bytheBankof Canadaand theCanadianOffice of theSuperintendentof Financial Institutions, bythe US Office of the Comptroller of the Currency, and by the Central Bank of Norwayprovided venues to present innovative research studies, but also, importantly, toreceive feedback from RTF member institution colleagues.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 65The researchpapersand findingsproduced by the RTF-TC are in most casespreliminaryand still undergoing revision and refinement.Still, RTF-TC researchhas produced many new insights and analysis that help ustobetter understand the linkagesbetweenthe financial sector and real economy.The work of the RTF-TC included detailed econometric analysis of credit data frommany RTF member countries, theoretical modelling contributions, dynamicstochastic general equilibrium calibration exercisesand experiments, and theinvestigation of new analytical approaches for financial stability monitoring andsystemic risk analysis.The resultsof theseprojects should help to inform macroprudential policydevelopment.The final products of the RTF-TC project are two working papersthat summarise thefindings of the many individual research projects that were undertaken and discussedin the courseof the project.The first workingpaper, Basel Committee Working Paper No 20, ―The policyimplicationsof transmission channelsbetweenthe financial system and the realeconomy‖, analysesthe link betweenthe real economyand the financial sector, andchannelsthrough which the financial system may transmit instability to the realeconomy.The second working paper, Basel Committee Working Paper No 21, ―Models andtools for macroprudential analysis‖, focuseson the methodological progressandmodelling advancementsaimed at improving financial stability monitoring and theidentification of systemic risk potential.Becauseboth working papersaresummaries, theytouch only briefly on the resultsand methodsof the individual researchpapersthat were developed during the courseof the project.Eachworking paper includescomprehensivereferenceswith information that willallow the interested reader to contact any of the individual authorsand acquire themostup-to-date version of theresearchthat wassummarisedin eachof theseworkingpapers.Paul Kupiec, FDIC and Chairman of the Basel Committee Research Task ForceBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 66Models and tools for macroprudential analysisIntroductionThe findings of the ResearchTask Force Transmission Channel (RTF-TC) projectarereported in two summarypapers.The rolethat thefinancial systemplayed in transmittinginstability to therealsectorofthe economyis examinedin the first report of the RTF-TC (Basel CommitteeWorking Paper No 20).This report focuseson the methodological progressand modelling advancementsuseful for improving the existingfinancial stability analytical framework – that istheframework to identify, assessand monitor systemic risk.Systemic risk is defined asthe risk of disruptionsin the provision of key financialservicesthat can have seriousconsequencesfor the real economy.The RTF-TC contributing member institutions conducted new researchthat waspresentedat international workshopsorganised by the group. Thisresearchallowedthegroup to study theinteractionsbetweenthe financial system and thereal economyand, more generally, thoseinteractionsthat have the potential for producing systemicrisk.The workshopsfacilitatedcommunication among member institution researchers.In summarising the findings of the group, this report acknowledgesthe jointcontribution of the membersof the group and of all the other participantsat theworkshops(both authorsand discussants).The Appendix lists the paperspresented and the workshop participants.Wecaution that this document is not a comprehensiveliteraturereview, but reflectsthe specific contributions and insights of the RTF-TC members.This summaryof the RTF-TC‘s findings is organised into four sections.Section 1discussesanalytical methodsused to measuretheimpact of macro-financialshocks on the real economy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 67This section includes studies that use dynamic stochastic general equilibrium models(Section 1.1) as well as studies that use more traditional macro stress testing methods(Section 1.2).Section 2 discussesdevelopmentsin modelling financial sector liquidity riskincluding the potential for contagion.Section 3 discussesmethodsfor measuring the potential for systemic risk.Section 4 summarisesRTF-TC studies that quantify bank behavioural responsestochanging central bank and macroprudential policies and macroeconomic conditions.Eachsection includesa summary of the remaining gapsin the literature.1. What are the impacts of a macro-financial shock on thefinancial sector and the real economy?How should the transmission of a macro-financial shock on thebanking sector, the macroeconomy, and the possible feedbackbetweenthe two sectorsbe measured?The recent global financial crisishighlighted somekey featuresthat needto beincorporated into operational macroprudential models.One featuremodels must take into account is the importance of the credit andmaturity transformationmechanismthat lies at theheart of banking. In normal times,banks fund themselveswith short-term liquid contracts and invest in illiquid creditinstruments with longer maturity duration.Financial sector shockshave the potential to disrupt the normal credit intermediationprocessand may result in a widespread curtailmentof credit to bank dependentcustomers.Asecond important modelling feature identified by the crisis is the ability to accountfor interdependencies(both linear and non-linear) among key financial andmacroeconomic variablesand for feedback effects betweenthe financial and realsectors.Models should alsoaccount for the fact that, for a set of interconnected, highlyleveraged financial institutions, systematic risk is likely to play a more important rolethan idiosyncratic risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 68Thesetwomodelling features, in addition to thelessonslearnedfromtherecentcrisis,emphasisedthe need to build a model that can incorporate out-of-equilibriumdynamics, learning, herding behaviour, and contagion.The RTF-TC researchincluded studies using two different methodsformacroprudential modelling that encompassesthoseaspects:dynamic stochasticgeneral equilibrium (DSGE) models and traditional econometric macro stresstestingmodels.DSGE models are computable general equilibrium models built frommicroeconomic-consistentfoundations.Thesemodels arecalibratedto mimic historical data patternsbut arenot estimatedinthe traditional econometric sense.While DSGE models can be designed to include interestingbehavioural featuresintheir representative agents, they do not generatetime-seriesforecasts.DSGE models are instead designed to answercomparative static or ―what if‖exercises.In contrast, traditional macroprudential stresstesting methods rely on reducedformeconometric model specificationsthat are estimatedusing historical data.Thesemodels need not be linked to an underlying model of a rational optimisingrepresentative agent.The ideal macro-financial model would incorporate featuresof both of theseapproaches, but the development of operational hybrid models is unlikely in the nearterm.Additionally, an important challengeis that thisideal model cannot be overlycomplex.Model resultsmust be intuitive and their logic accessible for financial stabilityauthoritiesto better understand the most important featuresof the transmissionchannelsbetweenthefinancial sectorandthereal economyduringperiodsof extremewidespread stress.At present, thereis no single ―best‖ approachfor macroprudential modelling; theapproachmust be tailored to the data available and to the question at hand.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 691.1Are dynamic stochasticgeneral equilibrium (DSGE) modelsuseful for understanding the channels of transmission offinancial sector shocks?Can they be used to quantify the impact of a financial sectorshock on the real economy?Can DSGE modelshelp identify whether macroprudentialregulationswill attenuate or amplify a shock?How do monetary and macroprudential policiesinteract?Can DSGE modelsbe used to optimise macro prudentialregulation?DSGE models are complex, non-linear systemsof equations.Initially, DSGE models weredeveloped in the Real BusinessCycle literature.Enhanced DSGE modelsthat included market imperfections and nominal rigiditiesweredeveloped in the so-called New Neoclassical Synthesis which createdmodels inwhich monetary policy isno longer neutral in the short run.DSGE models have threedistinguishing features.First, they are constructedfrom microeconomic foundations assuming rationalforward-looking optimising behaviour of individual economic agents.Secondly, DSGE modelsareconstructed to be internally-consistent with theirassumptionsand can capturethe behavioural interactionsbetweenhouseholds, firms,and policymakers.Assuch, DSGE models assume the existence of a stable equilibrium and the risks inthese models are purely exogenous shocks that drive the economy temporarily awayfrom the steady state to which it dynamically converges according to the optimisingbehaviour of the different agents.Thirdly, typical DSGE methodscannot easily incorporate irrationality, inefficientmarkets,and the formation of asset price bubbles.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 70DSGE modelscan be usedto analyseand understand themechanismsthroughwhichexogenousshocksaretransmitted to the real economyasthe real economy adjuststowardsa new equilibrium.In this capacity, DSGE models have been used to explain:(i)How macro variables react to aggregate shocks, either real (eg productivity,exogenousdemand, etc) or monetary shocks,(ii) The transmission channels of different economic policies, and(iii)The role of different real and nominal rigiditiesthat maybe sourcesof theobserveddynamics of the macroeconomy.In this context, systemic risk is representedby macroeconomic instability, which isoriginated either by a real or a financial exogenousshock, and is propagated throughexcessive lending and excessive GDP growth in booms, and vice versa in downturns.In the aftermath of the recent global financial crisis, DSGE modelshave beencriticisedfor relying too heavily on the assumptionof a perfectly competitive capitalmarket.Indeed, under this assumption, the Modigliani-Miller (M-M) theorem holds, andmodels are incapable of capturing credit channel effects.Becausethesemodels lacked a realisticfinancial sector, they wereof little useduringthe crisis.In this section, wediscussRTF-TC researchefforts to attempt to include an accuratefinancial sector into a DSGE framework and how this research hasmade DSGEmodels more useful in answering questionsregarding financial sector shocksandregulation.The original models of banking activities are too simplistic to usefor policy analysison the effectsof capital regulation on credit intermediation.RTF-TC studieshave attempted to improve existing models by developing a stylisedmodel of the banking sector that recognisesfinancial frictionson the borrowing andlending side and thereby including a role for bank capital.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 71Micro-founded financial frictionsare modelled by assuming imperfect informationbetweenlenders(interbank market or depositors) and borrowers(financialintermediaries).Credit contractsin the funding market for banksarenot perfect, due to the possibilityfor banks to be impacted by shocks and the impossibility for their creditorsto fullyobservetheseshocks.In somecases,the modelling approach allows for banks to default in equilibrium, aswell.Oncethe model includesfinancial frictions, thereis a natural economic role for bankcapital. Several papersanalyse how frictionsin the financial sector can influence thebank balancesheetand endogenously createan optimal bank capital structure.RTF-TC researchusesbank capital to mitigate asymmetric information frictionsbetweenlendersand borrowers(financial intermediaries).This endogenousresolution of the agency problem results in constraints on banks‘leverage ratios and implies that equilibrium credit flows will depend on the banks‘equity positions.Any unexpected movement in asset prices – either endogenously, via demand forinvestment, or exogenously via a financial shock – will affect the banks‘balancesheetand risk premium.The shock will endogenously alter the demand for bank capital to attenuate the riskpremium and the set of feedbacks that augment the initial change in investment andasset prices.Banks‘endogenousdemand for capital alsointeractswith the interbank market indetermining loan supply.In thesemodels, the introduction of a binding regulatory constraint has importantimplicationsfor the dynamicsof the macroeconomic variables, becausea costlytrade-off arisesbetween equity issuanceand a decreasein lending.With theseenhancements, DSGE models are better able to addressfundamentalpolicy issues, suchasthe overall importance of financial sector shocksin explainingthe businesscycle and the role of monetary policy and/ or prudential regulationtoavoid or mitigate financial crises.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 72For example, one RTF-TC study showsthat, in the presenceof financial frictions,aggressiveinterest rate cutsarerequired to offset adverse financial shocks.Another RTF-TC study usesan enhanced DSGE model to assessthe interactionbetweenmonetary and macroprudential policies and the design of an optimal mix ofthesepolicies.Acomparison of the effects of countercyclical capital requirements, maximumloan-to-value ratios, and maximum leverage ratioswith traditional monetary policyinstrumentsshowsthat countercyclical financial-sectorregulation mayproveusefulinmitigating the business-cycle fluctuations in the aftermath of a technological or amonetaryshock, but might aswell have an amplification effect if the banks‘capitalunexpectedly drops.Even though DSGE models cannot be used to examinethe endogenouscreation ofbubbles, an RTF-TC study attemptsto model how the economyis affectedby the lifecycle of bubbles.The resultssuggestthat ownership of the over-valued asset isan important issue.The boom-bust cycle is strongly amplified when the asset experiencing the pricebubble is held by banks, but the economy is much lessaffected if the bubble asset isheld by unleveraged agents.Suchresearch mayhelp develop earlywarning indicatorsof dangerousbubbles,discussedfurther in Section 3, and an evaluation of credit conditions that mayproducesuch bubbles.The findings of many of the RTF-TC DSGE studies are preliminaryand subject tofurther refinement.The studies tend to each focus on a particular financial shock in isolation(eg a shockaffecting borrowers‘net worth, asset prices, or banks‘capital).Depending on the type of financial shock considered, itsconsequencesand thetransmission mechanism can be very different.Second, and perhapsmore fundamentally, the work of the RTF-TC group hashighlighted akey issuethat macroprudential analysts must resolve whenusing DSGEmodels for policy analysis: theymust strike a balance betweensimplicityandtransparencyon the one hand, and reality and completenesson the other hand.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 73Perhaps,theanswerlies in thespecificpurposefor which the model is usedin a giveninstance.In fact, when the focus ison the quantification of the impact of shocks and the roleplayed by banking regulation, a rich framework is needed in order to incorporatemeaningful behaviour of the financial system and feedback effectsto themacroeconomy.Someof the researchconducted by RTF-TC introduced a banking sector in acomplicated manner whichmakesit difficult to fully understandtheforcesdriving theinteraction betweenthe real and financial sectors.Incontrast, if theaim isto understand thetransmissionchannelsbetweentherealandthe financial sectors, then simpler models appear to be more desirable.While the DSGE model findingsreported in this summary are informative, furtherresearchand analysis is required.SinceDSGE models assume forward-looking rational expectationsequilibria, theymust be modified to include some type of market or information imperfection beforetheycan accommodate fads, bubbles or the market pricing imperfectionsthat shouldbe consideredwhen analysing financial stability.Sincethe root causesof investment fadsand market inefficienciesremain a mysteryfor the most part, there arepotentially many waysthat thesefeaturesmight beintroduced into DSGE models and in somecasesthereis little empirical basis for themechanism used to generate the financial sector inefficiency.More generally, such studies and the corresponding models, both theoretical andempirical, are but one input into regulatory(and monetary) policymaking, inconjunction with qualitative judgementsand analysing trendsin a broad range ofdata.The RTF-TC group hasalso highlighted several directions for future research onDSGE models:Appropriately enhanced, models can potentially be used to help assesstheinteractions(and the possible trade-offs) betweenmacroprudential, monetary andfiscal policies, since all policies have a bearing on financial stability.There isa need for a formal normative (welfare) analysis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 74What are the costsof a macroprudential policy (eg increasedbank capitalrequirements)and how aretheydistributed among different agents?Can wecompare the transition costswith the potential benefits in termsof decreasedswingsin the businesscycle?Do weneed to consider the accompanying fiscal policy?- The verynature of financial intermediationis to assumefinancial risk due tobalancesheet mismatch betweenassetsand liabilities.The research of the RTF-TC group has modified and createdmodels toincorporate a more accurate picture of the financial sector.However, maturity mismatch and the effects of market valuation on assetsstillneed to be satisfactorily incorporated, especiallysince they represent animportant aspectof the recent financial crisis.More generally, future research needsto focus on endogenising the systemic-riskexposuresof banks.- DSGE models can be useful for understanding the bank capital channel, but theyarelimited by their solution method. DSGE models equilibria are approximatedaround the model‘s steadystate and such solutionsmay becomeinaccurate whenconsidering large deviationsfrom the steady path.Thesemodels alsorequire a unique equilibrium and therebycannot encompassmodels with multiple equilibria that allow movementsbetween equilibria.It isanopenissuewhetherlocalsolution methodsareusefulfor studying financial(in)stability and whether they arecapable of producing reliable quantitativeinformation in caseof financial turmoil.- Disaggregated models of the economy that include different degreesof borrowerriskiness could help addressquestionssuch as:At any given moment, whichsectorsareat risk?How interdependent arethe sectors(in other words, what is the correlationamong sectors)?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 75Bycontrast, current DSGE models only consider the net worth of the borrowersindependently of the sector to which the borrowersbelong and individual riskstheymight face.Several researchpapersof the RTF-TC group representearly attemptsatincluding sectoral diversification and matching different degreesof riskinessincapital requirements.More generally, therearea number of featuresthat could potentially be useful toadd to DSGE models (diversity of entitiesin the system and their interactions,riskappetite and expectations) that could help policymakersunderstand complexquantitative questions.Still, more researchisneededin this area.1.2How cantraditional macro stresstesting models(those usinga suite-of-models approach) be improved to bettermeasurethe transmission and the lasting effects of amacro-financial shock?Macrostresstesting refersto a range of analytical models and tools that are used bycentral banksand supervisoryagenciesto assessfinancial sector vulnerabilities toseverebut plausible scenariosof widespread exogenousshocks.For many central banksand supervisors, the practice of macrostresstesting wasintroduced aspart of the Financial SectorAssessment Programsconducted by theIMF and the World Bank.Assuch, macro stresstests can provide valuable information on the potential negativeeffects on the financial sector that are imposed by severe real sector shocks, and thushelp policymakers assessthe soundnessof the financial system.Ideally, macro stresstestscould allow bank supervisorsto identify institutionswhosecurrent financial condition posesrisks under alternativemacroeconomic scenarios.Central banksand supervisorstypically usea suiteof models and tools in amulti-stage processto conduct macrostresstesting of credit risk.The first stage involves projecting the dynamic paths of keymacroeconomicindicators(such asGDP, interest rates, and house prices) under a certain stressscenario.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 76The projectionsnormally usesomecombination of structural macroeconometricmodels, VAR models and vector error correction models, or some other statisticalapproach.In the second stage, a credit risk satellitemodel is estimatedusing either loanperformancedata (such asnon-performing loans, loan lossprovisions, or historicaldefault rates)or micro-level data relatedto the default risk of the household and/orcorporate sector.The satelliteor auxiliary model is then used to link a measure of credit risk to thevariables from the macroeconomic model and to map the external macroeconomicshocks to a bank‘s asset quality shocks.Finally, the last stage involvesestimating the impact of the asset quality shockson abank‘s earnings and/or capital.Oneof themain limitationsof traditional stresstesting is that thesatellitemodelsthatareused treat the macroeconomic variables asexogenousand ignore the feedbackeffectsfrom a situation of distressin the banking system to the macroeconomy.In conducting macrostresstests, the statistical relationship betweenmacroeconomicvariables and indicatorsof the banks‘financial condition can change dramaticallyunder stressedconditions.Therefore, if the focus isonly on the conditional mean of a risk measure (as is typicalof a traditional stresstesting exercise), it can be an inadequate approach in assessingthe impact of an aggregate shock.During periodsof extremestress,it is especially important to focus on unexpectedlossesin order to assessthe tails of the loss distributions.The research of the RTF-TC group focused on the quantile regression (QR) methodto addressthisissue. The QR approach focuseson the tail eventsof conditional riskindicator distributions.It allowsfor the possibility of extremeeventsleading to changesin the statisticalrelationshipsbetween the risk indicatorsand macroeconomic variables acrossthequantiles of the distribution of a given stressindicator and by doing so, provides amore complete picture of covariateeffects.For example, a covariatesrelationship with a stressfactor can differ substantially atlower and upper quantilesof a dependent variable compared to itsrelationship at itsmean or median values.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 77RTF-TC researchshowed that the QR approach is robust to extremeevents and canalsobe used to construct density estimatesand forecastsof real activity and financialstressand expectedshortfall measuresof systemic real risk and systemic financialrisk.The QR approach produced more conservative resultswhen compared with otherapproaches to modelling the macro-credit risk link.The method is very flexible and could have a variety ofadditional applicationsin the areaof stresstesting, such asforecastinginterestincome, fee income, profits, or loan loss provisions; or on probability of default (PD)estimatesand loss-given-default (LGD) estimateswhich influence risk-weightedassetsand capital adequacyratios.To read the paper:http: / /www.bis.org/publ/bcbs_wp21.htmBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 78The policy implications of transmission channelsbetween thefinancial system and the real economyBCBS Working Papers No 20, May 2012The Basel Committees ResearchTask Force Transmission Channel project aimed atgenerating new researchon variousaspectsof the credit channel linkagesin themonetarytransmission mechanism.Under the credit channel view, financial intermediariesplay a critical role in theallocation of credit in the economy.They arethe primarysource of credit for consumersand businessesthat do not havedirect accessto capital markets.Among more traditional macroeconomic modelling approaches, the credit view isunique in its emphasis on the health of the financial sector asa critically importantdeterminant of the efficacyof monetary policy.The final products of the project are two working papersthat summarisethe findingsof the many individual researchprojects that wereundertaken and discussedin thecourseof the project.The first workingpaper, Basel Committee Working Paper No 20, "The policyimplicationsof transmission channelsbetweenthe financial system and the realeconomy", analysesthe link betweenthe real economyand the financial sector, andchannelsthrough which the financial system may transmitinstability to the realeconomy.The second working paper, Basel Committee Working Paper No 21, "Models andtools for macroprudential analysis", focuseson the methodological progressandmodelling advancementsaimed at improving financial stability monitoring and theidentification of systemic risk potential.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 79Becauseboth working papersaresummaries, theytouch only briefly on the resultsand methodsof the individual researchpapersthat were developed during the courseof the project.Eachworking paper includescomprehensivereferenceswith information that willallow the interested reader to contact any of the individual authorsand acquire themostup-to-date version of theresearchthat wassummarisedin eachof theseworkingpapers.The policy implications of transmission channelsbetween thefinancial system and the real economyIntroductionThe recent global financial crisiswasa catalyst for regulatorychange.Policymakers havestrengthened existing micro-prudential tools, such asbank-specificcapital and liquidity requirements, and introduced newmacro-prudential tools, such ascountercyclical capital requirements, capitalsurchargesfor systemically-important financial institutions, and loan-to-value capstopromote financial stability.In addition, stresstesting hastakenon new importance both asa meansfor helpingpolicymakers decide on a courseof action and asa tool for communication.At the sametime, data emerging from the crisis provides new information abouttransmission channelsbetween the financial system and the real economy.For example, it isnow obviousthat economic models and analysis mustaccount forthestateof thefinancial system whenforecastingtheevolution of themacroeconomy.Moreover, the crisishas shownthat linear approximations based on data from normaleconomic timesfail in periodsof financial sector stress.Suchissueshighlight the need to improve our understanding of the role of thefinancial sector in the monetary transmission channel.Over the past twoyears, a subgroup of the ResearchTask Force, the TransmissionChannels (RTF-TC) project, hasworked to produce original researchthat addressesquestionsand outstanding issuesregardingtherolethefinancial sector plays, both foreconomic growth and asa sourceof economic instability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 80During this period, researchhasbeen presented by the contributing institutionsatseveral international workshops.Theseworkshopshave facilitated the communication of ideasand the interaction ofresearchersworking on the relevant topics.Many significant contributionshave been made during this time.This document summarisesthe group‘s findings.It isimportant to rememberthat most of this researchispreliminary, and individualauthorswill continue to refinetheir analysis and conclusions.Sowhile we offer this summary of the group‘s findings, we stresstheir preliminarynature, and caution against using these resultsto formulate policy without furtherresearchand supporting analysis.Moreover, wecaution that this document is not acomprehensiveliteraturereview, butreflectsthe specific contributions and insights of the RTF-TC members.This report isdesigned asa reference document for policymakers, bank supervisors,and researchersalike and is organised around four topics:(1)The interactionsbetweenbank credit, monetarypolicy and growth in the realeconomy;(2) Costsand benefitsof bank capital and liquidity regulation;(3) Bank risk taking and monetary policy;(4) Asset price bubbles and cyclical properties of regulation.For each of these topics, several key questions have been identified for discussion.Weconclude eachsection by highlighting the new issuesand questionsthat havearisen and identify someremaining gapsin the literature.1. The interactionsbetween bank credit, monetary policy andgrowth in the real economyBrief summary of literatureBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 81This section focuseson the interactionsbetween credit, economic growth, thebanking sector and the real economy.It iswell-known that monetary policy affectsthe supply of bank credit.Halvorsen and Jacobsen (2009), Hammerlsland and Traee(2010) and Tabak et al(2010) all confirm that tighter monetarypolicy hasa negative impact onbank lending.Moreover, this effect reflects at least in part a reduction in loan supply asshown byCiccarelli et al (2010), Black and Rosen (2009), Jimenez et al (2010), Havro and Vale(2011) and Jimborean and Messonier (2010).The transmission channel of loan supply to the real economyis investigated inHiratakaet al (2010), Dedola and Lombardo (2009), Jimenez et al (2010), de Haasandvan Horen (2010) and Black and Rosen (2009).Thesepapersfind that bank balancesheet conditionsgreatly influence thetransmission of shocksto the real economyasthe health of bank balancesheetsaffectsbank lending and the credit available to bank dependent borrowers.The efficacy of monetary policy may depend on market conditions. Havro and Vale(2011), Ciccarelli et al (2010), de Haasand van Horen (2010) and Boissay (2011) showthat a drop in market liquidity weakens thecredit channel of monetary policy andleads to a negative contribution to GDP.Monnin and Jokipii (2010) find a positive link betweenmeasuresof banking sectorsoundness and growth in the real economy.SomeRTF-TC researchfocused on understanding the impact of leverage andliquidity on the provision of credit. The evidence appearsto be mixed.Someauthorsdo not find a clear direct effect of leverage on lending (Havro and Vale(2011)), while othersprovide evidence that better capitalised banks, to a varyingdegree, aremorewilling to lend (Berrospideand Edge (2010); Foglia et al (2010)).Further evidence of the importance of bank health is provided by Francis andOsborne (2009) who show that bankswith capital in excessof their own capital targetlend more than their peers.The impact of liquidity on the provision of credit appears to be similar. Bankswithmore liquid portfoliosappear more willing to lend (Havro and Vale (2011)).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 82Basedon findings by the RTF-TC, this section of the report addressesthe followingquestions:(1)How does monetary policy impact the credit channel?(2) Do financial market conditionsimpact the credit channel?(3)What is the relative importanceof the bank lending and borrowerbalance sheetchannelsin the financial transmission mechanism?(4)How do higher capital standards impact economic growth, credit availability andfinancial stability?(1) How doesmonetary policy impact the credit channel?Empirical studies have found evidence that increasesin the central bank policy ratehave a negative impact on bank lending.Examplesofsuchpapersusing macroeconomic data include Halvorsen and Jacobsen(2009) and Hammerlslandand Traee (2010) which study both the UK and theNorwegian economies.Similarly, at the micro (bank) level, Tabak et al (2010) find that bank lending isreducedin responseto an increasein the central bank policy rate in Brazil.While such an effect is consistent with the existenceof credit channel influencesoncredit supply, thesestudies do not prove that credit channel effectsare present sincetheydo not identify whether the amount of credit changesbecause of a shift in creditsupply or a change in credit demand.Several papershave tried to solve this identificationproblem.Ciccarelli et al (2010) use the confidential euro area Bank Lending Survey and thepublicly-available US Senior Loan Officer Survey to disentangle the effects of loansupply from loan demand.They find loan supply to be moresensitive to monetary policy shocksthan loandemand.Black and Rosen (2009) usebank-level data on extensionsof businesscredit toexaminehow monetary policy affectsaggregate loan supply.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 83They examinethe distribution of loans acrossfirmsof different sizes, the maturitystructureof loan originationsand the supply of loans from small and large banks.They find monetarypolicy affectsaggregate loan supply by causing variation in thematuritiesof new originations, with theimpact being at least asstrong for largebanksasfor small banks.Jiménez et al (2010) usedisaggregated data for analysing the bank lending channeland conclude that the provision of loans is significantly affected by tighter monetarypolicy.Havro and Vale (2011) aswell asJimborean and Mésonnier (2010) provide furtherevidence using Norwegian and French data, respectively.The empirical findings highlighted above suggest that at least part of the effect onbank lending from tighter monetarypolicy is supply driven, ie there is a bank lendingchannel for monetary policy.(2) Do financial market conditionsimpact the credit channel?Financial market conditionsappear to affect the strength of the credit channel.More specifically, a decreasein market liquidity weakensthe credit channel ofmonetarypolicy and resultsin slowerGDP growth for any given level of the policyrate.Even in the presence of very low interest rates, when market liquidity conditions arepoor, credit availability is subdued as banks tighten lending standards, especially foruncollateralised borrowers.Recenttheoretical models have considered the optimal policy responsesto adversefinancial shocks;such models suggest that aggressive easing of monetarypolicy isappropriate and that higher capitalised banking systemscan attenuate this liquidityeffect.Norwegian bankswerenot exposedtosubprime-related assets,but theywereaffectedby global market liquidityconditions.Havro and Vale (2011) regard the aftermath of the Lehman crisis asan exogenousliquidity shock for the Norwegian banking system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 84They find that, following the Lehman bankruptcyshock, Norwegian banks‘loansupplycurvebecameconsiderablysteeperand thetraditional bank lending channel ofmonetarypolicy may not have been working in the crisis period.In a related study, Ciccarelli et al (2010) show that during the recent financial crisis,liquidity problemshad a strong negative impact on GDP growth by reducing loansupply to businesses.The wholesalemarket plays a central role in determining market liquidity conditions.Boissay (2011) argues theoretically that the wholesale financial market improves theallocation of liquidity inside the banking sector, but becomes fragile when availableliquidity exceedsthe liquidity absorption capacity of the economy.This leadsto a ―crisis time‖ equilibrium that is characterised by deleveraging.Monetary policies may have to adapt to reflect the condition of the financial sector.De Fiore and Tristani (2009) develop a model that relaxesthe assumption offrictionlessfinancial marketsand show that an aggressiveeasing of policy is anoptimal responseto adverse financial market shocks.Similarly, using dynamic stochastic general equilibrium (DSGE) modelswithfinancial frictions, Dib (2010) finds that higher capital requirementscan attenuate thereal impact of financial shocks on the macroeconomy; and Tomura (2010)demonstratesthat liquidity mismatchesin bank balancesheetslead to anendogenousdemand for bank capital to prevent bank runs.Inafinancial crisis, bank behaviour canoffset monetarypolicy stimulus.De Haasandvan Horen (2010) examine how the global financial crisisprompted banks to tightenlending standardsdespitevery low policy interestrates.Using data on syndicated loans made to private borrowersin 65countriesover theperiod 2005–2009, they find tighter lending standardsfor uncollateralised loans, forloans to first-time borrowersandfor financial-sector borrowersin developedcountries.Increasesin borrowerscreeningand monitoring were lessevident for rated borrowersand for loans structured by well-known arrangers.Analysis of counterparty exposuresmayhelp anticipate bank crisis behaviour.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 85Castrénand Kavonius(2009) useeuroarea flow-of-fundsdata to construct asector-level network of bilateral balance sheet exposures, which they extend torisk-based balance sheets.They find that bilateral cross-sector exposuresareimportant channels through whichfinancialintermediariesaffect borrowersin other sectorsincluding the transmission offinancial sector shocks.(3) What is the relative importance of the bank lending andborrower balance sheet channels in the financial transmissionmechanism?The evidence of the importance of bank capital positions for sustaining bank loangrowth is mixed but the data supports the importance of household balance sheetsasa factor limiting credit.Somestudies find that well capitalised banks are more likely to grant credit and arelesslikely to limit credit.However, other studies find banks that areholding lesscapital are more willing tolend.On the borrowerside of the equation, researchshowsthat balance sheet conditionsarethe dominant credit channel affecting households.Households with weakbalance sheetsand credit performancearelesslikely to obtaincredit from a bank.Bank capital conditionscan affect the strength of the credit channel. Foglia et al(2010) usebank loan- and firm-level data to separate bank lending effects fromborrowerbalance sheet effects in order to quantify how loan supply constraintsaffectedreal investment spending following the collapse of Lehman Brothersin 2008.They find that well capitalised bankswith balanced maturity structureswere lesslikely to ration credit.Moreover, after the Lehman crisis, rationed firmstended to reduceinvestmentspending by a greater amount than non-rationed firms.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 86Jiménez et al (2010) usean extensive dataset of businessloan applications andoriginationsto examinehow lending is relatedtothe balancesheet conditionsof boththe banks aswell asthe firmsseeking credit.They find that both of thesebalance sheets(banks‘and business‘) play an importantrole in determining how changesin economic activity or short-term interest ratesaffect the extension of credit.Unsurprisingly, well-capitalised firmsweremore likely to be granted credit than theirmore poorly-capitalised counterparts.However, banks with lesscapital or liquidity (ie riskier banks) weremore, not less,likely to make loans.Avery et al (2010) uselocalised measuresfor bank health and household debtperformanceto examinehow bank and borrowerbalancesheetsaffect local economicactivity.On the local level, bank capital had a stronger direct link to economic activity(unemployment rates) during the housing boom and bust period than during theprevious decade.However, this capital channel doesnot appear to operate through expandedhousehold lending, a finding that may reflect that national lendersdominate USmortgage and consumer credit markets.This is consistent with the idea that balance sheet conditionsare the dominant creditchannel affecting households and suggests that, at least at the local level, banksmatter mainly for businessspending, through commercial and industrial lending.Theoretical models may help to explain the interaction between bank lending andborrowerbalance sheet channelsthat weobserve in the data. Hirakata et al (2011)develop a DSGE model wherefinancial intermediariesinvest household savings withentrepreneurs.In this model, shocksto borrower creditworthinessarepropagated to the realeconomythrough the revisionsof credit contracts.When the model is estimated using US data, the authorsfind that adverseshockstofinancial intermediaries causelarger economic downturnsthan do shockstoentrepreneurs.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 87In another theoretical paper, Dedola and Lombardo (2009) model a two-countryeconomic system with a financial accelerator and an endogenousportfolio choice toshow how foreign exposuresin the balance sheetsof leveraged investorscanpropagateshocksacrosscountries.Inthis framework, financial sectorshockscancauselargerealsectorshockseven withminimal balance sheet exposureto foreign riskyassets(solong asasset marketintegrationacrossbordersgenerates an equalisation of external finance premia facedby leveraged investors).In this scenario, a global flight to qualitywill yield similar (de-)leveraging, financialand macroeconomic dynamics acrosscountries.Bank lending shocks have important effectson real sector growth and volatility.Halvorsen and Jacobsen (2009) find that bank lending shocksexplain a substantialshareof output gap variability in Norwayand the UK from 1988through 2009.This period includesboth the Norwegian banking crisis (1988–1993)and the morerecent financial crisisin the UK.Using data for 18 OECD countries from 1981through 2008, Monnin and Jokipii (2010)examinethe relationship between banking sector stability and the real economy.Using country-level indicatorsof financial sector health, they find a relationshipbetweenbanking sector stability and the performanceof the real economy.In a related study, Jimborean and Mésonnier (2010) link French bank balance sheetcharacteristics to macroeconomic fluctuationsand find that banking sectorconditionsmatter more for real sector performanceduring crisis periods.Moreover, since the resultsshow that feedback effects tend to be largelydriven byperiodsof instability, thereare likely to be real economic benefits from well-executedmacroprudential supervision.Togetherthesestudies suggest several important waysthrough which financial sectorproblemsmagnified real sector volatility.Bank capital and liquidity problemshad adverse real consequencesthroughreductionsin credit supplied to businesses.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 88At the sametime, the severeimpairment of households‘balance sheetsand thedeteriorationof their credit performancereducedthe willingnessof even healthybanks to lend to the household sector.(4)How do higher capital standardsimpact economic growth,credit availability, and financial stability?Sincethe financial crisis, policymakers have focused on regulatoryenhancementsaimedat preventing future crises.Bank capital regulation has been at the forefront of discussionsasa meansto ensurethe resilience of the global financial system.Despite the obviousbenefitsof increasing required capital, criticsarguethat strongercapital and liquidity regulationswill reducebank credit, stifle economic growth andreducefinancial stability.In this section, wediscussthe RTF-TC‘s findings regarding bank capital, economicgrowth, credit availability, and financial stability.(a) Bank capital and economic growthBank capital and liquidity regulations must strike a balance betweencostsandbenefits. Several paperspresentedat the RTF-TC workshopscomparethe costsandbenefitsassociatedwith higher capital and/or liquidity requirements.For example, Francis and Osborne (2010) model the costs of additional capital asanincreasein the wedge between lending and deposit rates and estimate the neteconomic benefitsassociated with a range of changesin prudential standards.In a related study, Kato et al (2010) show that the optimal level of bank capital variesconsiderably depending on the level of banks‘liquidity aswell asmacroeconomicconditions.The optimal level of bank capital maynot be constant over the businesscycle.In addition to comparing costsand benefits associatedwith tighter regulations, Katoet al (2010) highlight the need for a countercyclical buffer to better prepare forprospective distress.Repullo et al (2010) offer a specific proposal for a countercyclical capital buffer.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 89Christensenet al (2011) show that absent regulation, bank leverage fluctuatesasthemacroeconomic environment changesto accommodate the economy‘s requirementsfor lending with the natural inertia in bank capital.Regulation that limits, or directs, movements in leveragecan thusimportantly affectthe propagating impact of bank capital.(b) Bank capital and credit availabilityWhen a bank faces a capital shock from lossesor a changein regulation, it mustconsider the trade-off between the marginal costsof issuing equity and the marginalcostof cutting back on lending.Kiley and Sim (2010) model this trade-off. Banksrespond to a shock through a mix offinancial disintermediation and recapitalisation.Agur (2010) analysesthe trade-off between financial stability and credit rationing thatariseswhen capital requirementsareincreasedand showsthat with greater useofwholesale finance, capital requirementshave a stronger impact on the real economy.This impact resultsfrom feedback effectsbetweenloan rates and funding rates. Sinceuninsuredfinanciers–whorepresentwholesaleinvestors–careabout theriskofthe bank they are lending to, higher loan rates lead to higher funding rates, whichamplifies the impact of capital requirements.The empirical evidence on the effectsof capital shocks on lending supports thetheory.Francis and Osborne (2010) usedata on UK banks and show that better capitalisedbanks aremorewilling to supply loans.This feature is especially true in timesof crisis (Foglia et al (2010)). Coffinet et al(2010) usemicrodata on French banks to show that bank capital behavesin aprocyclical manner especially when better quality capital is considered.Darracqet al (2010) assessthe effects of introducing risk-sensitive and more stringentcapital requirements.They show that a bank capital shock resultsin an increase in bank leverage which, inorder for banks to re-establish their target leverage ratio, leads to an increase in banks‘loan-deposit margins.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 90This is mainly driven by higher lending rates, which in turn lower loan demand andreal activity.They concludethat if banks have more time to adjust their activitiesand balancesheetsto a new environment, they will tend to smooth the impact of the shock.(c) Bank capital and financial stabilityIn the aftermath of the recent financial crisis, much debate hasbeen focused on newregulationsthat wereintroduced to preservefinancial stability.In addition to the need to increaseindividual bank resilience, a consensushasemergedregarding the need to consider financial stability from a systemicperspective.Somepapersstudied by the working group estimate models of bank defaultprobabilitiesaswell asthe probability of a financial crisismore generally.Osborne et al (2010) and Kato et al (2010) estimate probit/logit models of theprobability of a financial crisis occurring.Capital and liquidity ratios are key determinantsof the likelihood of a crisis withhigher ratiosbeing associated with a reduced probability.Higher capital and liquidity standards lower the probability of a crisis.Capital regulationsmay need to consider the potential for contagion. Gauthier, Leharand Souissi (2010) estimate overall systemic risk by explicitly incorporating contagionexternalitiespresent in the financial system.They show that systemic capital allocationscan differ substantially and are notdirectly related to bank size or individual bank default probability.Systemic capital allocationmechanisms are estimatedto reducedefault probabilitiesof individual banks aswell asthe probability of a systemic crisisby about 25%.Their resultssuggestthat financial stability can be enhanced by implementing asystemic perspectiveon bank regulation.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 91New questions and issuesthat have arisenIn assessing this strand of literature, somenew questionsand issueshave arisen.What roles do the structuresof the bank and the non-bank sectorsplay in thelonger-term development of real estate booms?Evidencesuggests that low interest rates were oneof the key factorscontributing tothe leverage build up; however, competition betweenthe un-regulated and regulatedfinancial sectorsmay have contributed to risk taking in extending credit to riskierborrowers.How have credit market developmentsthat increasethe degreeof lending beyond thebanking sector affected linkages between the banking system and the real economy?Similarly, how do secular trendsin bank credit extensions– such asshifts toasset-basedlending in real estate boom periods – affect linkages betweenbanks andthe real economyduring bust periods?Finally, an important dimension of the bank lending channel is the potential for amisallocation of resourcesin the real economy.Istheresome wayto quantify the real effectsof bank lending in termsof types ofinvestment spending occurring in the real sector of an economy and the attendantmisallocation of resourcesassociatedwith overbuilding in the residential real estatesector?Remaining gapsin the literatureSeveral important gapsremain in the literaturestudying the interaction betweencredit, growth, the banking sector and the real economy.Evidenceon the role of financial markets in the credit transmission channel ofmonetarypolicy remainsscarce,while the role of market funding and securitisationshould alsobe further researched.In addition, in light of the vast amount of public fundsinjected into the financialsystem during the courseof the financial crisis, the efficacyof public (vsprivate ormarket-based) capital injectionsremains relativelyunexplored.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 92Suchevidence could perhapsinform on the macroeconomic implications of lossabsorbency that isprovided using contingent capital or bail-in debt instrumentstosystemically important institutions.Moreover, another interestingquestion is whether new regulationsshould account forgovernment shareholdersin the bank.From a methodological point of view – regardlessof the methodology used (ieVAR-type models, DSGE models, or theoretical models) – limited attention has beenpaid to nonlinearities and structural breaks.For instance, theeffectof BaselII inceptionor thespecificityof downturn periodshasonly been scarcely investigated.In light of the recent financial crisis, nonlinearities in relationshipsin crisis andnon-crisis periodshave emergedasa key gap in the research. More work is needed tounderstand differencesbetweenhow credit channels work in both good and badtimes.In addition, thereis little evidence on how the financial environment prior to a crisisaffectsthe economic significance of a particular credit channel for economic activity.Further work on theseissueswould also be fruitful.Additionally, morework needs to be done to identify shocks to loan supply that aredue to changesin loan demand generatedby future profit expectations.Credit demand reflects expectationsabout future investment opportunitiesasassetvaluesare inherently forward looking.Thus lower asset valuescan change credit demand by affecting the balance sheetsofbanks and borrowers,but they may also signal lowerexpected future returnsfromholding the asset which mayitself reducethe demand for credit.Finally, moreresearchisneeded to understand how linkagesbetweenbanking sectorconditionsand real sector activity are related to specificinstitutional and regulatoryfeaturesof an economy.2. Costs and benefits of bank capital and liquidity regulationBrief summary of literatureBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 93Higher capital and liquidity requirementsmaygenerate social benefitsby reducingthe frequency and severityof banking crisesand the accompanying lossof economicoutput, and maygenerate costsby impacting the price and availability of credit andother financial services,and therebyaltering the level of investment and output in theeconomy.Schanz(2009), Schanz et al (2011), Barrell et al (2009) and Kato et al (2010) aim toquantify the overall costsand benefitsof higher capital and/or liquidity standards.The resultsof thesestudies are broadly similar, although thereare some quantitativedifferences, reflectingdifferent assumptionsabout departuresfrom theModigliani-Miller (M-M) theorem, among other factors.In termsof the benefitsthat would result from tighter regulation, Barrell et al (2009)and Kato et al (2010) both find that higher standardsshould lower the probability of afinancial crisis.In contrast, Schanz et al (2011) concludesthat the resultsvary depending on thespecificassumptionsthat aremade in the model.The thrust of theliteratureontherole of bank capital and liquidity is that morecapitaland liquidity will smooth credit availabilityover financial cycles, although whetherthis outcomecanbe achieved by imposing fixed requirementsremainssomewhatlessclear.This section considersthe following questions:(1)What are the costsand benefitsof higher capital and liquidity requirements?(2)What are the key differencesbetweenstudies on the costsof increasedcapitalrequirements?(3)Whataretheimplicationsof theseliquidity and credit supply findingsfor theBaselliquidity standards?(4)Isit possible to quantify the benefitsof tighter regulation?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 94(1) What arethecosts and benefits of higher capital andliquidityrequirements?Following the recent financial crisis, it has been widely recognised that in order toreducethe risk of future financial crises,both capital and liquidity buffersareneededto withstand shocks.Several papersshed light on the costsand benefitsof stricter capital and liquidityregulationsand provide significant insight into the new standards.The costsof higher capital and liquidity requirementsaregenerated by the impactthat higher requirementshave ontheprice and the availabilityof credit, and theeffectthat this has on the level of investment and output in the economy.Oneof the benefitsof higher capital and liquidity standards is a lower probability of afinancial crisis and the associatedreduction in the expectedcost of such a crisis intermsof lost output.The studies reviewed(Schanz et al (2011), Barrell et al (2009) and Kato et al (2010))make varying assumptionsabout each of theseelements, leading to somewhatdifferentresultsin termsof theoverall costsand benefitsof themorerobuststandards.Osborne et al (2010) enhance the UK Financial ServicesAuthority/National Instituteof Economic and Social Research (FSA/N IESR) modelling framework by includingmicro-foundationsthat generate individual bank responsesto changesin prudentialstandards.They alsoinclude alternativeparameterisationsof the macroeconomic costsandbenefitsused in the framework.Macroeconomic costsassociatedwith liquidity are refined using market andregulatorydata (between 1999and 2007) and integrated into the National InstituteGlobal Econometric Model (NiGEM) framework and the model is modified toaccount for changesin the composition of regulatory capital.The improved model hasfewer type 1errors(ie the failureto identify an observedcrisis) and fewertype 2 errors(ie the false identification of a crisis).This finding suggests that capital and liquidity requirementsareboth important forreducing the probability of and macroeconomic costsof a crisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 95(2) What are the key differencesbetween studieson the costs ofincreased capital requirements?Bank capital iscostly because of frictionsin financial marketsthat lead to deviationsfrom M-M, which would otherwisepredict that higher equity capital would notincreasebanks‘funding costs.In the calculationof the costs, banks are assumedto passon the extra funding costsfromhigher capital to borrowersbyraising lending rates.This reducestheactivitiesofborrowers,therebyresulting in a lossin GDP.The papersrevieweddiffer from each other in the assumptionsthat theyadoptregardingthe magnitude of the deviationsfrom M-M, resulting in different estimatesof the costsof higher capital requirements.To estimate the effects of costly bank capital, Schanz et al (2011) applies a range ofassumptionsabout deviations from M-M to data on the cost of equity and debt in theUK.The paper concludesthat the curve showing the marginal benefitsof higher capitalratiosis quite steep at the intersectionwith all of the (horizontal) marginal costestimates, so estimatesof the ―optimal‖ capital ratio do not varymuch in the costestimates.Dueto the challenges associatedwith achieving a definitive parameterisationof therelationship betweencapital ratios and the cost of credit, Barrell et al (2009) take anempirical approach using an estimateof the long-run relationship betweenthecapitalratio and the cost of credit for the economyof the UK.The parameterstheyestimateresult in animpact of aonepercentagepoint increaseinthe capital ratio of around 12–15basis points.Comparedto the Schanz et al (2011) results, these representa relatively conservativeparameterisation.The study by Kato et al (2010) usesa formula for welfare lossassociatedwith capitalrequirementstaken from van den Heuvel (2008).Changesin the cost of bank credit will translate into changesin investment,consumption and GDP.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 96Schanzet al (2011) calculatesthe long-term impact of the increasein loan rates onGDP using a CES production function with increasedfirms‘cost of capital due tohigher loan rates, whereasKato et al (2010) and Barrell et al (2009) usein-housemacroeconomic models for this element of the modelling.The cost of higher liquidity is calculated by a ―cost of carry‖ that isequal to theincreasein the cost of credit required to offset the impact of holding a higherproportion of liquid assetswith lower yield, such ascash and government bonds, oneither return on equity (ROE) or return on assets(ROA).(3) What arethe implicationsof these liquidity and credit supplyfindingsfor the Basel liquidity standards?The effectsof liquidity requirements may depend on monetaryconditions.Muchof theresearchconsidering theimpactof higherliquiditystandardsonfinancialstability has been limited to empirical modelsof the probability of a financial crisis.Several recent studies have examined how liquidity conditionsaffect credit supplyunder tight monetary conditions.Among these, Jimenez et al (2011) finds that banks with more liquid assets tend to bemore resilient to tight monetary policy and deteriorating economic conditions, whileweakerbanks tend to contract credit supply.Theseresultsmay be explained by banks with stronger balance sheetsbeing betterable to raise fundsduring tight monetaryconditions, consistent with the finding thathigher liquidity is associatedwith a lower probability of a crisis (and, in the caseofSchanzet al (2011), lower probability of individual banksdefaulting).Thesefindings are largely consistent with the traditional view of the bank lendingchannel.Banks with stronger liquidity positions are more likely to maintain lending, but thismay not provide accurate guidance asto the potential impact of minimum liquiditystandards.The beneficial impact of higher liquidity during stressed market conditions, togetherwith the already existing literature on the bank lending channel seem to suggest thathigher liquidity standards will smooth credit supply over financial cycles.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 97However, weshould be cautiousabout drawing conclusions about liquidityrequirementsfrom results on the effect of liquidity conditions.There are other factorswhich could explain the resultswith respectto liquidityconditions.For example, banks that anticipate strong loan demand in the near future, or banksthat have a lot of outstanding loan commitments mayoptimally decide to hold moreliquid assets todayin order to be readyfor the moment the lending opportunitiesmaterialise, asin the traditional ―pecking order‖ theory of corporate finance.This could explain the observed correlation, but it doesnot mean that if banksarerequiredto hold moreliquid assetsthen theywill automaticallylend more, astheywillnot have the same investment opportunities.Indeed, requiring higher liquid assetscould reduce the supply of credit if it reducesthe net present value of lending opportunities.Consider aswell the issue that a bank subjected to a regulatory requirement to hold aspecifiedlevel of liquid assets maynot be able to absorb shocks aswell asone notsubject to the requirement.The former may be unable to sell itsliquid assetsbecause it would fall below theliquidity requirement.In this manner, liquidity held by choice is distinct from liquidity held because of arequirement.Another possibility recognisesthat banks may adjust their loans and liquidity tomaintain a preferredbalance.Supposeexogenousfactorscould push liquid assetsabove banks‘desiredlevel.The bank mayrespond by expanding credit to regain itsdesired balance with liquidassets.Hence,the correlation between liquid asset holdingsand credit supply could be just ashort-run phenomenon (eg Francis and Osborne (2009)or Berrospideand Edge(2010)).According to this view, higher liquidity standards could reducecredit supply byreducing the amount of excessliquid assets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 98This view suggests that studies need to closely examine the reasons why some bankshave higher liquidity ratios than othersin order to be able to understand the effect ofhigher liquidity standards.(4) Isit possible to quantify the benefits of tighter regulation?Estimatesof the benefitsof tighter regulationdepend on whether empirical modelsincorporate non-linear termsto account for the potential imperfect substitutabilitybetweenliquidity and capital.Papersby Barrell et al (2009) and Kato et al (2010) model the probability of a financialcrisis basedon historical data and using capital and liquidity measuresasregressors.There are two significant differencesbetweenthe studies. Barrell et al (2009) modelonly linear effects for the capital ratio and the liquidity ratio and this assumption canlead to corner solutionswhereit is optimal to hold either capital or liquidity, but notboth.Kato et al (2010) identifiesnon-linear effectsof capital and liquidity, which impliesthat capital and liquidity maybe imperfectsubstitutesfor eachother, in thesensethathighercapital ismoreeffective in reducing theprobability of acrisisif liquidity is highaswell.The finding that capital and liquidity are mutually reinforcing maybe interpretedasproviding support for the introduction of international liquidity standardsasasupplement to capital standards.Another important distinction is the useof different measuresof liquidity. WhereasBarrell et al (2009) find a role for the ratio of liquid assets-to-total assets, Kato et al(2010) have the same finding but also find that higher liability-side liquidity (ie theextent to which firmsrely on long-term debt) is alsoa key mitigant of the probabilityof crisis.Calculatingthenetbenefitsof higherstandardsmeanscombining theestimatesof thereductionin the likelihood of a crisis by the estimated cost of a financial crisis.The difficultiesfor doing this arewell describedby Schanzet al (2011) who show boththat a wide range of estimates are available, and that very different resultscan beobtained by varying the assumption of whether financial crisesresult in a permanentreductionin growth.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 99New questions and issuesthat have arisenThe introduction of Basel III has generated substantial interest in understanding theeconomic consequencesof enhanced prudential standards.Many of the costs and benefits associated with the new ruleshave been addressedinthe literaturediscussedabove.However, several new questionsand issueshave emerged.The studies have looked at the potential impact of liquidity standards, which are nowbased on an internationally agreedstandard.While the researchsuggeststhat banks with greaterliquidity can better maintainlending over the cycle, thereis a need for further researchon how banksreact toliquidity standards, the potential costsof such standards, and the potential impact onbanks‘risk-taking.Analytical input will beneededto monitor and investigatehow thenewstandards(theliquidity coverage ratio (LCR) and the net stable funding ratio (NSFR)) work inpracticeto reducethe risk inherent in a bank and the banking sector.What are the likely behavioural effectsof new capital and liquidity standards?In particular, what impact will higher standardshave on banks‘risk-taking?Could the substantial increasein standards seenin Basel III result in a migration ofrisk to the nonbank sector, and if so, how can this be addressed?How do the costsand benefits of higher standardsvary depending on economic andfinancial conditions?The papersbySchanz et al (2011) and Katoet al (2010) showed that variationsin initialconditionshad a large effect on the resultsin termsof optimal calibrationofprudential policy and thus it will be important to understand what drivesthesedifferences, particularly in light of the increasedfocus on ―macroprudential‖ policies.Indeed, the net benefitsassociatedwith Basel III implementation in eachjurisdictionwill likely depend on the economic and financial conditionsbefore and during thetransition period, which of coursecan vary acrossjurisdictions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 100How should feedback effectsfrom the macroeconomybe evaluated, both in thecontext of whether therearesteady-state or transitional costsof higher standards, andhow shockscan be amplified by an undercapitalised banking system when standardsarein somesensetoo low?Remaining gapsin the literatureTogether, the papersdiscussed above provide a useful clarification of the issuesrelatingto bank capital and liquidity regulations, but several gaps in the literatureremain.More work is needed to understand the nature of the costsof a financial crisis.In particular, is the effect on economic growth temporaryor permanent?Isthe loss due to the occurrenceof a crisis recoverable?What determines the magnitude of a loss?Do output lossestimatesneed to be adjusted for the possibility that a financial crisiscould potentially be causedby a slowdownof the economy, rather than the other wayaround?Moreover, it is still unclear how the probability of a crisis occurring would changewhenbanks with different levels of capital and liquidity – even if the averageof thebanking sector asa whole is still the same– are interconnected within a certainjurisdiction and acrossjurisdictions.Inaddition, theextent towhichbankswould passonthecostsfrom stricterregulationto their borrowersremainsunclear.To whatextent would theeffectcomefromincreasingloan ratesand to whatextent bycredit rationing?How does the impact change depending on the economic environment, the degree ofcompetition in financial service markets, financial structure (the importance ofindirect finance), and the size of the borrowers?Finally, even though a leverage ratio has been introduced aspart of the Basel IIIpackage, most of the studies reviewedfocus on risk-weightedcapital ratios.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 101In this context, it may be useful to further examine how and when these two differentcapital regulations might complement or contradict each other for reducing the risksposed to the financial system and the real economy.To read more:http: / /www.bis.org/publ/bcbs_wp20.htmBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 102Joint Consultation Paper on the proposed response to theEuropean Commission‘sCall for Advice on the FundamentalReview of Financial Conglomerates Directive14May 2012The Joint Committee of the European SupervisoryAuthorities (EBA, EIOPAandESMA) is launching today a three-month public consultation on the proposedresponseto the call for technical advice from the European Commission on thefundamental review of the Financial ConglomeratesDirective (―the FICOD―).This consultation coversthree broad areaswhereadvice is sought by the EuropeanCommission: the scope of application, the group wideinternal governancerequirementsand sanctionsand supervisory empowermentsunder the FICOD.In itsproposed response,the Joint Committee issuesa seriesof recommendationsforthe review of the FICOD, including the wideningof the scope of supervision,addressing requirementsand responsibilities to a designated entity within thefinancial conglomerate and the framework of supervisory powersprovided by theFICOD.Moreover, the Joint Committee will be providing later this year, a supervisorycontribution to the wider fundamental review of the FICOD, which isbeing carriedout by the European Commission.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 103EBA, EIOPA and ESMA‘s Joint Consultation Paper on itsproposed response to the European Commission‘s Call forAdvice on the Fundamental Review of the FinancialConglomeratesDirectiveLondon, Frankfurt, Paris, 14May 20121.Responding to thisConsultationThe threeEuropean SupervisoryAuthorities, theEuropeanBankingAuthority (EBA),the European Insuranceand Occupational PensionsAuthority (EIOPA) and theEuropean Securitiesand MarketsAuthority (ESMA) invite commentson all mattersinthis.Commentsaremost helpful if they:- Respond to the question stated;- Indicate the specific question to which the comment relates;- Contain a clear rationale;- Provide evidence to support the viewsexpressed/ rationale proposed;and- Describe any alternative regulatorychoicesEBA/EI OPA/ESMAshould consider.2. Executive Summary1. The Joint Committee of the European SupervisoryAuthorities‘ SubCommittee on Financial Conglomerates(JCFC) received a Call for Advicefrom the European Commission in April 2011to look at the(A) scopeof application, especially the inclusion of nonregulated entities(B) internal governance requirementsand sanctions, andBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 104(C) supervisory empowerment of Directive 2002/87/EC on the supplementarysupervision of credit institutions, insuranceundertakingsand investment firmsin afinancial conglomerate (FICOD).This adviceshall contribute to theEuropeanCommission‘s fundamental reviewof theFICOD, following the short technicalreview, resulting in Directive2011/89/EU (hereafter FICOD12).2.Asa result of itsanalysis, the EBA, EIOPAand ESMA, hereinafter theESAs, proposethe following answersto the questionsrisen by theCommission in itsfourth Call for Advice (hereinafter CfA):Question1CfA: What should be the perimeter of supervision, when afinancial conglomerate issupervisedon a group wide basis?3. Recommendation 1:The Perimeter of supervision should be enlarged to ensure a more thorough groupwide supervision and avoid possible regulatory arbitrage, by enhancing the groups ofentities that can be included in the identification of a financial conglomerate.Accordingly the ESAssuggest to allow for a more consistent and broaderidentification of financial conglomeratesto modify the definition of ―financial sector‖[according to Article 2 (8) FICOD] and/ or the definition of ―regulated entities‖[according to Article 2 (4) FICOD]. Therefore, the definition of financial sector[Article 2 (8) FICOD] should be enlarged to include insuranceancillaryservicesundertakingsand all special purposevehicles/entities to enable a broaderidentificationof financial conglomerates,andtoenablethat therisksareappropriatelycaptured.4. The ESAshave assessed whether Institutionsfor occupationalretirement provision (IORPs) should be included aspart of a financialconglomerate and are mindful of the national specificities of IORPs.The ESAswelcomethe viewsof the stakeholderson the following options:Option1:Include IORPswithin the definition of ―financial sector‖, in a similar manner to theinclusion of Alternative Investment Fund Managers(AIFM) and Asset ManagementCompanies (AMC) within FICOD, e.g. by enlarging the definition of a regulatedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 105entity according toArticle 2 (4) FICOD and by amending Article 3 FICODrespectively.Option2:Maintain the status quo; such that IORPswould not be included within group widesupervision at cross5sectoral level, given that prudential risks posed by IORPstofinancial conglomerates have not been demonstrated.However, this might imply that relevant financial activitiesof IORPsmight not betaken into account when identifying a financial conglomerate and applyingsupplementarysupervision.5. Recommendation 2:Mixed financial holding companies (MFHCs), even if unregulated, should be madesubject to supplementary supervision or any type of requirementsthat are proposedbelow.Accordingly, MFHCsshould be included together with regulated entitiesasthe legaladdresseeof supplementary supervision.6. Recommendation 3:Companies undertaking solely industrial activities(with no financial servicesactivityat all), such asindustrial conglomerates, should not be subject to direct financialsupervision asthe supervisory focusmight be diverted from financial undertakings.Mixed activity holding companies (MAHCs) and mixed activity insuranceholdingcompanies (MAIHCs) should not becomedirect addresseesof FICOD, but thesupervisor should have the ability to accessrelevant information from such MAHCand MAIHC within itssupervisory tool kit.The following supervisory tools arenot mutually exclusive and the ESAswelcometheviewsof the stakeholdersin order to assessthe implication of this recommendationfurther.7. Supervisorsshould be empowered:Tool 1–Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 106To require the creation of an intermediatefinancial holding which isresponsible forall the entities (or at least, all the regulated entities) carrying out financial activitiessubject to supplementarysupervision andwhich will be the ―addressee‖ for supervision.Tool 2–To designate one single ―point of entry‖ at the top of the unregulated entities in placeof a formal ‗common chapeau‘of the financial entities in the group.This point ofentryisnot alegal person,but asimple referencefor thesupervisors(e.g.a specific team or division or a memberof the Board of the parent entity).Tool 3–To designatea specified regulated entity aspoint of entry which doesnot necessarilyneed to be the top entity of the entire financial conglomerate.This option has merit if the enforcement requirementsand sanctioning measuresaddressedto the top entity cannot be adequately enforced by the supervisors.Question2 CfA: Given your experience and expertise, which legal entityin a conglomerate should be responsible and qualify for compliance withgroup wide requirements, i.e. which legal entity should be theresponsible parent entity?8. Recommendation 4:The European Commission should identify and define an ultimate responsible entityfor the financial conglomerate according to the following minimum criteria: control,the dominant entity from the market‘sperspective (market listed entity) and theability to fulfil specificdutiestowardsitssubsidiaries and itssupervisor.Question3 CfA: Given your supervisory experienceand expertise, whichrequirementsshould be imposed on this qualified parent entity in thecontext of group wide supervision?9. Recommendation 5:This ultimate responsible entity should be responsible for compliance with groupwide requirements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 107The EuropeanCommissionshould explicitly requiretheultimate responsibleentitytohave a coordinating and directing role over the other entitiesof the conglomerate.Moreover, someexisting requirementsfor regulated entitiesand requirementsthatcan be derived from the ESAs‘guidelines on InternalControls should also be applicable for the top parent entity, whether theregulated entity is a Holding Company or a Financial Holding Company(FHC), InsuranceHolding Company (IHC) or a MFHC.Question 4 CfA6: Given your supervisory experience and expertise, whichincentives (special benefits or sanctions) would make the enforcement ofthe group widerequirementsmore credible?10.Recommendation 6:In order to ensurethat the group wide requirementsare enforceable, the EuropeanCommission should develop an enforcement regimetowardsthe ultimate responsibleentity and its subsidiaries.This would imply adual approachwith enforcementpowerstowardsthetop entity forgroup5wide risks and towardsthe individual entities for their respectiveresponsibilities.Corrective measuresshould be directed towardsthe entity that isresponsible for therespective breach.11.Recommendation 7:In any case, the supervisor should have a minimum set of measures, consisting ofinformative and investigative measures,at hand (seeRecommendation 3).Supervisorsshould be able to administer sanction measuresaddressedat the MAHCor MAIHC, wherethis entity doesnot to provide the requestedinformation.Moreover, when(under Tool 1, Recommendation3) an intermediatefinancial holdingcompany has been established, supervisorsshould be able to administer sanctionmeasuresat this intermediatefinancial holding company.Question5 CfA: When reflectingupon this advice, would supervisorsinEurope need other or additional empowerment in their jurisdictions?12.Recommendation 8:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 108WhilsttheFICOD providestheESAsand thesupervisorswith alargesupervisorytoolkit, supervisor‘s actual useof this tool kit should be enhanced.Further a minimum set of enforcement measuresthat national supervisorsshouldhave at their disposal towardsthe group (Article 16FICOD), should be achieved bythe ESAsdeveloping guidelines or by being askedto develop binding technicalstandards for a common reporting schemeon risk concentrations and intra grouptransactions,(including the possibledevelopment of guidelines for quantitative limitsunderArticle 7 (3) and 8 (3) FICOD).This alsoimplies creating a minimum set of sanctioning measuresthat should beapplied towardsthe group in caseof a breach of group wide requirements.In addition, the European Commission should take into account sectoraldifferencesthat may arisebetweenCRD IV and SolvencyII.Structuresof a financial conglomerateThe following example illustrates that there are somegroup structuresthat make itverydifficult to identify a financial conglomerate:In somecasesasubgroup within alargecomplex group (hereafterLCG) qualifiesasafinancial conglomerate. But after calculating the threshold for the entire group(including the ―real‖ industry) this group doesnot fulfil the FICOD‘s 40% thresholdand, therefore, the wholegroup will not be subject to supplementarysupervision.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 109This situation may also be a wayof avoiding supplementary supervision.By setting up a chain of holding companies with subsidiaries of ―real‖ industry the40%threshold will not be fulfilled after a certain point.Currently, the supervisor is only allowed to addressthe regulated entity (e.g. in orderto get information).The regulated entity hasto cooperate with its parent entity (and is responsible for thedeliveredinformation to the supervisor) but has(under company law) no powers to get necessaryinformation.Thereforethe possibility to addresssupervisory issuesconcerning information andsanctionsto holding companies should be strengthened.In addition, theremight be structureswhich are even more complex.In thesecasesindustrial groups mayhave many different regulated entitieswhich arenot held by one parent entity but arespread over the group.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 110In this case, it is almost impossible for supervisorsto identify the holdingcompanywhich may qualify asMAHC or MAIHC.Further, supervisorsmight not be able to supervise the group on a groupwidelevel toavoid double gearing; but the regulated entitiesof the banking and insurancesectorareall supervised on a solo level.The potential negative effects (arising from intragroup transactionsor riskconcentrations) arescarcely visible.This may lead to spillover effects (either from the industrial part to the financial partor vice versa).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 111Consequently, supplementarysupervision on a group wide level would help (if thisgroup doesnot qualify asa financial conglomerate according toArticle 3 FICOD).Thus, introducing a responsible entity within the group asan addresseeforsupervisory actionswould lead to moreclarity from a supervisory point of view.To learn more:http: / /www.eba.europa.eu/cebs/media/Publications/Consultation%20Papers/2012/JC%2001/JC-CP-2012-01--ESAs-Joint-CP----EC-call-for-advice-on-fundamental-FICOD-review-.pdfBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 112Market entry criteria revised for banking sector in Hong KongThe Banking Ordinance (Amendment of Seventh Schedule) Notice2012, which seeksto update certain market entry criteria for the banking sector in Hong Kong, will begazetted on Friday, 18May 2012.Aspokesman for the Financial Services and the TreasuryBureau said, ―Theseamendmentsseekto removefrom theBankingOrdinancecertainlicensingcriteriaforbanks, which have becomeunnecessarily restrictiveand put Hong Kong at adisadvantagewhen compared with other international financial centres.Theselicensing criteria to be repealed may restrict well-managedand reputabledomesticand overseasinstitutions from establishing a presencein Hong Kong.‖The Notice seeksto remove the present licensing requirement under which anapplicant for a bank licence must have total customer deposits of not lessthan HK$3billion and total assetsof not lessthan HK$4billion.The Notice also seeks to remove some present impediments which restrict foreignbanks from entering the Hong Kong market through the establishment of a locallyincorporated subsidiary.Aspokesman for the Hong Kong MonetaryAuthority said, ―Some internationalfinancial institutions do not take deposits aspart of their normal business. Theproposedrevisionswill allow a broader range of qualified domestic and internationalinstitutions to participatein our financial markets,without compromising thestabilityof Hong Kong‘s banking system.‖The proposedamendmentsarosefrom areview last year by the Hong Kong MonetaryAuthority, which concluded that somelicensing conditionsunder the BankingOrdinance applying to Hong Kong arenot found in other major financial marketssuchastheUnited Kingdom, theUS, Germany, Switzerland, Australia and Singapore.Theseconditionsarealsonot part of the international standards for bankingsupervision and regulation.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 113The Notice will be tabled before the Legislative Council on Wednesday, 23 May 2012.Subject to the negative vetting of the Notice by the Legislative Council, theamendmentswill take effect on July 12, 2012.Hong Kong MonetaryAuthority16May 2012Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 114The fit and proper requirements…Tribunal upholds FSAdecision to ban and fine former UBSadvisers£1.3m for not being fit and proper in relation to anunauthorised trading scheme21May 2012The UpperTribunal (Tax and ChanceryChamber) hasdirected theFinancial ServicesAuthority (FSA) to fine Sachin Karpe £1.25 million and Laila Karan £75,000 and banthem both from performing any role in regulated financial servicesfor failing to actwith integrity, in breach of Principle 1of the FSA‘s Statementsof Principlesand Codeof Conduct for Approved Persons(―APER‖) and for not being fit and proper persons.BetweenJanuary 2006to January 2008, Karpe wasDeskHead of theAsia II Desk atUBSAG (UBS) international wealth management businessin London.BetweenFebruary2007and January 2008, Karan worked asa Client Advisor on theAsia II Desk, reporting directly to Karpe.The Asia II Desk provided servicesto customersresident in India, or of Indian origin.KarpeDuring the relevant period Karpe carried out substantial unauthorised trading,predominantly in FX instruments, with a grossvalue of billionsof pounds across39customer accounts.Healsomade unauthorised transfersand loans betweenclient accountsin order toconceal lossesarising from the unauthorised trading.Hedirected others(including Karan) to assist him in arrangingthetransfersandloans,and creating false documentation for the unauthorised trading.His schemeresultedin substantial lossesfor 21customers.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 115UBS has since paid compensationto the affectedcustomersin excessof US$42million.Karpe alsoestablished an investment structure to enable a major (Indian resident)customer (via an investment fund incorporated in Mauritius) to breach Indian law inclear contravention of UBSguidelines.Ultimately, the customer invested over US$250million in the fund.Karpe deliberatelyand repeatedly misled compliance in order to accommodate hiscustomer.Karpe alsomisled UBS and senior management about paying compensation to acustomer using monies from another customer account.The Tribunal found that:―Mr Karpe inducedothersserving on his deskto participatein what wasan obviouslydishonest courseof conduct...we infer that the whole motivation wasto benefit himindirectly and in thelongterm byobtaining newclientsthrough hisapparent prestige,increasing fundsunder management and therebyadvancing his career and increasinghis bonuses.‖The Tribunal accepted that the compliance failings at UBS might have created anenvironment within which staff could ―get away with‖ misconduct – however, thiswasno excusefor Karpe‘ssustained dishonesty.KaranKaran did not instigate the unauthorised trading; however, she wasawarethatunauthorised activity wasoccurring on some customer accounts for which she wasresponsible.BetweenFebruary2007and January 2008, rather than escalatingthis knowledge,Karan assisted Karpe in concealing the unauthorised activity.In particular, Karan preparedfalse, handwritten telephone attendancenotespurporting to record customer instructionsshe had received when shehad takennosuchinstructions;routed transactionsthrough a suspenseaccount in order to concealtheir origin and destination; signed a number of UBS documentsrecording theBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 116approval of transactionson the accounts without having received instructionsorauthorisation from the customers;and failed to escalate herknowledgeofunauthorised loans betweencustomers.MsKaran also failed to escalateher knowledgethat Mr Karpe had misled UBS andsenior management about paying compensationto a customer using monies fromanother customer account.The Tribunal noted that:―We recognise that Ms Karan had been placed in an extremely awkward situationthrough the manipulation of Mr Karpe.The fact, however, is that over and over again she choseto go along with and, onoccasions, to facilitate Mr Karpe‘swrongdoing.‖Tracey McDermott, acting director of enforcement and financial crime, said:―Karpeexploited and abused his position of trust, and persuaded more junioremployeesto engage in misconduct to assist him.Suchbehaviour is in breach of his obligations to his employer, his clientsand hiscolleagues aswell asto the regulator.It hasno place in the financial servicesindustry.Wewelcomethe Tribunal‘s confirmation that aswell asbanning Karpe, a significantfinancial penalty should alsobe imposed.This sendsa clear message of the consequencesof such behaviour.―Karansought to categoriseherself asa victim in this matter. The Tribunal (as hadthe FSA) recognised that shedid not initiate the misconduct, and wasplacedin adifficult position by Karpe.However, the findings and the resulting sanctions send a clear messagethat anapproved personmust take responsibilityfor their own actions.Wherean approved personis awarethat colleaguesareengaging in misconduct, weexpectthem to blow the whistle, not to becomeinvolved themselves.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 117―Those who take on the responsibility of being an approved person should be in nodoubt about our commitment to take the strongest action to tackle behaviour whichfalls below the high standards weexpect.‖In November 2009the FSAfined UBS £8million for systemsand controls failuresinrelation to the unauthorised activity which occurredon theAsia II Desk.In December2011JaspreetSingh Ahuja and in November 2009Andrew Cumming,both formerAsia II Desk client advisers,werebanned and fined £150,000and£35,000respectively.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 118SpeechbyAndrea Enria, Chairpersonof the European BankingAuthorityFinancial integration and stability in Europe: the role of theEuropean Banking Authority23May2012, at the15thChina Beijing International High Tech Expo China FinancialSummit 2012Dear CHITEC host, Ladiesand Gentlemen,It isa pleasureto have been invited to addressyou thismorning at the China Financial Summit 2012.Given the very difficult environment weare facing in thefinancial markets, and especially in the European bankingsector, this conference provides an excellent opportunity togive this international gathering someinsight into therecently established European BankingAuthority, theEBA, including the role it plays in tackling the crisis, andin strengthening the regulatory framework for European banks.While the immediate challenges aredominating our thoughtsat present, it is alsoimportant that wecontinue to develop the structural changesnecessaryto deliver amore secure and stable banking environment for the long term.The extent of the problemswhich have beset the global financial system over the lastfive yearsareunprecedented in modern timesand have exposed seriousweaknessesin financial regulation and supervision.In his February2009report, Jacques de Larosière pointed to the belief that in the runup to the commencement of the crisis in 2007, financial regulation and supervisionhad been too weakand provided the wrong incentives.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 119Lack of adequate macro-prudential supervision, ineffective early warningmechanisms, lack of franknessand cooperation betweensupervisorsand lack ofcommondecision makingprocesswereamong thekeylessonslearnedfromthecrisis.Wehad a Single Market, closely integrated especially after the introduction of theeuro, but the regulatory and supervisory environment has remained very diverse,notwithstanding the efforts for harmonisation.Akey component of the European responseto addressing thesedeficiencies wastheestablishment of the European System of Financial Supervision on 1January 2011.This includesthe European Systemic Risk Board (ESRB), in charge ofmacroprudential supervision, and the threeEuropean supervisory authorities, theEBAfor banking, ESMAfor securitiesand marketsand EIOPAfor insuranceandoccupational pensions.The EBAhas been given a wide-ranging mandate. In the field of supervision, whilethe day-to-day oversight of banks‘ safety and soundness remains a responsibility ofnational authorities, the EBAhas been entrusted with key responsibilities.Theseinclude the regular conduct of risk assessments, which should alsolead to theestablishmentof a risk dashboard, and of area-widestresstests, aimedat ensuring theresilience of European banks in front of adverseshocks.The EBAalsofosterscooperation between home and host authorities and activelyparticipatesin and overseesthe work of supervisory colleges for cross-bordergroups.Additional tasksareenvisaged in the area of crisismanagement wherethe EBAis inchargeof coordinating recoveryand resolutionplansfor the major European bankinggroups.In the area of rule making, the EBAplays a major role in the establishment of theso-calledSingle Rulebook – i.e. technical rules truly uniform throughout theEuropean Union, adopted through legal instrumentsthat aredirectly binding in allthe 27Member States of the Union.Last but not least, wehave been entrusted with the responsibility for monitoring andtacklingconsumer issues.Let me first give you an overview of the EBA‘s role and activities in relation to microprudential supervision, and namely to the Authority‘s efforts in tackling the financialcrisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 120TheEBA‘s effortsin tackling the crisisThe EBA‘s initial prioritieswere centeredon the challenges raised by thedeteriorationof the financial market environment.In the first part of 2011, weconducted a stresstest exercise, aimed at assessing thecapital adequacyof the largest European banks in front of adverse macroeconomicdevelopments.The exercise focusedon credit and market risks and also, in recognition of the risksthat subsequently crystallised, incorporated sensitivity to movementsin fundingcosts.Bankswererequired alsoto assessthe credit risk in their sovereign portfolios.Inmanyrespects,I believetheexercisewassuccessful:in orderto achievethetoughercapital threshold, anticipating many aspectsof the new Basel standards, banks raised€50bnin fresh capital in the first four monthsof the year; weset up a comprehensivepeer review exercise, which ensured consistencyof the resultsacrossthe EuropeanSingle Market, notwithstanding the many differencesin national regulatoryframeworks;the exercise includedan unprecedenteddisclosure of data (more than3200datapointsfor eachbank), including, amongstother things, detailedinformationon sovereign holdings.However, the progressof the stresstest wastrackedby a significant furtherdeteriorationin the external environment.The main objective of restoring confidence in the European banking sector wasnotachieved, asthesovereigndebt crisisextendedto morecountries,thusreinforcing theperniciouslinkage betweensovereignsand banks.Soonafter the completion of the stresstest, most EU banks, especially in countriesunder stress,experienced significant funding challenges.In this context, the IMF and the European Systemic Risk Board (ESRB), called forcoordinated supervisory actionsto strengthen the EU banks‘capital positions.The EBAassessmentwasthat without policy responses, the freeze in bank fundingwould have led to an abrupt deleveraging process,which would have hurt growthprospects and fuelled further concernson the fiscal position of some sovereigns, in anegative feedback loop.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 121Wethen called for coordinated actionon both the funding and the capitalisationside.Whileadvising the establishmentof an EU-widefunding guaranteescheme, the EBAfocused itsown efforts on thoseareaswhereit had control, primarily bankcapitalisation.To this end, the EBA‘s Board of Supervisors, comprising the heads of all 27nationalsupervisory authorities, discussed and agreedthat a further recapitalisation effort wasrequiredaspart of a suite of coordinated EU policy measures.This resulted in the EBAissuing a Recommendation that identified a temporarybuffer to addresspotential concernsover EU sovereign debt holdings and requiredbanks to reach 9% Core Tier 1.The total shortfall identified was€115bn.The measure, agreedin October 2011and enacted in December2011, seeksthatSupervisoryAuthorities should requirethosebanks coveredby itsRecommendationto strengthen their capital positionsby end of June 2012.The Recommendation wasswiftly followed by the ECB‘s long term refinancingoperations (LTROs), arguably the key ―game changer‖ in this context.The LTROs allowedbanks to satisfytheir funding needs in front of a significantamount of liabilities to roll over in 2012, thus preventing a massive credit crunch.The recapitalisationwasa necessarycomplementarymeasure:while banks neededunlimited liquidity support, to keep supporting the real economy, they had to beaskedto accelerate their action to repair balance sheetsand strengthen capitalpositions.When the processis completed, European banks will be in a much stronger position,alsovis-à-vis their main peersat the global level.The EBAis, in general, satisfied with the progressmade in the fulfilment of thisRecommendation and notes that the actions taken by the bulk of banks includecapital strengthening and adequate recognition of losses.In addition, threebanks identified ashaving weaknesseshavesubsequentlyundergone restructuringprocessesand will no longer exist in the sameform asat themoment of the stresstest.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 122Wehave put alot ofeffortsto avoid that banksreachedthetargetratio bycuttingassetlevels instead of raising capital, thus reducing credit availabilityfor corporates,especially small and medium enterprisesand households.However, a deleveraging processis needed in the banking sector.It hasalready started, with a different pacein different areasof the global financialsystem and needsto be accomplished in an ordered fashion.The first step has been the increasein capital levels, long overdue and one of thecornerstonesof the regulatory reformsendorsed by the G20 Leaders.The second step requiresa reductionin size of balance sheets, especially byaddressing non-performing assets and de-riskingin areas suchascapital marketactivities and real estate lending, which grew too much in the run-up to the crisis.The third step entails a refocusing of businessmodels, especially towardsmorestablefunding structuresand the gradual exit from the extraordinarysupport measuresputin place by central banks.I am convinced that without an ordered deleveraging process,through a significantstrengthening of capital and a selective downsizing of asset levels, wewould failaddressing the fragilitiesthat are preventing banks from performing theirfundamental functions.Supervisory CollegesThe misalignment betweenthe international nature of the major banking groups anda national system of supervision has been a contentioussubject for many years.In the years preceding the crisis and in an effort to improve supervision, colleges ofsupervisorswereestablished, to varying extents, for major banking groups.However, asthe financial stressesdeveloped in 2008, thesestructuresdid not workeffectively in a large number of cases.The already difficult situation wascompounded by the lack of dialogueandinformation exchange between supervisory authorities, asnational priorities tookprecedencein the decision making process.Giventheproblemswhichthislackof cooperationpresented,therewasaclearneedtoradically overhaul the voluntary structureswhich existed.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 123This need hasmanifesteditself in legislative changesto the Capital RequirementsDirective (CRD), the primary European legislation that implements the Basel accordfor banking in theEU, and in specificprovisions incorporatedintothe mandate of theEBA.Supervisorycolleges are now required for all crossborder banking groups operating inthe European Economic Area and the EBA has been granted full participation rightsasa competent authority.The EBAstaff areattending supervisory collegesof the major systemically importantgroups in Europe and go to thesemeetingswith a clearly defined goal of promotingandmonitoring theefficient, effective and consistentfunctioning of collegesaswell asfostering the coherent application of the EU law by supervisors.Also, since 2011, European colleges arethe forum in which the consolidatingsupervisor and the competent authorities responsible for the supervision ofsubsidiaries arerequired to reach a joint decision on the capital of the group and therelevant subsidiaries.The formal system of joint risk assessments,which underpins this process,and thedrive to makethecoresupervisorydecision oncapital, representsamajor stepforwardin the coordination of crossborder supervisory processes.I am glad to saythat in many of thesemeetingsfor banking groupswhich haveoperations outside the European Union, consolidating supervisorswill often invitesupervisorsfromcountriesoutsidetheEU sothat theycangive afirsthand account ofthe risks being run in the entities they oversee.The EBAstrongly believesthe work to implement thesearrangementshas to bestrengthened in order to improve the effectivenessof supervision for cross-bordergroups.Good progresshas been made in many quarters.Forinstance, national authoritiesarecoming to their joint decisionsonthecapital of abanking group using the common structuresand templatesset out in guidelinesissuedby the EBA.However, thereis still a long wayto go to enhance consistencyin supervisoryoutcomesand to achieve adequate levels of information exchange and cooperation.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 124Crisis ManagementIt isat thesetimesof intensechallenge, that structuresand relationshipsaremosttested, and weactually seehow well coordination of supervision worksat aninternational level- and seemost clearly wherefault linescontinue to exist.BeforeI give you someviewson what ishappening within the EU regulatorycommunity, I needto forcefullymake thepoint that primaryresponsibility to enhancepreparednessfor a crisis situation lies with the banks themselves.Banksmust learn the lessonsof the crisis and materially improve their riskmanagement processes.They must embed into their processesthe capacityto perform real stresstests andmake suretheyarewell equipped to withstand severeadversemarket developments.Part of this processwill involve the development of effective Recovery and ResolutionPlans (RRPs) and the identification of the steps to be taken when the viability of thefirm is at risk.The guidance of the Financial Stability Board is a key benchmark in thisarea.For cross-border groups in the European Union, colleges of supervisorswill developplansfor the coordination of supervisory action in emergencysituations.CollegesaresupplementedbytheCross-BorderStabilityGroups(or ―crisiscolleges‖),which bring together fiscal authorities, central banks and supervisors.But thelessonof thecrisisisthat voluntarycooperation arrangementsarenot enough.Stronger legal and institutional underpinningsareneeded to enforceeffective crisismanagement and resolutiontools in the European Single Market.An important step hasalreadybeen taken to strengthen the European institutionalsetting with the provisions set out in our founding Regulation, which givesthe EBAresponsibilitiesin areassuch asthe monitoring of colleges, the development ofRecoveryand Resolution Plans and the conduct of EU-wide stresstests.In addition, when an emergencysituation is declaredby the European Council, theEBAhasbeen given the power to addressspecific recommendationsto nationalsupervisory authorities with a view to coordinating their actionsand, if necessary,apply European decisions directly to individual institutions in caseof inaction bynational authorities.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 125Nonetheless,the structuresare not completeand a more formal role for the EBAincrisis management will depend on the outcome of the European Commission‘s workon new legislation for bank recoveryand resolution, due out soon.The legal underpinning for crisis resolution needsto be fully harmonised in order toallow for an integrated process,with close cooperation betweenthe authoritiesinvolved.This should allow interconnecting national resolution proceduresso asto ensure anintegratedapproachfor cross-border firms, ensuring an equitable treatment ofcreditorsin all jurisdictions.At the sametime, mechanismsshould be in placeto constrain the actionsof nationalauthoritiesand drive towardscoordinated, firm-wide solutions.Over time, the EBA‘s role in this area is likely to grow substantially, including itsrolein mediating between conflicting interests of national authorities asserious problemsemerge.Rule Making and the Single RulebookAsproposed by de Larosière in his report, the EBAnow has the capacityto draftdirectly applicable rules,by meansof regulatoryand implementing standardsthat willthen be adopted by the European Commission asEU Regulationsand therebybecomedirectly binding in the whole EU, without the need for nationalimplementation.This processwill help eliminate many of the inconsistencieswhich have arisen fromoptions, national discretions, and the different interpretationsadopted when previousrulesweretransposed into national legislation by the 27EU Member States.Materially reducing the fragmentation in the EU regulatory regime will providegreater certainty to market participantsand stronger foundations for convergence insupervisory practices.Basedupon the current legislativeproposals for the implementation of Basel 3, about200deliverables will be expectedfrom the EBA, including proposals for around 100Technical Standards such ason the definition of capital, capital buffers, liquidity,remuneration, and the leverage ratio.This will be essential to ensure level playing field and avoid in the future that theregulatorylever is used to attract businessin national market placesor to favourBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 126national champions, a processthat has played a great role in the relaxation ofregulatorystandardsin the run up to the crisis.The EBAcan alsoissueGuidelines and Recommendations which arenot legallybinding, albeit the EU national supervisory authorities need to indicate publiclywhether they intend to comply, and if this is not the casethey will need to publiclyexplain the reasons.The EBAcan alsoconduct peer reviewsin order to make sure that the commonstandards and guidelinesareeffectively applied in a consistent and effective fashion.ConclusionsLadies and gentlemen,Today I tried to convey to you an overview on the difficult challengesthe EBAisfacing.In our first 16months of activity, wehave alreadydone a huge effort to strengthen thecapital position of EU banksand to restoreconfidencein their resilience.The work is not over in this area.The liquidity support provided by the ECB avoided an abrupt deleveraging process,but banks arestill in the processofrepairing and downsizingtheir balancesheetsandof refocusing their corebusiness.We, as supervisors, need to accompany this processand do our utmost to ensure thatit occursin an ordered fashion, without adverse consequences on the financing of thereal economy.In the coming months wehave to completethe preparationfor the implementation ofthe reformsagreedby the G20 Leaders,in particular Basel 3.It isa major challengefor regulatorsacrossthe world and the EBAis establishingclose contacts with fellow supervisorsin other countries, including China, to ensurethat thereis alwaysan open dialogue and a common commitment to strengtheningthe safety and soundnessof banks.In the EU, this challenge is compounded with our resolve to setup a much moreuniform regulatorysettingfor all thebanksoperating in theSingleMarket, with thesocalled Single Rulebook.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 127Strengthening regulation is not enough if it isnot coupled with more effectivesupervision, especially for those large and complex groups that are active on across-border basis and maygenerate systemic risks acrossjurisdictions.This requiresidentifying best supervisory practices and ensuring convergencetowardsthesebenchmarks, aswell asstrengthening cooperation within colleges ofsupervisors.This has surely a strong European dimension, due to the relevance of cross-borderbusinesswithin the Single Market, but requiresalso close cooperation withsupervisorsin other regions.Weare surely committed to bringing our contribution to the successof thisendeavour.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 128Wehave a very interestingpaper from theBank of international Settlementsthatclarifies issuesof the Basel ii / iiiframeworks.Fundamental review of the tradingbook - consultative documentMay 2012This consultative document setsout a revisedmarketrisk framework and proposesa number of specificmeasuresto improve trading book capitalrequirements.Theseproposals reflect the Committees increasedfocus on achieving a regulatory framework that canbe implemented consistently by supervisorsand which achievescomparable levels ofcapital acrossjurisdictions.Keyelementsof the proposals include:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.comA more objective boundary between the trading book and the banking bookthat materially reduces the scope for regulatory arbitrage - feedback is sought on twoalternative approaches;Moving from value-at-riskto expected shortfall, a risk measurethat bettercaptures"tail risk";Calibrating the revisedframework in both the standardised and internalmodels-based approachesto a period of significant financial stress, consistent with thestressedvalue-at-risk approachadopted in Basel 2.5;Comprehensively incorporating the risk of market illiquidity, again consistentwith the direction taken in Basel 2.5;Measuresto reduce model risk in the internal models-based approach,including a more granular models approval processand constraintson diversification;andArevisedstandardised approach that isintended to be more risk-sensitive andact asa crediblefallback to internal models.
  • 129The Committee is alsoproposing to strengthen the relationship between themodels-based and standardised approaches by establishing a closer link betweenthecalibration of the two approaches, requiring mandatory calculation of thestandardised approach by all banks, and considering the meritsof introducing thestandardised approach asa floor or surchargeto the models-based approach.Furthermore,thetreatmentofhedging anddiversification will bemorecloselyalignedbetweenthe two approaches.Commentson thisconsultative document should besubmitted byFriday7September2012by e-mail to baselcommittee@bis.org.Alternatively, commentsmaybesent bypostto theSecretariat of theBaselCommitteeon Banking Supervision, Bank for International Settlements, CH-4002Basel,Switzerland.All commentswill be published on the Bank for International Settlementss websiteunlessa commenter specifically requestsconfidential treatment.Oncethe Committee hasreviewedresponses, it intends to releasefor comment amoredetailed set of proposals to amend the Basel III framework.In line with itsnormal process,the Committee will alsosubject such proposals to athorough Quantitative Impact Study.AbbreviationsCDS Credit default swapCRM Comprehensiverisk measureCTP Correlation trading portfolioCVA Credit valuation adjustmentES Expected shortfallGAAP Generally AcceptedAccounting PrinciplesIFRSInternational Financial Reporting StandardsIRC Incremental risk chargeMTM Mark-to-marketOTC Over-the-counterP&L Profit and lossPVBP Presentvalue of a basis pointRWARisk-weighted assetsBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 130SDR Special drawing rightsSMM Standardised measurement methodVaR Value-at-riskFundamental review of the trading bookExecutive summaryThis consultative document presentsthe initial policy proposals emerging from theBasel Committee‘s (―the Committee‖) fundamental review of trading book capitalrequirements.Theseproposals will strengthen capital standardsfor market risk, and therebycontribute to a more resilient banking sector.The policy directions set out in this paper form part of the Committee‘s broaderagenda of reforming bank regulatorystandards to addressthe lessonsof the financialcrisis.Theseinitial proposals build on the seriesof important reformsthat the Committeehas already delivered through Basel III and set out the key approaches underconsideration by the Committee to revisethe market risk framework.Theseproposals alsoreflect the Committee‘s increasedfocus on achieving aregulatoryframework that can be implemented consistently by supervisorsand whichachievescomparable levels of capital acrossjurisdictions.The Committee‘s policy orientations with regard to the trading book area vitalelement of the objective to achieve comparability of capital outcomesacrossbanks,particularly thosewhich are most systemically important.BackgroundThe financial crisis exposed material weaknessesin the overall design of theframework for capitalising trading activities and the level of capital requirementsfortrading activities proved insufficient to absorb losses.Asan important responseto the crisis, the Committee introduced a set of revisionstothe market risk framework in July 2009(part of the ―Basel 2.5‖ rules).Thesesought to reduce the cyclicality of the market risk framework andBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 131increasethe overall level of capital, with particular focus on instrumentsexposed tocredit risk (including securitisations), where theprevious regime had been foundespecially lacking.However, the Committee recognised at the time that the Basel 2.5 revisionsdid notfully addressthe shortcomingsof the framework.Asa result, the Committee initiated a fundamental review of the trading book regime,beginning with an assessmentof ―what went wrong‖.The fundamental review seeksto addressshortcomingsin the overall design of theregimeaswell asweaknessesin risk measurementunder both the internalmodels-based and standardised approaches.This consultative paper sets out the direction the Committee intends to take intacklingthe structural weaknessesof the regime, in order to solicitstakeholders‘commentsbefore proposing more concreterevisionsto the market riskcapital framework.Key areas of Committee focusThe Committee hasfocused on the following keyareasin itsreview:The trading book/banking book boundaryThe Committee believesthat itsdefinition of the regulatory boundary hasbeen asource of weakness in the design of the current regime.Akey determinant of the boundary is banks‘ in t ent to t rade , an inherentlysubjective criterion that hasproved difficult to police and insufficiently restrictivefrom a prudential perspectivein somejurisdictions.Coupled with largedifferencesin capital requirementsagainst similar types of risk oneither side of the boundary, the overall capital framework proved susceptible toarbitrage.While the Committee consideredthe possibility of removing the boundary altogether,it concluded that a boundary will likely have to be retained for practical reasons.The Committee is now putting forth for consideration twoalternative boundarydefinitions:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 132―Trading evidence‖- based boundary:Under this approachthe boundary would be defined not o nly by banks‘ intent,bu t alsoby evidence of their ability to trade and risk manage the instrument on atrading desk.Any item included in the regulatory trading book would need to be marked to marketdaily with changesin fair value recognised in earnings. Stricter, more objectiverequirementswould be used to ensure robust and consistent enforcement.Tight limitsto banks‘ability to shift instrumentsacrossthe boundary following initialclassification would also be introduced.Fundamental to this proposal is a view that a bank‘s intention to trade –backedup by evidence of this intent and a regulatoryrequirement tokeepitemsin theregulatorytrading book once they areplaced there – is the relevant characteristic fordetermining capital requirements.In somejurisdictions, application of this type of definition of the boundary couldresult in regulatory trading books that areconsiderably narrowerthan at present.Valuation-based boundary:This proposal would move awayfrom the concept of ―trading intent‖ and construct aboundary that seeksto align the design and structure of regulatorycapitalrequirementswith the risksposed to a bank‘s regulatory capital resources.Fundamental to this proposal is a view that capital requirementsformarket risk should apply when changesin the fair value of financial instruments,whether recognisedin earningsor flowing directly to equity, poserisks to theregulatoryand accounting solvencyof banks.This definition of the boundary would likely result in a largerregulatory trading book,but not necessarily in a much wider scope of application for market risk models ornecessarily lower capital requirements.Stressed calibrationThe Committee recognisesthe importance of ensuring that regulatorycapital issufficient in periodsof significant market stress.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 133Asthe crisisshowed, it ispreciselyduring stressperiodsthat capital is most critical toabsorb losses.Furthermore, a reduction in the cyclicality of market risk capital chargesremains akey objective of the Committee.Consistent with the direction takenin Basel 2.5, the Committee intends to addressboth issuesby moving to a capital framework that is calibrated to a period ofsignificant financial stressin both the internal models-based and standardisedapproaches.Moving from value-at-risk to expected shortfallAnumber of weaknesseshave been identified with using value-at-risk (VaR) fordetermining regulatory capital requirements, including itsinability to capture―tailrisk‖.For this reason, the Committee hasconsidered alternative risk metrics, in particularexpectedshortfall (ES).ESmeasurestheriskinessofaposition byconsidering both thesizeandthelikelihoodof lossesabove a certain confidence level.In other words, it is the expectedvalue of thoselossesbeyond a given confidencelevel.The Committee recognisesthat moving to ES could entail certain operationalchallenges;nonethelessit believesthat theseare outweighed by the benefitsofreplacingVaR with a measurethat better capturestail risk.Accordingly, the Committee is proposing the use of ES for the internal models-basedapproachand alsointendsto determine risk weights for the standardised approachusing an ES methodology.Acomprehensive incorporation of the risk of market illiquidityThe Committee recognisesthe importance of incorporating the risk of marketilliquidity asa key consideration in banks‘regulatory capital requirementsfor tradingportfolios.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 134Beforetheintroduction oftheBasel2.5changes,theentiremarketriskframework wasbased on an assumption that trading book risk positions were liquid, ie that bankscould exit or hedge thesepositionsover a 10-day horizon.The recent crisis proved this assumption to be false.Asliquidity conditions deterioratedduring the crisis, banks wereforced to hold riskpositions for much longer than originally expected and incurred large lossesdue tofluctuations in liquidity premia and associatedchangesin market prices.Basel2.5partly incorporatedtheriskof marketilliquidityintomodellingrequirementsfor default and credit migration risk through the incremental risk charge (IRC) andthe comprehensiveriskmeasure(CRM).The Committee‘s proposed approachto factor in market liquidity riskcomprehensively in the revisedmarket risk regimeconsistsof threeelements:- First, operationalising an assessmentof market liquidity for regulatory capitalpurposes.The Committee proposesthat this assessment be basedon the concept of―liquidity horizons‖, defined asthe time required to exit or hedge a risk positionin a stressedmarket environment without materially affecting market prices.Banks‘exposureswould be assigned into five liquidity horizon categories,ranging from 10days to one year.- Second, incorporating varying liquidity horizonsin the regulatory market riskmetric to capitalise the risk that banksmight be unable to exit or hedge riskpositions over a short time period (the assumption embedded in the 10-day VaRtreatment for market risk).- Third, incorporating capital add-onsfor jumps in liquidity premia, which wouldapply only if certain criteria weremet.Thesecriteria would seek to identify the set of instruments that could becomeparticularly illiquid, but wherethe market risk metric, even with extendedliquidity horizons, would not sufficiently capture the risk to solvency from largefluctuations in liquidity premia.Additionally, the Committee is consulting on twopossible optionsfor incorporatingthe ―endogenous‖ aspect of market liquidity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 135Endogenousliquidity isthe component that relatesto bank-specificportfoliocharacteristics, such asparticularly large or concentrated exposuresrelative to themarket.The main approachunder consideration by the Committee to incorporate this riskwould be further extension of liquidity horizons;analternative could be application ofprudent valuation adjustmentsspecifically targetedto account for endogenousliquidity.Treatment of hedging and diversificationHedging and diversification are intrinsic to the active management of tradingportfolios.Hedging, while generally risk reducing, also givesrise to basis risk that must bemeasuredand capitalised.In addition, portfolio diversification benefits, whilst seemingly risk-reducing, candisappear in timesof stress.Currently, banksusing the internal models-based approachare allowed large latitudeto recognisethe risk-reducing benefits of hedging and diversification, whilerecognition of such benefitsis strictly limited under the standardized approach.The Committee is proposing to more closely align the treatment of hedging anddiversification between the two approaches.In part, this will be achieved by constraining diversification benefits in the internalmodels-based approach to addressthe Committee‘s concernsthat such models maysignificantly overestimate portfolio diversification benefitsthat do not materialise intimesof stress.Relationship between internal models-based and standardisedapproachesThe Committee considersthe current regulatory capital framework for the tradingbook to have becometoo reliant on banks‘internal models that reflect a private viewof risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 136In addition, the potential for verylargedifferencesbetweenstandardised and internalmodels based capital requirements for a given portfolio is a major level playing fieldconcern and can also leave supervisorswithout a credibleoption of removing modelpermission when model performanceis poor.To strengthen the relationship between the models-based and standardisedapproaches the Committee is consulting on threeproposals:- First, establishing a closer link betweenthe calibration of the two approaches;- Second, requiring mandatory calculation of the standardised approach by allbanks;- Third, considering the meritsof introducing the standardised approach asa flooror surcharge to the models-based approach.Revised models-based approachThe Committee hasidentified a number of weaknesseswith risk measurementunderthe models-based approach.In seeking to addresstheseproblems, the Committee intendsto(i)Strengthen requirementsfor defining the scopeof portfoliosthat will be eligible forinternal models treatment; and(ii)Strengthen the internal model standardsto ensure that the output of such modelsreflectsthe full extent of trading book risk that isrelevant from a regulatorycapitalperspective.To strengthen the criteria that banks must meet before regulatorycapital can becalculatedusing internal models, the Committeeis proposing to break the modelapproval processintosmaller, more discretesteps,including at the trading desklevel.This will allow *** model approval to be ―tu rne d -off‖ m ore ea sily *** than atpresentfor specific trading desksthat do not meet the requirements.At the trading desk level, wherethe bank naturally has an internal profit and loss(P&L) available, model performancecan be verified more robustly.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 137The Committee is considering two quantitative tools to measurethe performanceofmodels.First, a P&L attribution processthat provides an assessmentof how well a desk‘s riskmanagement model capturesrisk factorsthat drive its P&L.Second, an enhanced daily backtesting framework for reconciling forecastedlossesfrom the market risk metric with actual losses.Although the market risk regimehas alwaysrequired backtesting of modelperformance, the Committee is proposing to apply it at a moregranular trading desklevel in the future.Where a trading desk does not achieve acceptable P&L attribution or backtestingresults, the bank would be required to calculate capital requirementsfor that deskusing the standardised approach.To strengthen model standards, the Committee is consulting on limitingdiversification benefits, moving to an expected shortfall metric and calibrating to aperiod of market stress.In addition, it is consulting on introducing a more robust processfor assessingwhether individual risk factorswould be deemed as―modellable‖ by a particularbank.This would be a systematic processfor identifying, recording and calculatingregulatorycapital against risk factorsdeemed not to be amenable to market riskmodelling.Revised standardised approachThe Committee hasidentified a number of important shortcomingswith the currentstandardised approach.Astandardised approach servestwo main purposes.Firstly, it provides a method for calculating capital requirementsfor banks withbusinessmodels that do not require sophisticated measurement of market risk.This is especially relevant to smaller banks with limited trading activities.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 138Secondly, it provides afallback in theevent that abank‘sinternalmarket risk model isdeemedinadequate asa whole or for specific trading desksor risk factors.This second purposeis of particular importance for larger or more systemicallyimportant banks.In addition, the standardised approach could allow for a harmonised reporting of riskpositions in a format that isconsistent acrossbanks andjurisdictions.Apart from allowing for greater comparability acrossbanks and jurisdictions, thiscould alsoallow for aggregation of risk positionsacrossthe banking system to obtaina macroprudential view of market risks.With thoseobjectives in mind the Committee has adopted the following principles forthe design of the revised standardised approach:simplicity, transparencyand consistency, aswell asimproved risk sensitivity; acrediblecalibration;limitedmodel reliance;and acredible fallback to internalmodels.In seeking to meet theseobjectives, the Committeeproposesa ―partial risk factor‖approachasa revised standardised approach.The Committee alsoinvitesfeedback on a ―fuller risk factor‖ approach asanalternative.More specifically:(a) Partial risk factor approach:Instrumentsthat exhibit similar risk characteristicswould be grouped in bucketsandCommittee-specified risk weights would be applied to their market value.The number of bucketswould be approximately 20acrossfive broad classesofinstruments, though the exact number would be determinedempirically.Hedging and diversification benefits would be better captured than atpresentby using regulatory correlation parameters.To improve risk sensitivity, instrumentsexposed to ―cross-cutting‖ risk factorsthatarepervasiveacrossthe trading book (eg FX and interest rate risk) would be assignedto more than one bucket.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 139For example, a foreign-currency equity would be assigned to the appropriate quitybucket and to a cross-cutting FX bucket.(b) Fuller risk factor approach:This alternative approach would map instrumentsto a set of prescribedregulatoryrisk factorsto which shocks would be applied to calculatea capital charge for theindividual risk factors.The bank would have to usea pricing model (likely itsown) to determine the sizeofthe risk positionsfor each instrument with respectto the applicable risk factors.Hedging would be recognized for more ―systematic‖ risk factorsat the risk factorlevel.The capital charge would be generated by subjecting the overall risk positionsto asimplified regulatory aggregation algorithm.The appropriate treatment of creditAparticular area of Committee focus has been the treatment of positions subject tocredit risk in the trading book.Credit risk has continuous (credit spread) and discrete (default and migration)components.This has implicationsfor the types of models that areappropriate for capturing creditrisk.In practice, including default and migration risk within an integrated market riskframework introducesparticular challengesand potentially makes consistentcapitalchargesfor credit risk in the banking and trading books more difficult to achieve.The Committee is thereforeconsidering whether, under a future framework, thereshould continue to be a separate model for default and migration risk in the tradingbook.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 140Areas outside the scope of these proposalsThe Committee thinks it is important to note that thereare two particularareasthat ithas considered, but are not subject to any detailedproposals in this consultativedocument.Interest rate risk in the banking bookAlthough the Committee hasdetermined that removing the boundary between thebanking book and the trading book may be impractical, it is concerned about thepossibility of arbitrage acrossthe banking book / trading book boundary.Amajor contributor to arbitrage opportunitiesare different capital treatmentsfor thesameriskson either side of the boundary.One example is interest rate risk, which isexplicitly captured in the trading bookunder a Pillar 1capital regime, but subject to Pillar 2 requirementsin the bankingbook.The Committee hasthereforeundertaken some preliminarywork on the key issuesthat would be associatedwith applying a Pillar 1capital charge for interestrate risk inthe banking book.The Committee intends to consider the timing and scope of further work in this arealater in 2012.Interaction of market and counterparty riskBasel III introduced a new set of capital chargesto capturethe risk of changestocredit valuation adjustments(CVA).This is known asthe CVArisk capital charge and will be implemented asa ―standalone‖ capital charge under Basel III, with a coordinated start date of 1January 2013.The Committee is awarethat someindustry participants believe that CVArisk, asthemarket component of credit risk, should be captured in an integrated fashion withother formsof market risk within the market risk framework.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 141The Committee hasagreedto consider this question, but remains cautiousof thedegreeto which theseriskscan be effectively capturedin a single integratedmodelling approach.It observesthat thereis no clear market standard for the treatment of CVArisk inbanks‘ internal capi tal .Occasionally, even within individual banks, different treatmentsfor CVArisk seem toexist.For the time being, the Committee anticipatesthat open questions regarding thepracticalityof integrated modelling of CVAand market risk could constrain movingtowardssuch integration.In the meantime, the industry should focus on ensuring a high-qualityimplementation of the new stand-alone charge on 1January 2013.This is consistent with the Committee‘s broader concernsover the degree of relianceon internal models and the over-estimation of diversification benefits.For this reason, this consultative document sets out initial proposals on revisionstothe capital framework for capturing market risk and doesnot offer specificproposalsfor dealing with CVArisk.Nonetheless,stakeholdersmay wish to provide their viewson whether CVAriskshould be incorporated into the market risk framework and, if so, how this could beachieved in the context of the emerging revisionsto the market risk frameworkpresentedin this paper.Next stepsThe Committee welcomescommentsfrom the public on all aspectsof thisconsultative document and in particular on the questionsin the text (summarised atthe end of this document) by 7 September2012by e-mail to baselcommittee@bis.org.Alternatively, commentsmay be sent by post to: Basel Committee on BankingSupervision, Bank for International Settlements, Centralbahnplatz 2, CH-4002Basel,SwitzerlandAll commentswill be published on the Bank for International Settlements‘websiteunlessa commenter specifically requestsconfidential treatment.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 142Oncethe Committee hasreviewedresponses, it intends to releasefor comment amore detailed set of proposals to amend the Basel III framework.Asis itsnormal process,the Committee will subject such proposalsto a thoroughQuantitative Impact Study.AnnexLessons from the academic literature and banks‘ riskmanagement practicesIn itsdeliberationson revising the prudential regime for trading activities, theTrading Book Group hasdrawn on lessonsboth from the academic literatureandbanks‘currentand emerging risk management practices.1. Messagesfrom the academic literature on risk measurementin the trading bookSelected lessonson VaR implementation:(a)Thereis no unique solution to the problem of theappropriatetimehorizon for riskmeasurement.The horizon depends on characteristics of the portfolio and theeconomic purposeof measuring itsrisk.(b)Commonly used square-root-of-time VaR scaling rules (which ignore futurechangesin the portfolio) have been found to be an inaccurate approximation in manystudies.That said, no widely acceptedalternative has emerged.(c)There are limitationsof VaR models that rely on the useof continuous stochasticprocesseswith only deterministic volatility assumptions.Introducing either stochastic volatility assumptionsor stochastic jump processintomodelling of risk factorswill help to overcome theseshortcomings.(d) Backtesting proceduresthat only focus on the number of VaR violationsareinsufficientto determinethe appropriateness of the model assumptions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 143The useof conditional backtesting proceduresor other techniques (like the timing ofviolationsor the magnitude of the VaR exceptions) can improve the backtestingprocess.(e) No consensushas yet emergedon the relativebenefitsof using actual orhypothetical results(ie P&L) to conduct backtesting exercises.Incorporating market liquidity risk:The literature distinguishes, first, betweenexogenousand endogenousmarketliquidity risks;and, second, betweennormal (or current) liquidityrisk and extreme(orstressed) liquidity risk.Portfolios may be subject to significant endogenous liquidity costsunder all marketconditions, depending on their size or on the risk positionsof other marketparticipants.According to accountingstandards, endogenousliquidity costsare not taken intoaccount in the valuation of the trading books.Afirststepto incorporating this riskin aVaRmeasurewouldbe to takeit intoaccountin the valuation method.In practice, the time it takes to liquidate a risk position varies, depending on itstransaction costs, the size of the risk position in the market, the trade executionstrategy, and market conditions.Somestudies suggestthat, for some portfolios, this aspectof liquidity risk could alsobe addressed by extending the VaR risk measurementhorizon.Risk measures:VaR has been criticisedin the literaturefor lacking subadditivity. Aprominentalternativeto VaR is ES, which issubadditive.Despite criticism focused on the complexity, computational burden, and backtestingissuesassociatedwith ES, the recent literaturesuggests that many issueshave beenresolved or have been identified aslessseverethan originally expected. Spectral riskmeasuresare apromising generalisationof ES that iscited in the literature.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 144Stresstesting practices for market risk:Stresstesting often wasimplemented asan ad hoc exercise without any estimate ofscenario probability or useof a bank‘s VaR risk measurement framework.More recent researchadvocates the integration of stresstesting into the riskmodelling framework.This would overcome the drawbacksof reconciling standalone stresstest resultswithstandard VaR model output.Progresshasalsobeen achieved in theoretical researchon the selection of stressscenarios.The regulatorystressedVaR approach hasnot beenanalysed in the academicliterature.Unified versuscompartmentalised risk measurement:Recently, attention has shifted towardsunified approaches to risk measurement thatconsider all risk categories jointly.Theoretically, an integrated approach is needed to capturepotential compoundingeffectsthat are ignored in traditional compartmentalised risk measurementapproaches (eg separatemeasuresfor interest rate, market, credit and operationalrisk).Thesemight underestimate risk if a portfolio cannot be cleanly divided intosub-portfolios along risk categories.Irrespective of the separation of assets into ―books‖, it is not alwaystrue thatcalculating different risks for the same portfolio in a compartmentalisedfashion andadding up the compartmentalisedmeasureswill be aconservative estimateof thetruerisk.This insight is particularly important for ―back-fitting packages‖,such asthe IRC.Risk management and VaR in a systemic context:Anumber of studies criticise VaRbasedcapital rules asbeing procyclical in nature.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 145This may induce cyclical lending behavior by banks and exacerbate thebusinesscycle.Another criticism of VaR-based capital rules is that banks may fail to considersystem-wide endogeneity in their internal decisions.If all banksdo this, they mayact uniformly in boomsand bustsleadingto instabilitiesin asset markets.Unfortunately, the literaturedoes not offer convincing alternatives.2. Key findings from a survey of industry practicesThe Trading Book Group conducted a survey of industry practices in riskmanagement, capital allocation and other measuresfor thetrading book that could beused to inform the development of regulatorycapital standards.The key findingsareasfollows.Length of holding period for risk assessment:For day-to-day risk management the useof one-day VaR is universal among bankssurveyed.However, for internal capital adequacyand strategic risk management, banks aregenerally moving beyond short-horizon models (eg one-day and 10-day VaR).It isnow acknowledgedthat, to determine the level of capital necessaryto remain inbusinessafter sustaining a largeloss, risk must be assessedover a longer holdingperiod.Shorter horizonsdo not addressthe liquidity risk for all exposuresand do not capturetail eventsthat are important for capital adequacy.Somebanks are developing risk models with varying holding periodsfor riskassessment acrossproductsand conditional on the market liquidity of the exposure,though validation will be difficult.Alternatives to traditional VaR models:Many banks seethe need for a measureof risk for exposuresthat arehard to capturein traditional VaR models.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 146Stresstestsare utilised but most view that risk needs to be assessedover a range ofpossible scenariosbecause the nature of the next crisis cannot be predicted.Consequently, more ambitiouscomprehensivestatistical models of stressscenariosareused.Suchmodels allow systematic assessmentof risk acrossmultiple stressscenariosbeyond thosepresent in historical data sets.Theseapproaches are similar to reversestresstestsin that they aresensitive to thescenario to which the bank ismost exposed.Alternatively, some banks recommend the useof risk sensitive add-onsto risk modeloutputsfor exposureswhoserisks cannot be reliably measuredwith VaR.Thesebanks believe that useof add-onswherecomplexity and model uncertaintyexist would be preferableto blunt risk-insensitivestandardised measures.The samecomplexityand measurementissuesthat arechallengesfor VaR modelsarelikely to affect the robustnessof standardised risk weights.Model validation:The emerging modelling approaches for assessmentof exposuretostressevents will present a challenge for model validation because of the paucity ofrelevant historical data.In addition, models that assessriskover long holding periodssuch asin the IRCmodel presentavalidationchallengebecausesomeproductshavelessthan10yearsofhistorical data.In caseswherehistorical data are not sufficient for traditional backtesting, severalbanks suggested using benchmark portfoliosto discover which models wereoutliersin underestimating of risk.Scaling of VaR and nonlinearities:Nonlinearitiesin exposuresarecapturedin mostbanks‘modelsto somedegreealbeitimperfectly.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 147Almost all banks‘VaR models capturenonlinearities at a local level (small pricechanges) for much of their market risk exposure, but many banks‘VaR models fail tocapturenon-linearity at a global level (large pricechanges).Acommon weaknessin the captureof non-linearity is the useof scaling of onedayVaR to estimate exposuresat longer holding periods.Suchscaling only captureslocal non-linearity in the range of one-day price changesand can underestimate non-linear exposure over longer horizons, even when fullrevaluation is used.To learn more:www.bis.org/publ/bcbs219.htmBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 148Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 149Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 150Basel III – the big issuesSpeechbyAndrew Bailey, Director of UK Banks& Building Socieities at the SeventhCity of London SwissFinancial RoundtableThank you for inviting me to speak this morning.Firstly I do want to take this opportunity to mark thestalwart service that Angela has given to the BritishBankers‘Association (BBA) over the last five years.None of your predecessorscan have faced such adifficult task, which you have carried out with greatfortitude.I want to spend my timethis morning on the big issuesthat lie behind the subject ofBasel III and national finishes.Whyareweundertakingsuchwide-rangingreforms?The simple answer, because wehave had a major crisis, is not good enough asanexplanation – it explainsthetiming of the reforms,but the substanceof them requiresmore explanation.Let me put forward a number of principles on which I want to focus this morning.First, achieving a stable financial system will in turn enable the development of astrong, competitive system, and likewise will foster the strength of financial centres.Financial stability and competitivenessarenot fundamentally in conflict; rather, theformer is a necessarybut not sufficient condition of the latter, much asstable lowinflation is a condition of sustainable economic growth.The key point hereis that our respective objectivesof stability and competitivenessarefundamentally not at odds.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 151Second, theotherkeyobjective of thereformsisto achieve thestabilityof thefinancialsystem without recourseto public money asthe buttress– both implicit dependenceand in bad statesof the world explicit dependence.This objective has a number of profound consequences, including placing theresolutionof banks and itsplanning at the heart of bank supervision.Again, I think this objective of resolvability is fundamentally consistent with theobjective of having a competitive financial system.The reasonI believe thisstrongly is that with well-established resolution tools andplans, the incentives for governmentsto want to intervene in the operationsof bankswill be reduced.Likewise, assupervisorsweshould be lessinterventionist for a bank that can beresolved.Of course, resolution is never costless, and this should guide our interventions, butotherthingsequal wewill belessintrusive wherewearemoreassuredofresolvability.Asan example of that approach, I think that with a robust resolutionplan in place –which can be quite simple for small banks– weshould be more open to allowing newentrantsto start-up, and then sink or swim.This is important becausewewill only foster more competition if weenable banks toleave the scene if their businessmodel does not work.So, again, an objective of resolvability for banks doessupport the objective ofcompetitiveness.The third principle on which I want to focus concernsclarity in the objectives ofsupervision.Put simply, it does not support an effective regime to create unnecessary uncertaintyon the ultimate objectives of prudential supervision – ie how large should the capitaland funding buffersheld by banks eventually be.Lackof clarityin this respect isnot in myview conducive to awell-functioning marketeconomy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 152There are at least two complicationshere.First, quitesensiblywewant supervision tobe judgemental, in other wordsto embodysensible flexibility.Likewise,wethink that exercising judgement is in largepart about applying theBaselIII framework on a forward-looking basis in order to assessthe vulnerability ofinstitutions to big risks.Indeed, the big switch herewasarguably from the Basel I to Basel IIframeworks,which introduced judgement into the capital adequacyframework byallowing firmsto useapproved models to measurerisk.Thesemodels are by their nature inherently judgemental tools for both firmsandsupervisors– the question is not whether the model is right in an absolute sense(itwon‘t be) but whether it helpsto form an acceptable view of prudent capitalrequirements.But, the useof judgement in this wayinevitably createsuncertainty on how it will beapplied in the future.The second complication in termsof clarity around the objectives of supervision isthat weare applying the Basel III changesasa transition over a number of years.This is wisein termsof the consequencesof the change and their impact on the realeconomy, but it promptsuncertaintyoverhowAugustinian authoritiesmaybein theirapproachto transition.Clearly, I think it is fair enough to say that the UK and Switzerland do not look to beparticularlyAugustinian in their approaches.I think the key point herefor me is to minimise uncertainty and thusto support afunctioning market economy.I am not asupporter of asystem which leavespeople guessing whatwewill eventuallywant from banks.Looking at the UK arrangements,it is in my view helpful that a consensusis buildingaround the Independent Commission on Banking‘srecommendationsof 17%primaryBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 153loss-absorbing capacity measuredon a risk-weightedassets basis, with a core tieronecapital or common equity component within that of 10%.All of this should be measuredon a Basel III basis, and supported by a leverage ratio,asthe ICB recommended.And, thereshould be clear liquidity standards.Switching to the Basel III capital standard will require a transitionwherebanks dorestructuretheir balance sheetsand retain more earningswhiletheytransition.Providing the objectives are well understood, I believe the bankscan make thistransition.But I do acceptthe challenge that the processneeds to be well understood – marketsaremorelikely to give bankscredit for their prudential buffersof capital and liquidassetsif they understand the end-points and the waysin which weassupervisorswillexercise our judgement.An important example of this useof judgement is that whenweask banks to holdprudential bufferswetreat them just like that – ie asprotection which can be used,and wherethe responseof the supervisor to a firm going into a buffer is to requireasensible plan to correct the useof a buffer over a reasonable period of time.To conclude, supervision needsto support banksoperating in a market economy.This meansearning a sensible rate of return calculatedon a basis that appropriatelyfactorsin the amount of risk taken.I dobelieve that BaselIII iscorrecttoraiseprudential requirements;that isthecruciallessonof the crisis.Wearealsoright in myview to endthedependenceonpublic moneythrough effectiveresolutiontechniques.Here, by the way, we should thank a Swissbank, Credit Suisse, for providing much ofthe early thinking to support the notion of bail-in asthewayto end the dependence onpublic money.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 154But, aspolicymakers, weneed to enable our judgementsand standardsto beunderstoodand appropriately predictedsothat wesupport theoperation of banks in amarket economy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 155EBA BS2012 048 final30April 2012Report on the fulfilment of the EBARecommendation following the 2011EU-wide stresstestExecutive summaryFollowing the publication of the 2011EU-wide stresstest resultsin July 2011, the EBAissueda Recommendationto national supervisory authorities (NSAs) to ensure thatappropriatemitigating actionswereput in placewith respectto(i)Bankswith a Core Tier 1capital (CT1) ratio below 5% in the adversescenario and(ii)To bankswith a CT1ratio close to 5% in the adversescenario and with sizeableexposuresto sovereigns under stress.Forward looking mitigating measureswereidentified in the publication templatesforrelevant banks to addressweaknesses.The EBA, asa part of its ongoing monitoring activities, has continued to assesstheimplementation of thesemitigating measuresagainstthe requirements of the EBARecommendation.NSAsresponsible for the supervision of the banks falling under the scope of the EBARecommendation have provided the details of the mitigating measurestaken for therespective banks and of their close monitoring of banks asa part of ongoingsupervisory activities.In total, eight banks of the 90participating in the EBA2011stresstest exercisehad aCT1 ratio under the adversescenario below the set 5% benchmark.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 156According to the information provided to the EBA, mitigating measureshave beenput in place for all bankswith a post stresscapital ratio below 5%, and weredeemedsufficient by the EBAto comply with itsRecommendation.Following a deterioration of the external environment, in many cases, additionalmeasureshavebeen put in place by NSAswhich the EBAnotes and supports.In somecases,these actionsareongoing and NSAshave confirmed to the EBAthatthemitigating actionsarebeing closely followed under national initiatives and will befinalised within reasonable timelines agreedbetweenbanks and their respectiveNSAs.Most of the banks with a CT1 ratio above 5% and with sizeable exposurestosovereignsunder stresswill be addressed under the monitoring of the December2011Recommendation following the resultsof the 2011EU Capital exercise, wheretheyhave been included in the sample of 71banks.The EBAis, in general, satisfied with progressin the fulfilment of the July 2011Recommendation noting the actionsthat have been taken that include capitalstrengthening and adequate recognition of losses.In addition, thosebanksidentified ashaving weaknesseshavesubsequentlyundergone restructuringprocessesand will no longer exist in the sameform asat themoment of the stresstest.Someof the banks falling under the scopeof the July 2011Recommendation and theDecember2011Recommendation aresubjecttotheimplementation of morestringentmeasuresunderthe pre-agreedEU/IMF assistanceprogrammesand to a separatemonitoring by the socalled ―Troika‖ authorities(EU Commission, ECB, IMF).Background and introductionThe resultsof the second EU-wide stresstests conducted by the European BankingAuthority (EBA) in cooperation with the EU Commission, European Systemic RiskBoard (ESRB), European Central Bank (ECB) and national supervisory authorities(NSAs) were published in July 20111.The aim of the stresstest wasto assesstheresilienceof 91participating banksfrom 21EEAcountries against an adverse but plausible scenario.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 157The aggregate Core Tier 1(CT1) ratio of the 90banksthat published information inthe 2011EBAstresstest decreasedfrom 8.9% to 7.7% after two yearsof stress.The largest driver of the decreaseis impairment chargeswhich led to CT1 decreaseof3.6 percentage points.Asa result of the application of the adversemacro-economic scenario and commonconstrainingassumptionsapplied in theexercise, thepoststresscapital ratiosof eightbanksfell below thecapital threshold set at thelevel of 5%CT1 with theoverall capitalshortfall of EUR 2.5 bn based on the EBAdefinition of CT1.In addition, 16banks displayed post stressCT1 ratiosbetween 5 and 6% after theapplication of the adversescenario over the two-year time horizon.On the basis of the resultsof the stresstest, the EBAissued itsfirst formalRecommendation addressedto NSAsand requiring remedial actions.Inparticular, pursuant toArticle 21.2(b) of theEBARegulation, theRecommendationpublished asa part of the EBAAggregate report, statesthe following:a.NSAs to request bankswhoseCT1 ratio falls below the 5% threshold under theadverse scenario defined in the stresstest exerciseto promptly remedy this capitalshortfall.In particular, national supervisorsshould ensure that thesebanks arerequested topresentwithin threemonths (i.e. by 15October 2011) to their competent authoritiesaplan to restorethe capital position to a level at least equal to the 5% CT1benchmarkbased on this analysis.The remedial measuresagreedwith the competent authority had to be fullyimplemented by end of 2011, with flexibility allowed only if justified by marketconditionsor requiredprocedures.b.NSAsto request all banks whoseCT1 ratio under the adversescenariois above butclose to 5% and which have sizeable exposuresto sovereignsunder stressto takespecificstepsto strengthen their capital position, including where necessaryrestrictionson dividends, deleveraging, issuanceof fresh capital or conversion oflower quality instruments into Core Tier 1capital.Thesebanks wereexpectedto plan remedial actionwithin three months.The planshad to befullyimplemented within nine monthsfrom thepublication of thestresstest results.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 158With the publication of theseRecommendations, the EBAcommitted to reviewingtheir fulfilment and to publishing the outcomesof such review.This report directly addressesthe fulfilment of the first part of the July 2011Recommendation (banks failing to meet the 5% CT1 threshold), whereasthe secondpart will be followed–up under the December 2011EU Capital exerciseRecommendation.Link to the 2011Capital exerciseFollowingthefurtherescalationof thesovereign debt crisis, and theannouncement oftheEuropean coordinatedpolicy packageon26October2011, theEBAhasconducteda Capital exerciseamongst 71banks aimed at assessing banks recapitalisationneedsafter the prudential revaluation of the sovereign exposuresandat applying highercapital threshold set at 9% CT1.It should be noted that the EBACapital exercise wasnot a stresstest.Against the ongoing developmentsin the marketsand the deterioration of thesovereign debt crisisin Europe, the EBAreviewedbanks‘actual capital positionsandsovereign exposuresasof September 2011and requestedthem to set aside additionalcapital buffers.The capital buffer is designed to provide reassuranceto marketsabout the ability towithstand a range of shocks and still maintain adequate capital.Following the outcomesof the Capital exercise, the EBAhas issued itssecondRecommendation requiring banks failing to meet the capital threshold to ensurethatappropriatemitigating measuresareput in placeand that by30June2012,all 71banksattain and maintain until such time asthis Recommendationhas been amended,repealedor cancelled, the temporarycapital buffer at a level of 9% CT1 (December2011Recommendation).To this end, the NSAs have been recommendedto ensure that all banks build atemporarycapital buffer to reacha 9% CT1ratio by 30June 2012, after the removal ofthe prudential filterson the sovereign assetsin the available-for-sale portfolio and theconservative valuation of sovereign debt exposuresin the held-to-maturity and loansand receivablesportfolios, reflecting market pricesasof 30September 20113.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 159Pursuant to this Recommendation, the EBAhas set up a seriesof follow-up stepsrequiring banks with a capital shortfall to present the recapitalisationplans outliningthe measurestheyplan to takein order to meet the 9% CT1capital threshold by 30June2012.Suchrecapitalisationplans have been scrutinised by the respective consolidatingNSAsin close cooperationwith the Colleges of Supervisorsand the EBA.The December2011Recommendation effectivelyaugmentsthe outcomesof the 2011stresstests.Therefore, the mitigating efforts for banks falling under the second part of the July2011Recommendation (banks close to the threshold but with sizable exposurestosovereignsunder stress), will be monitored under the December2011Recommendation and arenot discussedin this report.Methodology for assessing the fulfilment of theRecommendationThe assessmentof the fulfilment of the July 2011Recommendation is based on theinformation on mitigating measuresprovided to the EBAby the consolidating NSAsof the banks failing to meet the capital threshold.The assessmentis based on recalculating the CT1 ratio under the adverse scenario for2012adjusting risk weightedassets(RWA) and CT1 capital according to themitigating actionsreported by NSAs(either in a separate communication or in thestresstest disclosuretemplates).This assessmentisbasedontheinformation collectedduringthestresstestsaswell ason additional information on the mitigating measuresprovided by the NSAswithoutrecalculating possible impactsof the stressor taking into account actual financial orportfolio information.Someof the banks subject to the July 2011Recommendationare undergoing deeprestructuring aspart of the pre-agreedmeasuresunderEU/IMF programmes.This directly affectsthe Greek banks, wherequantitative capital targetsstemmingfrom the pre-agreedEU/IM F programmesexceedthe resultsof the EBAEU-widestresstests and the EU Capital exercise.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 160The implementation of EU/IMF measuresand fulfilment of capital targetsis beingclosely followed by the respective national authorities together with the EUCommission, ECB and IMF.Fulfilment of the Recommendation by banks below 5% CT1thresholdIn total, eight out of the 90banksthat published theresultsof the2011EU-wide stresstest have a CT1 ratio under the adversescenario that falls below the threshold of 5%.The aggregate CT1 capital shortfall for thesebanks amounted to EUR 2.5 bn (seeChart 1).When analysing the impact of the mitigating measuresput in place after the stresstest, it should be noted that most of the banks with a shortfall have gone or currentlyareundergoing restructuring processesandwill no longer exist in the sameform asatthe moment of the stresstest.AustriaThe OesterreichischeVolksbankenAG (OeVAG) submitted a detailed restructuringplan to theAustrian NSAsto promptly remedyits capital shortfall and hasalreadyBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 161completeda major step: the closed sale of its international operations (VolksbankInternational AG) to the Russian Sberbank.Furthermore, OeVAG currently pursuesthe implementation of additionalrestructuring measures- based on a term-sheet agreedon by itsshareholdersand theRepublic of Austria - combining OeVAG and more than 60local Volksbanksinto asingle affiliated group according toArticle 3 Directive 2006/48/EC by mid of 2012.On 26April 2012, OeVAG‘s general meeting of shareholdersdecided on a number ofmilestonesin this regard, resulting in a new ownership - structure retroactive asof 31December2011, wherethe local Volksbankshold the majority of OeVAG and theRepublic of Austria is the second largestshareholder.After completion of these fundamental restructuring steps, OeVAG neverthelesswillcontinue to streamlineand restructurethe group with the final target of becoming aleancentral institution serving the local Volksbankswith a clear focuson theAustrianmarket.SpainIn total, five Spanish institutions have gone or are undergoing significant integrationprocesseswhich will result in their merger with other banks or their integration withinother groups of credit institutions.Eachof theseprocessesis at a different stageand is being closely monitored by theSpanish authorities.The timelinefor their completiondependsondifferentresolutionsand authorisations,and in somecases,it may fall outside the timeframe set by the EBARecommendation:- Caixa DEstalvis de Catalunya, Tarragona i Manresa:In this case, CatalunyaBank, in which the FROB has a stake of 90%, hasstarted the necessarystepsforan integration processwith another credit institution through a competitiveprocedurein accordancewithArticle 9.8 of Royal Decree-Law9/2009, on bankrestructuring and credit institutions equity reinforcement.- CaixaDEstalvisUniodeCaixes de Manlleu, Sabadell I Terrassa(Unnim): In thecaseof Unnim Banc, S.A. on 7 March 2012the Government Committee of theFROB, which wasitssole owner, drew up the restructuring plan for this bank,envisaging itsintegration within the Spanish bank BBVA.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 162- GrupoCaja 3: This bank announced on 29February2012itsmergerwith IbercajaBanco.- Caja deAhorros del Mediterraneo(CAM): On 7 December2011, the GovernmentCommittee of the FROB drew up restructuring plan for Banco CAM, whichenvisagesthat it will be integrated within Banco Sabadell.- BancoPopular is finalising itstakeover of Banco Pastor.GreeceTwoGreek banks, EFG Eurobank ErgasiasandAgricultural Bank of Greece,haveshowna capital shortfall in the stresstest.Thesebanks are undergoing deep restructuring aspart of the pre-agreed measuresunder the EU/IMF programme.Quantitative capital targetsstemming from the latter exceedthe results of the EBAEU-wide stresstestsand EU Capital exercise.The implementation of EU/IMF measuresand the fulfilment of capital targetsarebeing closely followed by the respective national authoritiestogether with the EUCommission, ECB and IMF.GermanyIn addition to the eight banks with identified capital shortfall, the EBAhas followedup on one bank, which did not publish the EBA2011stresstest results, namelyLandesbank Hessen-Thuringen (Helaba)to understand the actionsit has taken sincethe stresstest.Helaba has ―hardened‖ itsparticipation capital in order to comply with the CT1definition of the EBA.This conversion hasled to an increaseof CT1capital by EUR 1.92bn.Conclusions and further monitoringThe EBAis, in general, satisfied with the progressmade in the fulfilment of the July2011Recommendationnoting that theactionstakeninclude capital strengtheningandadequate recognition of losses.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 163In addition, the EBAsupports the measuresundertaken to significantly restructurethosebanks in difficulty and seesthis asan appropriate responseto theRecommendation.Generally, the EBAJuly 2011Recommendation hasbeen strengthened by the EBADecember2011Recommendation.The 71banks participating in the 2011Capital exercise are being monitored by theEBAin order to check whether they adhereto the CT1ratio of 9% by the end of June2012.Some Spanish bankssubject to the July 2011Recommendation are not represented inthe sample for the December 2011Capital exercise and therefore do not fall under thescopeof the December 2011Recommendation.Those banks remain under close scrutiny by their respective national supervisoryauthorities, and are also subject to the wide-ranging restructuring programmesundertaken under the aegis of the national measuresput forward by the SpanishGovernment.The EBAwill continue to monitor and assessrisks and vulnerabilitiesfrom amicro-prudential perspective in the EU banking sector employing a widerange oftools, including analysesof key risk indicators, bottom-up risk questionnairesto thesupervisorsof the largest cross-border banking groups, and joint risk assessmentsdone by the colleges of supervisors.The EBAiscurrentlydeveloping itsapproachto thenext EU-wide stresstestexercise,which will take place in 2013.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 164Chairman Ben S. BernankeAt the 48thAnnual Conference on Bank Structure and Competition, Chicago, Illinois(via satellite) - May 10, 2012Banks and Bank Lending: The State of PlayI am pleasedto speak this morning at what has become, over nearly 50years, perhapsthe most prestigious conferencefor bankers, academics, and bank supervisorsin theUnited States.The firstpart of myremarkswill highlight thesignificantprogressthat hasbeenmadeover the past several yearstoward restoring the banking system to good health.I will alsotalk about someof thechallengesbanks face astheyadapttothepost-crisiseconomic and regulatoryenvironment.I will then review recent trends in credit conditions, noting that bank lending hasgenerally been improving but remains restrainedin some areas.The State of the Banking SystemSincethe financial crisis, banks have made considerable progressin repairing theirbalancesheetsand building capital.Risk-basedcapital and leverage ratiosfor banks of all sizes have improved materiallyand are significantly above their previous highs.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 165Importantly, the 19 largest banking institutionsthat participated in the 2009stresstests, aswell asthe two subsequent ComprehensiveCapital Analysis and Review(CCAR) processes,have considerably moreand better-qualitycapital than a few yearsago.Indeed, thosefirmshaveincreasedtheir Tier 1commonequity, thebestbufferagainstfuture losses, by more than $300billion since 2009, to nearly $760billion.The Tier 1common ratiofor thesefirms, which comparesthis high-quality capital torisk-weighted assets, stood at 10-1/2 percent at the end of last year.The latest CCAR, conducted earlier this year, demonstrated that most of the 19 firmswould likely have sufficient capital to withstand a period of intenseeconomic andfinancial stressand still be able to lend to households and businesses.The hypothetical supervisory stressscenario used in the CCAR wasquite severe; itincluded a peak unemployment rate of 13percent, a 50percent drop in equityprices, and a 21percent further declinein housing prices,aswell assteep falls inpricesof financial assetsmost exposed to conditionsin Europe.Under this highly adversescenario, the 19bank holding companies wereprojected toincur aggregate lossesof more than $500billion through the fourth quarter of 2013.Nevertheless,their aggregate Tier 1common ratio wasprojected to be 6.3 percent atthe end of the scenario period, and 15of the 19bank holding companieswereprojected to maintain capital ratios above all four of the regulatoryminimumlevels--even after taking into account their proposals for capital actionssuch asdividends, sharebuybacks, and shareissuancein the baseline scenario.The banking sector overall alsohassubstantially improved itsliquidity position overthe past few years.Indeed, large banksin the aggregate have more than doubled their holdingsof cashand securitiessince 2009.Large bankshave reducedtheir collective dependence on short-term wholesalefunding, and many are flush with retail deposits, which tend to be a more stablefunding source.Challengeson the liquidity front remain, however: Some largefirmsstill rely heavilyon wholesale short-term funding; and the liquidity needs of the banking system asawhole may becomesomewhat higher for a while assomeof the securitiesissuedunder the Federal Deposit InsuranceCorporations Temporary Liquidity GuaranteeProgram comedue, and asthe unlimited insuranceon noninterest-bearingtransactionaccounts expiresat the end of the year.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 166Nevertheless,over time, greater liquid asset positionsand reduced dependence onwholesale short-term funding, together with more and better capital, will make thebanking sector lesssusceptibleto unexpected disruptionsin short-term fundingmarkets.The credit qualityof large banks assetsis looking better aswell, although theimprovementshave been uneven acrosstypesof loans.In the aggregate, delinquency rateson loan portfolios at largebanks have declinedsubstantially from their peaks.However, while delinquencies on commercial and industrial (C&I) loans andconsumer loans have fallen to the lower end of their historical ranges, delinquencieson loans backed by commercial or residential real estatehave declinedonlymoderatelyand remain elevated.The profitability of largebankshas been edging up ascredit quality hasfirmed andbankshave trimmed noninterest expenses.Even so, large banks profitability remains well below the levels that prevailed beforethe financial crisis began, and banks continue to struggle to expand their revenues.Developmentsthat can be tracedback to the financial crisis--including a still-weakeconomy, changesin market conditionsand practices, and tighter financialregulations--areclearly important reasonsfor thesetrends.Community banks play important roles in local economies, and so it is notable thattheir condition has alsoimproved.Their regulatorycapital ratioshave increasedsignificantly since 2009and stand wellabove their recent norms.Ashas been the caseat largebanks, delinquency and charge-off rates at communitybanks have declined acrossmost major categoriesof loans, and fewerinstitutionsfailed in 2011than in each of the previous two years. That said, clustersof small bankfailurescan affect credit availabilityin a community whilebank-dependent borrowerswork toestablish new relationships with surviving institutions.In addition, while standard measuresof community banks profitability, such asreturn on equity and assets, improved last year, aswasalsotrue at largerinstitutions, most of the gains weredue to reductionsin loan lossprovisions ratherthan to moresustainable sourcesof profit such asexpandedlending.Financial-market indicatorsreflect the substantial improvementsin banks financialconditionssince the crisis aswell asthe sizable challenges remaining.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 167Bank credit default swap (CDS) premiumsare now well below their crisis peaks, andbank stock priceshaveretracedsomeof theirearlier lossesand haveoutperformedthebroader market this year, boosted somewhatby the releaseof the CCAR resultsinMarch and first-quarter earningsthat largely beat analysts expectations.However, CDS premiumsremain elevated for someof the larger, more globallyconnected firms, and their stockscontinue to trade at market-to-book ratiosof lessthan 1.Anumber of key systemic risk measuresthat evaluate the potential performance offirmsduring timesof financial market stresshave improved in recent months.Theseindicatorsof systemic risk are now well below their levels in the crisis, and,overall, they present a picture of a banking system that hasbecomehealthier andmore resilient.Regulatory and Financial ChallengesBanksface a number of significant challengesasthey adapt to the post-crisiseconomic environment and to new domesticand international regulatoryrequirements.The most systemically important financial firmswill facemeaningfully higher capitaland liquidity requirementsand continue to undergo regular supervisory stresstests.They will alsobe required to submit so-called living wills to facilitate their orderlyresolutionif necessary.Additionally, banks must enhancetheir reporting systemsand improve disclosure.Thesenew requirementsarecritical to safeguard the stabilityof the financial systemand to help prevent another costly crisis.At the sametime, regulatorsappreciate that the new rulesimposesignificantburdenson banks.For that reason, and to minimize adverseeffectson the supply of credit, many of themostsignificant rulesarebeingphasedin gradually and only afterextendedprocessesof consultation with industry and other stakeholders.It isworth reiterating that most of theseenhanced regulatoryand supervisorymeasuresfocuson the largest, most interconnected financial institutions, and weareworkingto ensurethat community banksarenot subjected to rulesdesignedprimarilyto constrain risks at larger institutions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 168Wehave an ongoing dialogue with community banksthrough manychannels, including, for example, our Community DepositoryInstitutionsAdvisory Council.The council, whosemembership isdrawn from smaller banks, credit unions, andsavingsassociationsin each of the 12Federal ReserveDistricts, meets with the Boardin Washington twice a year to discusssupervisory and regulatoryissuesthat affecttheir institutions.Wehave also established a special supervisorysubcommittee of the Board whichfocuseson community banking issues.In addition to strengthened regulatoryand supervisoryrequirements, banks facemarket demandsthat they operate with more resilient businessmodels.In many contexts, counterparties aredemanding greatersecurity in the form of moreand better-qualitycollateral or higher margins.In addition, lendersto banks maybe requiring greater compensationfor risk, therebyraising banks funding costs.Bankshave alsobeennavigatingan economic recoverythat hasbeen halting at times.Consequently, although the condition of the banking system is improving, demandfor credit generally has remained sluggish, and the creditworthinessof someborrowersthat would normally turn to banks for loans remains impaired.Thesefactors, together with tighter credit policies imposed by many lenders, haverestrained somewhat the expansion of bank credit.Credit Conditions and Bank LendingNotwithstanding the variousheadwinds, credit conditionsin the United States haveimproved significantly in a number of areas.Many--though certainly not all--businessesand householdsarefinding it easier toborrow than they did a few yearsago, in part becauseof better conditions in financialmarketsmore broadly.Large businesseswith accessto capital marketshave generally been able to raisefundsat attractive terms, with both investment- and speculative-grade firmstakingadvantage of historically low interest rates to issuebonds at a robust rate.Moreover, consumerswith strong credit historieshave ready accessto credit cardsand auto loans, supported by solid issuanceof consumer-related asset-backedsecurities.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 169Banksalsosupply credit by purchasing securities, and their purchaseshave grownrapidly in recent months--in particular, thoseof agency-guaranteed mortgage-backedsecurities(MBS).In this challenging time for housing markets, banksare attractedby the securitiesgovernment guarantee.Additionally, somelarger banks may be accumulating thesesecuritiesin preparationfor more-stringent liquidity regulations.Signsof improvement notwithstanding, credit conditionsin some sectorsand forsometypes of borrowersremain tight.Mortgage lending is an important example.Sinceits peak, U.S. home mortgage credit outstanding has contracted about 13percentin real terms.Many factorssuggestthat this situation will be difficult to turn aroundquickly, including the slow recoveryof the economy and housing market, continueduncertaintysurrounding thefutureof thegovernment - sponsored enterprises(GSEs), the lack of a healthyprivate-label securitization market, and cautiousattitudesby lenders.Financing conditions in the commercial real estate sector alsoremain strained asfundamentals, including high vacancy rates, depressedproperty prices, and the poorqualityof existingloans, continue to be weak.Moreover, the market for commercial MBS--a sourceof liquidity for some lendersinthis sector--is still struggling to regain itsfooting.The Federal Reserves quarterly Senior Loan Officer Opinion Survey on BankLending Practices (SLOOS) offersa more-nuanced view of how lending termsarechanging.The SLOOSindicatesthat standards and termsin many loan categorieshave easedsomewhatfurther in recent quartersfrom the verytight conditions that prevailedearlierin the recovery.For example, theApril SLOOSpointed to the first material net easing in lendingstandards for commercial real estateloans since 2005and to a further easing ofstandards for most typesof consumer loans.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 170In addition, SLOOSrespondentssuggested that stepped-up competition has induceda large number of domestic banks to reduce feesand spreads on C&I loans to firmsofall sizes.The SLOOSalsoindicatesthat demand for many types of loans has continued toincrease, with demand for C&I loans having risento relatively high levels.Consistent with theresultsof theSLOOS, C&I lending hasindeedbeenrising sharplylately.Bankshave focused on C&I lending because businessborrowerscreditworthinessisimproving and becausethe majority of C&I loans carryfloating interest ratesthatreduceinterest rate risk.In addition, domesticbanks reportedly arepicking up customersasa result of apullback by some European institutions.Auto lending alsohas reportedly been solid, reflecting strong fundamentals in automarkets--suchasrobust demand for used carsand relatively low delinquency ratesonexistingauto loans.The strong fundamentals for auto loansin turn alsoappear to have contributed to aneasing of lending standards and terms.But, asI mentioned earlier, residential mortgage lending has been particularlysluggish.Tight lending standardsand termsremain especially evident.To be sure, areturn to pre-crisis lending standards for residential mortgageswouldntbe appropriate; however, current standardsmay be limiting or preventing lending tomany creditworthyborrowers.For instance, in theApril SLOOS, weaskedbanks a hypothetical questionabout theirwillingnessto originate GSE-eligible mortgagesrelative to 2006for borrowerswith arangeof credit scoresand available down payments.The SLOOSfound that even when the loans were accompanied by a 20 percentdownpayment, many banks werelesslikely to originate loansto borrowerswith givenGSE-eligible credit scores, despite the originating banks abilityto sell the mortgageto the GSEs.Most banksindicated that their reluctanceto accept mortgage applicationsfromborrowerswith less-than-perfect recordsis relatedto "putback risk"--the risk that aBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 171bank might be forced to buy back a defaulted loan if the underwritingordocumentation wasjudged deficient in some way.Small businessesowners,whoin the past might have tapped into the equity in theirhomesor used their homesascollateral for small businessloans, alsohave foundconditionschallenging in recent years.The stock of small loansto businessesonbank balancesheetsat the end of last yearwasmore than 15percent below itspeak in 2008.Theseloans looked to have ticked up in the fourth quarter of 2011, consistent with thereported increasein demand for loans by small firmsin the SLOOS.Responsesto the monthly National Federation of Independent Businesssurvey alsosuggest somemodest improvement in the small businesssector: The shareofrespondentsreporting a need for credit hasmoved up from lowsof recent years, andthe net shareof respondentswhosay that credit is more difficult to obtain than it wasthreemonthsago is notably below itspeak in 2009.The Federal Reserveis keenly interested in understanding how shifts in loan supply,loan demand, and borrower qualitymay be affecting lending and, by extension, thebroader economy.Of course, sorting out the relative effect of changesin loan demand from the effect ofchangesin loan supply can be quite difficult because theycan be influenced by thesamefactors.For example, a shift in the economic outlook can affect both the willingnessof banksto lend and the desireand ability of firmsand householdsto borrow.Recentresearch at the Federal Reserveexaminescyclical changes in banks lendingstandards asreported in the SLOOS--a commonly used indicator of loan supply.It attemptsto assesshow much of thosechangeswerea "typical" response tomacroeconomic and bank-specificfactors, and how much was"atypical" orunexplained.This analysis suggeststhat the tightening of lending standards that occurredbetween2007 and 2009wasmuch greater than a model based on historical experience wouldpredict, contributing to the subdued paceof lending.These results are consistent with other evidence that the crisis induced exceptionallyhigh levels of risk aversion and uncertainty on the part of both lendersand borrowers,constraining the flow of credit.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 172Asthesefactorshave recededand theeconomyhasimproved, lending standardshavebecomelessstringent.Somebankersand borrowersbelieve that enhanced supervision and regulation hasmade it more difficult for banks to expand their lending.The Federal Reservetakes seriously itsresponsibility to ensurethat supervisoryactionsto protect banks safetyand soundnessdo not unintentionally constrainlending to creditworthyborrowers,and wehave taken a variety of stepsto addresstheseconcerns.For example, wehave issued guidance to supervisorsstressingthe importance oftaking a balanced approach to supervision and of promptly upgrading a bankssupervisory rating when warrantedby a sustainable improvement in its condition andrisk management.Someanalysis has indicated that, all else being equal, bankswith lower supervisoryratingstend to lend less;prompt upgrades by supervisorswhen such upgrades areappropriate may thus easean unnecessaryconstraint on lending.Indeed, in the fourth quarter of 2011and the first quarter of this year, the number ofratingsupgradesfor banks and bank holding companies supervised by the FederalReserveexceededthe number of downgrades. The last time that upgradesexceededdowngradeswasin 2005.In addition, wehave stepped up examinertraining on relevant lending issues, and wehave emphasized to examinersthat an open dialogue with bank management isessential.Wehave also looked into specific concernsraisedabout the examination processanditseffect on banks willingnessto lend.For example, during 2011, wereviewed commercial real estate loan classificationpractices to assesswhether examinerswere properly implementing the interagencypolicy statement on workouts of commercial real estate loans.Weanalyzed documentation for morethan 300loanswith identified weaknessesin sixFederal ReserveDistricts.We found that Federal Reserve examiners were appropriately implementing theguidance and were consistently taking a balanced approach in determining loanclassifications.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 173Moreover, the documentation wereviewed indicated that examinerswerecarefullyconsidering the full range of information provided by bankers, including relevantmitigating factors, in determining the regulatory treatment for the loans.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.comConclusionTo sum up, conditionsin the banking system--and the financial sector morebroadly--have improved significantly in the past few years.Bankshave strengthened their capital and liquidity positions.The economic recoveryhas facilitated the rebuilding of capital and helped improvethe quality of the loans and other assetson banks balance sheets.Nonetheless,banks still have more to do to restoretheir health and adapt to thepost-crisis regulatoryand economic environment. As the recoverygainsgreatertraction, increasing both the demand for credit and the creditworthinessof potentialborrowers,a financially stronger banking system will be well positioned to expand itslending.Improving credit conditionswill in turn help createa more robust economy.
  • 174Statistical release: OTC derivativesstatisticsat end-December 2011Monetary and Economic DepartmentMay 2012Bank for International SettlementsAsummary of the latest statisticsonover-the-counter(OTC) derivativesmarkets.Data at end-December2011are not fullycomparable withpreviousperiodsbecauseofan increasein thereportingpopulation.Australia andSpainreportedforthefirst time,expanding the reportingpopulation todealersheadquartered in 13countries.(Theother reporting countriesare Belgium, Canada, France,Germany,Italy, Japan, theNetherlands, Sweden, Switzerland, theUnited KingdomandtheUnited States.)Total notional amountsoutstandingof OTC derivativesamounted to$648trillion at end-2011(Graph 1, left-handpanel, and Table1).Notwithstandingtheincreasein thereportingpopulation, total notionalamountsdeclinedbetweenend-Juneand end-December 2011.At the same time, grossmarket values,whichmeasure the cost ofreplacingexistingcontracts, increasedto$27.3 trillion, driven mainlybyan increasein themarket valueof interest rate contracts.Consequently, grossmarket valuesrosefrom 2.8% of notional amountsatend-June2011to 4.2% at end-December2011.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 175Therise in grossmarket valueswasthe largest sincethe second half of2008.Grosscredit exposures,whichtakeaccount oflegallyenforceablebilateralnettingagreements,alsoincreased, but not by asmuch asmarket values.Grosscredit exposuresroseto$3.9trillion, their highest level sinceend-2008(Graph 1, right-hand panel).At the same time, theydeclined from 15.2% of grossmarket valuesat end-June2011to 14.3% at end-2011asdealersmade greater useof nettingtoreducetheir credit and settlement risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 176Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 177Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 178Testimony Before the US Senate Committee onBanking, Housing and UrbanAffairs, Washington, DCCFTC Chairman Gary GenslerMay 22, 2012Good morning Chairman Johnson, RankingMemberShelby and members of theCommittee.I thank you for inviting me totoday‘s hearingon implementationof the Dodd-Frank WallStreet Reform and Consumer ProtectionAct (Dodd-FrankAct), international harmonization of swapsmarket reforms, and theCommodityFuturesTradingCommission‘s(CFTC) role in overseeingmarketsfor credit derivativeproducts, suchasthosetraded by JPMorganChase‘sChief Investment Office.I alsothank my fellowCommissionersandCFTC staff for their hard workand commitment on implementingthe legislation.I‘m pleased to testifyalong withSecuritiesand ExchangeCommission(SEC) Chairman Schapiro.Swaps,now comprising a $700trillion notional global market, weredeveloped tohelp manageand lowerriskfor commercial companies.But theyalsoconcentratedand heightenedriskin international financialinstitutions.And whenfinancial entitiesfail, astheyhave and surely will again, swapscan contributetoquickly spreadingrisk acrossborders.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 179As the financial system failed in 2008, most of uslearned that theinsurancegiant AIG had a subsidiary, AIG Financial Products,originallyorganizedin theUnitedStates,but run out of London.Thefast collapseofAIG, a mainstayof Wall Street, wasagain soberingevidenceof the markets‘international interconnectedness.Soberingevidence, aswell, of how transactionsbooked in London oranywhere around theglobe can wreak havocon theAmerican public.Recently, we‘vehadanother stark reminder of how tradesoverseascanquicklyreverberatewith lossescomingback intothe United States.According to pressreports,the largest U.S.bank, JPMorgan Chase,justsufferedamulti-billion dollar tradinglossfrom transactionsin London.Thepressalsois reportingthat this tradinginvolved credit default swapsand indiceson credit default swaps.It appearsthat the bank here in theUnited Statesis absorbing theselosses.And asa U.S. bank, it is an entitywithdirect accesstotheFederalReserve‘sdiscount windowand federaldeposit insurance.I am authorizedby the Commission to confirm that the CFTC‘sDivisionof Enforcement hasopened an investigation relatedtocredit derivativeproductstraded by JPMorganChase‘sChief Investment Office.Although I am unableto provideany specific information about apendinginvestigation, I will describegenerallythe Commission‘soversight of theswapsmarkets, the entities and productsin ourjurisdiction, andtheDodd-Frank reformsrelevant tocredit defaultswaps,and in particular index credit default swaps.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 180The role the unregulated swapsmarket played in the 2008 crisis led to anew international consensus that the time had come for comprehensiveregulation.Swaps,whichwerebasicallynot regulatedinAsia, EuropeandtheUnitedStates,should now be brought intothe light of regulation.When President Obama gathered together the G-20leadersin Pittsburghin 2009, theyagreed that the swapsmarket neededtobe reformed andthat suchreform should be completedby December 2012.In 2010,Congressand the President came together and passed thehistoric Dodd-FrankAct.Thegoal of thelaw isto:- Bringpublic market transparencyand the benefitsof competition totheswapsmarketplace;- Protect against Wall Street‘srisksbybringingstandardizedswapsintocentralizedclearing; and- Ensure that swapdealersand major swapparticipantsare specificallyregulated for their swapactivity.Despite different cultures, political systems and financial systems,we‘ve made significant progress on a coordinated and harmonizedinternational approachto reform.Japan passed reform legislationin 2010,and hasmadereal progresson their clearingmandate.Further, theyhavea proposalbeforetheir Diet onthe use of tradingplatforms,aswellaspost-tradetransparency.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 181The European parliament last month adopted the European MarketInfrastructure Regulation (EMIR) that includes mandatoryclearing, reporting and risk mitigationfor derivatives.And the European Commissionhaspublished proposalsprovidingfor both pre-tradeand post-tradetransparency.Othermajor jurisdictions,includingthelargestprovincesinCanada, have the legislativeauthorityand havemadeprogressonswapsreform.Implementation of Dodd-Frank SwapsMarket ReformsThe CFTC has made significant progress in completing the reformsthat will bring transparency to the swapsmarket and lower itsrisk totherest of the economy.During the rule-writingprocess, wehavebenefitted from significantpublic input.CFTC Commissioners and staff have met over 1,600 timeswith thepublic and we have held 16 public roundtables on important issuesrelatedtoDodd-Frank reform.We are consultingcloselywithother regulatorson Dodd-Frankimplementation, includingthe SEC, theFederal Reserve, theFederal Deposit InsuranceCorporation, theOffice of theComptroller of the Currencyand other prudential regulators.Thiscoordinationincludessharingmanyof our memos, term sheetsanddraft workproduct.In addition, weare activelyconsultingwithinternational regulatorstoharmonize our approach to swapsoversight, and sharememos, term sheetsand draft workproduct with our internationalcounterpartsaswell.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 182We substantiallyfinishedour proposal phaselast spring, and thenlargelyreopenedthemosaicofrulesforadditionalpublic comments.Wehaveacceptedfurtherpublic comment aftertheformal commentperiodsclosed.Theagencyreceived3,000comment lettersbeforeweproposedrulesandmore than 28,000comment lettersin responsetoproposals.Last summer, weturnedthe corner and started finalizingrules. Todate, we‘vecompleted33ruleswith lessthan 20more to go.TheCommission is turning shortly totheruleto further define theterms―swap‖ and ―security-based swap,‖ the second of the twokeyjoint further definitionruleswith the SEC.Thestaff recentlyhasput forthtotheCommissionafinal ruleforourconsideration.It isessential that thetwoCommissionsmoveforwardon thefurtherproduct definition rulemakingexpeditiously.Consistent withtheprovisionsof theDodd-FrankAct, theproposalstatesthe CFTC regulatescredit default swapson broad-basedsecurity indices,whilethe SEC regulatesthem on narrow-basedsecurity indices(aswell ascredit default swapson singlenamesecuritiesor loans).Under the proposal, most of the credit default swapindicescompiled by the leadingindex provider, Markit, generallywouldbebroad-basedindices.Theseindiceswouldgenerallyinclude, but not be limitedto, Markit‘sCDX NorthAmerican Investment Grade, aswell asitsCDX North American High Yield.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 183While thecredit default swapsbased on theseindiceswouldbeswapsunder CFTC jurisdiction, theSEC wouldretain certainanti-fraudand anti-manipulationenforcement authorities over themaswell, asit had prior toDodd-Frank.TransparencyTheDodd-Frank financial reform shinesbright lightsoftransparency– tothepublic and toregulators– on theswapsmarketfor the benefit of investors,consumers, retireesand businessesinAmerica.Transparencyis criticaltoboth loweringthe riskof the financialsystem, aswell asreducingcoststo end-users.Themore transparent a marketplaceis tothepublic, the moreefficient it is, themore liquid it is, and the more competitiveit is.TheCFTC hascompletedkeyrulesontransparencythat, forthefirsttime, provide a detailedand up-to-dateview of thephysicalcommodity swapsmarketssoregulatorscan police forfraud, manipulationand other abuses.We havebegun to receiveposition informationfor largetradersintheswapsmarketsfor agricultural, energy and metal products.We alsofinished a rule establishingregistration and regulatoryrequirementsfor swapdata repositories,which will gather data onall swapstransactions.Startingthis summer, real-timereportingto thepublic and toregulatorswill begin for interestrateand credit default swapswithsimilar reporting on other swapslater thisyear.Also later this year, market participantswill benefit from thetransparencyof dailyvaluationsover thelife of their swaps.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 184Bycontrast, in thefall of 2008,therewasnorequiredreportingaboutswapstrading.This month, wecompleted rules,guidanceand acceptablepracticesfor designated contract markets(DCMs).DCMswill be abletolist and tradeswaps,helpingto bring thebenefit of pre-tradetransparencytotheswapsmarketplace.Looking forward, wehave twoimportant remainingtransparencyrulestocompleterelatedtoblock sizesand swapexecutionfacilities(SEFs).Thetrading of credit default swapindiceswill benefit from thetransparencyprovided on SEFs.TheJapaneseand European transparencyproposals, aswell asinitiativeswell underwayin other jurisdictions,will further aligninternational reform effortsand benefit thepublic.Central ClearingFor over a century, through good timesand bad, central clearinginthefuturesmarket hasloweredrisk to the broader public.Dodd-Frank financial reform brings thiseffectivemodel totheswapsmarket.Standard swapsbetweenfinancial firmswill move intocentralclearing, whichwill significantlylowertherisksof the highlyinterconnectedfinancial system.TheCFTC hasmade significant progresson central clearingfor theswapsmarket.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 185We have completedrules establishingnew derivativesclearingorganization risk management requirements.Tofurther facilitatebroad market access, wecompleted rulesonclient clearingdocumentation, risk management, and so-called―straight-throughprocessing,‖ or sendingtransactionsimmediatelytothe clearinghouseupon execution.In addition, theCommission hasadopted important customerprotectionenhancements.Thecompletedamendmentstorule1.25regardingtheinvestment offundsbring customersback toprotectionsthey had prior toexemptionsthe Commission granted between2000and 2005.Importantly, thispreventsuseof customer fundsfor in-houselendingthrough repurchaseagreements.Clearinghousesalsowill have tocollect margin on a grossbasisandfuturescommissionmerchantswill no longer be ableto offset onecustomer‘scollateral againstanother and then send onlythenet totheclearinghouse.And the so-called―LSOC rule‖ (legal segregation withoperationalcomingling) for swapsensurescustomer money is protectedindividuallyall thewayto theclearinghouse.Furthermore, Commissionersand staff havegotten a lot of feedbackfrom market participantson additional customer protectionenhancements,includingthrough a publicroundtable.Staff isactivelyseekingfurtherpublic input throughour websiteandfurther meetings.Staff will use this outreach and review to putforwardrecommendationsto the Commission for consideration.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 186In addition, theNational FuturesAssociation and the CME Grouphaveproposalsfor greater controlsfor segregation of customerfunds.CFTC staff is workingwiththese self-regulatoryorganizationsontheir proposals.CFTC staff now ispreparing recommendationsfor the Commissionand for public comment on clearingrequirement determinations.TheCommission‘sfirst determinationswill be put out for publiccomment this summer and hopefully completedthis fall.Theywill begin withkeyinterest rate products, aswell asa numberof CDX and iTraxx credit default swapindices.There is a great deal of consistencyamong the major jurisdictionsonthe clearing requirement, and the CFTC‘s timeframe broadly alignswith both Japan and Europe.Currently, clearingexistsfor much of thestandardizedinterestrateswaps,aswell asfor credit default swapindices, donebetweendealers.Themajor clearinghousesproviding swapsclearingare registeredwith the CFTC.Movingforward, theCommission will consider a final ruleon theimplementationphasingof the clearingrequirement and theend-userexceptionrelated tonon-financial companies.SwapDealersRegulatingbanksandotherfirmsthatdealin derivativesiscentraltofinancial reform.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 187Prior to2008, it wasclaimedthat swapdealersdid not needtobespecificallyregulatedfor their swapsactivity, astheyor theiraffiliatesalreadyweregenerallyregulated asbanks, investmentbanks,or insurancecompanies.Thecrisisrevealed the inadequacyof relying onthis claim.While bankswereregulatedfor safetyand soundness, includingtheir lendingactivities,therewasno comprehensiveregulation oftheir swapdealingactivity.Similarly, bank affiliatesdealingin swaps,and subsidiariesofinsuranceand investment bank holdingcompaniesdealing inswaps,werenot subject tospecific regulation of their swapdealingactivities.AIG, Lehman Brothersand other failuresof 2008demonstratewhathappenswith suchlimitedoversight.TheCFTC is well on thewaytoimplementingreformsCongressmandatedin Dodd-Frank to regulate dealersand help preventanotherAIG.TheCommission hasfinishedsalespractice rulesrequiringswapdealerstointeract fairlywithcustomers,providebalancedcommunicationsand discloseconflictsof interestbeforeenteringintoa swap.In addition, thisagencyhasfinalizedinternalbusinessconductrulestorequire swapdealersto establishpolicies to manage risk, aswellasput in placefirewallsbetweena dealer‘strading, and clearingandresearch operations.We completedin April a joint rule withtheSEC further definingtheterms―swap dealer‖ and ―securities-basedswapdealer,‖ which ispivotal toloweringtherisktheymayposetotherestof theeconomy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 188Basedon completedregistrationrules,dealerswill registerafter wefinalize the second major definition rulewiththe SEC: the furtherdefinitionof the terms―swap‖ and ―securities-basedswap.‖Swapdealerswhomake marketsin credit default swapindiceswouldbe amongst thosedealerswhomay have to register withtheCFTC.FollowingCongress‘mandate, the CFTC alsois workingwithourfellowfinancial regulatorsto completetheVolcker rule, whichprohibitscertain banking entitiesfrom engagingin proprietarytrading.In adoptingtheVolcker rule, Congressprohibitedbankingentitiesfrom proprietarytrading, an activitythat may put taxpayers at risk.At the same time, Congresspermitted bankingentitiestoengageincertainactivities,such asmarket making and risk mitigatinghedging.Oneof thechallengesin finalizinga rule is achievingthesemultipleobjectives.Theinternational communityisclosely coordinating on marginrequirementsfor unclearedswaps,and ison track to seek publiccomment in June on a consistent approach.This is critical to reducingthe opportunityfor regulatory arbitrage.TheCFTC‘sproposedmargin rule excludesnon-financial end-usersfrom margin requirementsfor unclearedswaps.I‘vebeen advocating withglobal regulatorsthat weall adopt aconsistent approach.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 189TheCommission is workingwithfellowregulatorshere and abroadon an appropriateand balanced approach to thecross-borderapplicationof Dodd-Frank swapsmarket reforms.TheCFTC will soonseekpubliccomment on guidanceregardingthecross-border applicationof TitleVII rules.Market Integrity/ Position LimitsFinancial reform alsomeansinvestors,consumers, retireesandbusinessesinAmerica will benefit from enhancedmarket integrity.Congressprovided theCommission withnew toolsin Dodd-Franktoensure thepublic hasconfidencein U.S.swapsmarkets.Rulesthe CFTC completed last summer closea significant gap intheagency‘s enforcement authorities.Therulesimplement important Dodd-Frank provisionsextendingour enforcement authorityto swapsand prohibited the recklessuseof manipulativeor deceptiveschemes.Thus, for example, the CFTC hasclear anti-fraud and anti -manipulation authorityregarding thetradingof credit default swapsindices.Also, theCFTC now can rewardwhistleblowersfor their helpincatchingmarket misconduct.CongressalsodirectedtheCFTC toestablishaggregatepositionlimitsfor both futuresand swapsin energyand other physicalcommodities.In October 2011, the Commission completed final rules to ensure nosingle speculator is able to obtain an overly concentrated aggregatepositionin the futuresand swapsmarkets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 190TheCommission‘sfinal rulesrequire compliancefor all spot-monthlimits60days after the CFTC and SEC jointlyadopt the ruletofurther definetheterm ―swap‖ and ―securities-basedswap‖ and forcertainother limits,followinga collectionof a year‘s worth of largetrader swapdata.Twoassociationsrepresentingthe financial industry, however, arechallengingthe agency‘sfinal rule establishingthoselimitsin court.TheCommission is vigorously defendingthe Congressionalmandateto implement position limitsin court.Last week, theCommission approved aproposed rule that wouldmodifythe CFTC‘saggregationprovisionsfor limitson speculativepositions.Theproposal wouldpermit any person witha 10to50 percentownership or equityinterest in an entitytodisaggregatethe ownedentity‘spositions,provided there are protectionsand firewallsinplaceto ensuretradingdecisionsare made independentlyof oneanother.Theproposal wasa responseto a Working Group of CommercialEnergyFirms(WGCEF) petitionseekingrelief fromtheaggregationprovisionsof theposition limitsrule.Position limitsis another area wherethere hasbeen closeinternational coordination.TheG-20leadersendorsed an International OrganizationofSecuritiesCommissions(IOSCO) report last November notingthatmarket regulatorsshould useposition managementregimes,includingpositionlimits,toprevent market abuses.TheEuropean Commission hasproposed sucha positionmanagement regime to the European Parliament.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 191Cross-border Application of Dodd-Frank‘s SwapsReformsTheDodd-Frank Act statesin Section 722(d) that swapsreformsshall applyto activitiesoutsidethe United Statesif thoseactivitieshave―a direct and significant connectionwithactivitiesin, or effecton, commerce‖ of theUnited States.CFTC staff will soonbe recommendingtotheCommission topublish for public comment a releaseon the cross-borderapplicationof swapsmarket reforms.It willconsist ofinterpretiveguidanceonhowthesereformsapplytocross-borderswapactivities.It alsowill includean overview astowhenoverseasswapsmarketparticipants,includingswapdealers,can complywith Dodd-Frankreforms through relianceon comparable and comprehensiveforeignregulatoryregimes,or what wecall ―substitutedcompliance.‖There is further work tobe done on theCFTC cross-borderrelease, but thekey elementsof the staff recommendationsare likelytoinclude:- First, when a foreign entitytransactsin more than a de minimislevelof U.S. facingswapdealing activity, theentitywouldregisterundertheCFTC‘srecentlycompleted swapdealer registrationrules.- Second, the releasewill addresswhat it meansto be a U.S. facingtransaction.I believe this must includetransactionsnot onlywithpersonsorentitiesoperatingin theUnited States,but alsowiththeir overseasbranches.In the midst of a default or a crisis,there is no satisfactorywaytoreallyseparatetheriskof a bank and itsbranches.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 192Likewise,I believe thismust includetransactionswithoverseasaffiliatesthat are guaranteedby a U.S. entity, aswell astheoverseasaffiliatesoperating asconduitsfor a U.S.entity‘sswapactivity.- Third, basedon input the Commission hasreceived from marketparticipants,thestaff recommendationswillincludeatieredapproachfor requirementsfor overseasswapdealers.Somerequirementswouldbe consideredentity-level, such asforcapital, risk management and recordkeeping.Somerequirementswouldbe consideredtransaction-level, suchasclearing, margin, real-timepublic reporting, tradeexecutionandsalespractices.- Fourth, such entity-level requirementswouldapplytoall registeredswapdealers,but in certain circumstances,overseasswapdealerscould comply withtheserequirementsthrough substitutedcompliance.- Fifth, such transaction-levelrequirementswouldapplyto all U.S.facingtransactions,but for certain transactionsbetweenan overseasswapdealer (includinga foreign swapdealer that isan affiliateof aU.S. person) and counterpartiesnot guaranteedby or operatingasconduitsfor U.S. entities,Dodd-Frank may not apply.For example, thiswouldbe thecasefor a transaction betweenaforeign swapdealer and a foreign insurancecompany not guaranteedbya U.S. person.In puttingtogether this release,wevealreadybenefitted from significantinput from market participants.Throughout our nearly60 ruleproposals,we‘veconsistentlyasked forinput on the cross-border applicationof swapsreforms.Commentersgenerallysaythey support reform.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 193But in what some of them call a ―clarification,‖ we find familiar narrativesof the past as to why many swapstransactionsor swap dealersshould notberegulated.Somecommenters haveexpressed theview that if a transactionis doneoffshore, it should not come under Dodd-Frank.Others contend that as long as an offshore dealer is regulated in somecapacity elsewhere, many of the Dodd-Frank regulations applicable toswapdealersshould not apply.Thelaw,thenature of modern finance, and the experiencesleadingup tothe2008crisis, aswell asthereminder of the last twoweeks,stronglysuggest this wouldbe a retreat from much-neededreform.When Congressand theAdministration came together todraft theDodd-FrankAct, theyrecognized the lessonsof the past whentheyexpresslyset up a comprehensiveregulatory approach specificto swapdealers.Theywerewell awareof thenature of modern finance: financialinstitutionscommonlyset up hundredsif not thousandsof ―legalentities‖around theglobewitha multitudeof affiliaterelationships.When one affiliateof a large, international financial group hasproblems, it‘saccepted in themarketsthat thiswill infect the rest of thegroup.This happenedwithAIG, Lehman Brothers,Citigroup, BearStearnsandLong-Term Capital Management.Implementation PhasingAs wemoveon from therule-writingprocess, acriticalpart of our agendais workingwithmarket participantson phased implementationof thesereforms.We have reached out broadlyon thistopic toget public input.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 194Last spring, wepublished a conceptsdocument asa guide forcommenters, held a two-day, public roundtablewiththe SEC, andreceivednearly300comments.Last year, the Commission proposed tworuleson implementationphasingrelatingtotheswapclearingand tradingmandatesand theswaptradingdocumentation and margin requirementsfor unclearedswaps.We have receivedvery constructivepublicfeedbackand hope to finalizetheproposed complianceschedulesin thenext few months.In additiontothese proposals, theCommission hasincluded phasedcomplianceschedulesin many of our rules.For example, both the data and real-timereportingrules, which werefinalized this past December, includephasedcompliance.Thefirst required reporting will be thissummer for interest rate andcurrencyswaps.Other commoditieshave until later this fall.Additional timedelays for reportingwerepermitteddependinguponasset class, contract participant and in the earlyphasesofimplementation.TheCFTC will continue lookingat appropriatetimingforcompliance,whichbalancesthedesireto protect thepublic whileprovidingadequatetime for industry tocomply withreforms.ResourcesConfidencein the futuresand swapsmarketsisdependent upon awell-fundedregulator.TheCFTC is a good investment of taxpayer dollars.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 195This hardworkingstaff of 710is just 10 percent more than what wehad inthe1990sthough thefuturesmarket hasgrownfivefold.TheCFTC alsowill soonbe responsiblefor theswapsmarket – eighttimesbigger than thefuturesmarket.Picture theNFL expandingeightfoldtoplay more than 100footballgamesin a weekend, leavingjust one referee per game, and, in somecases,noreferee.Imaginethemayhem onthefield,theresultinginjuriestoplayers,andthelossof confidencefanswouldhave in the integrityof thegame.Market participantsdepend on the credibility and transparencyofwell-regulatedU.S.futures and swapsmarkets.Without sufficient fundingfor theCFTC, thenation cannot beassuredthat the agencycan adequatelyoversee thesemarkets.ConclusionNearly four years after the financial crisis and two years since the passageof Dodd-Frank, it‘s critical that we fully implement the historic reformsofthelaw.It‘s critical that wedonot retreat from reformsthat will bringgreatertransparencyand competition to the swapsmarket, lowercostsforcompanies and their customers,and protect thepublic from therisksoftheseinternational markets.In 2008, the financial system and the financial regulatorysystem failed.Thecrisisplunged the UnitedStatesintotheworst recessionsincetheGreat Depressionwitheight millionAmericanslosingtheir jobs, millionsof familieslosingtheir homesand thousandsof small businessesclosingtheir doors.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 196Thefinancial stormscontinuetoreverberate withthe debt crisisinEurope affectingtheeconomicprospectsof peoplearound theglobe.The CFTC has made significant progress implementing reform havinglargely finished the rule proposals, and now having completed well overhalf of the final rules.We areon scheduletocompletetheremainingreformsthisyear, but untilwedo, thepublic is not fullyprotected.Last Updated: May22, 2012NoteGaryGensler wasswornin asthe Chairman of the Commodity FuturesTradingCommission on May26, 2009.ChairmanGenslerpreviouslyserved at the U.S.Department of theTreasuryasUnder Secretary of DomesticFinance (1999-2001)and asAssistant Secretary of Financial Markets(1997-1999).He subsequentlyserved asa Senior Advisor to theChairman of the U.S.SenateBanking Committee, Senator Paul Sarbanes,on theSarbanes-OxleyAct, reformingcorporate responsibility, accounting and securitieslaws.As Under Secretaryof the Treasury, Chairman Genslerwastheprincipaladvisorto TreasurySecretary Robert Rubin and later toSecretaryLawrenceSummerson all aspectsof domestic finance.Theoffice wasresponsiblefor formulatingpolicy and legislationin theareasof U.S.financial markets, public debt management, thebankingsystem, financial services,fiscalaffairs,federal lending, GovernmentSponsored Enterprises,and communitydevelopment.In recognitionof thisservice, hewasawardedTreasury‘shighest honor,theAlexander HamiltonAward.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 197Prior tojoiningTreasury, Chairman Genslerworked for 18years atGoldmanSachs,wherehewasselectedasapartner;in hislastrolehewasCo-head of Finance.ChairmanGensleris the co-author of a book, The Great Mutual FundTrap, which presentscommon senseinvestment advicefor middleincomeAmericans.He isasummacum laudegraduatefrom theUniversityof Pennsylvania‘sWharton School in 1978, witha Bachelor of Science in Economicsandreceiveda Masterof BusinessAdministration from the Wharton School‘sgraduatedivision in 1979.He liveswithhisthreedaughtersoutsideof Baltimore, Maryland.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 198ThomasJordan: Challengesfacing the SwissNational BankSpeechby Mr ThomasJordan, Chairman of the Governing Board of the SwissNational Bank, to theGeneral Meeting of Shareholdersof theSwissNational Bank, 27April 2012.Mr President of the Bank CouncilDear ShareholdersDear GuestsAlsofromamonetarypolicyperspective,theSwissNational Bank (SNB) has experiencedanotherdifficult year.In 2011, the escalation of the European sovereigndebt crisistriggereda very substantialappreciationof the Swissfranc.In order toavert major damageto theSwisseconomy, and workagainst thethreat of adeflationarytrend, theSNB had to reactfast withexceptional measures.I wouldlike tobegin by givingyou a review ofeconomicdevelopmentsand monetary policyin 2011.Then I will presentour assessment of theinternational economicoutlook and itsimpact on the Swisseconomy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 199I will alsooutlinetheoutlook for price stability. I will concludebyexplainingthe SNB‘s reflectionson current monetary policy.First, let me begin by reviewingtheeventsof last year.Review of 2011In termsof theeconomiccycle, the year 2011certainlybeganwell.Overall, economic activitywaslively, and thesituation on the labourmarket improved further.Despitethe appreciationof theSwissfrancin 2010,goodsexportswererobustduring the first few monthsof theyear.However,in spring 2011, theinternational economic recovery stalled.This wasattributableto several different factors.In major advanced economies, stimuli from fiscalpoliciesdiminished.Moreover,in the second quarter in particular, international economicgrowthsuffered from theeffectsof theJapaneseearthquakeandtsunami.Thedestruction of production plantsfor important intermediate goodsfortheelectronicsindustryled tosubstantial supplyproblemsworldwide,whichresulted in production losses.Finally, theconcernsabout fiscalproblemsin many advanced economiesincreased.In particular, the risk that the European sovereign debt crisismightescalatehung like a swordof Damoclesover the outlook for the entireinternational economy.Thedebt crisisdid indeed escalatein thesecond half of the year.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 200While, initially, it wasonlythesmall peripheralstatesof theeuroareathatencounteredproblemsbecauseof their high levelsof debt, the lossofconfidenceincreasinglyaffected the larger economiesof Europe aswell.At the same time, there wasgrowingconcern about the stability ofEuropean banks.Given thesedevelopments, uncertaintyin financial marketsincreasedsharplyin the second half of the year.At the same time, the demand for safe-haveninvestmentssoared.As weall know, these investmentsincludethosein the Swissfranc. TheSwisscurrencyhad already gained in valuein the second quarter.However,betweenJulyand thebeginningofAugust, it appreciatedverysubstantiallywithina very short period.In August 2011, theSwissfrancreachedan all-timehigh againstboth theeuroand theUSdollar, in both nominal and real terms.Ladies and Gentlemen, in August 2011, the Swissfranc wasmassivelyovervalued, accordingto any yardstick.In addition, in practicallythe same period, theinternational economicenvironment had becomenoticeablygloomier.Thissituation presented an acuterisktoour economy, aswell ascarryingthethreat of a deflationarytrend.Consequently, the SNB reactedfast and announced anunscheduledinterest rate reduction on 3August.In addition, from thismoment onwards,it increasedthesupplyof Swissfrancliquidityby a hitherto unprecedentedamount, in several steps,withtheaim of weakeningthe Swisscurrency.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 201Overall, the liquiditymeasuresachievedthe expected results.Theybrought about significantlylowerinterest ratesin the Swissfrancmoneymarket – interest ratesthat were, at times,evennegative.This tended to weakenthe attractivenessof Swissfranc investments.Thusthe upwardtrend of theSwissfrancagainstthe eurowascheckedfor the timebeing.However, the exchange rate remained very volatile, due to the persistenceof negative reportsfrom abroad, and at the end of August the Swiss francappreciatedagain.In this market environment, whichwasextremelyuncertain and nervousbecauseof the European debt crisis,theliquiditymeasureswereultimatelyinsufficient tohalt the appreciationof the Swissfranc.In recognitionof thisfact, theSNB decidedtointroduceameasurewhichwasexceptional in every respect.On 6September, theSNB set a minimum exchangerate of CHF 1.20pereuro.It statedthat it wouldenforcethis minimum rate withthe utmostdetermination and waspreparedtobuy foreign currencyin unlimitedquantitiesfor this purpose.This policy is still in force, without any restriction.Theimpact ontheSwisseconomyof thedeteriorationin theinternationalenvironment aswell asthe exchangeratemovementsin JulyandAugusthadbeen steadily increasing.Economicactivityweakenedsignificantlyover the course of 2011and thepressure on profit marginsintensifiedfurther in many industries.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 202However,in thepast few monthsthere have been growingsignsthat theeconomicsituationin Switzerlandhasstabilisedasa result of theminimum exchangerate.Thustheminimum exchangerate of CHF 1.20per euro has, todate,proved tobe effective.It hasreduced the very substantial overvaluation of theSwissfranc.Moreover,the extreme exchangeratefluctuationswhich had beenexperienced previouslyhave been lessened.This hasgiven businessleaders a better basis for planning, thereby clearlylimiting the damage inflicted bythe appreciation of the Swissfranc on thereal economy.However,apart from the exchangerate, future economicgrowthin ourcountry will once again depend on developmentsin the internationaleconomy.That is whyI will now present to you our assessment of theinternationaleconomicoutlook.Economic outlook and outlook for price stabilityThelatest economicstatisticssuggest that the international economicrecoverywill continue, although growthratesare likely tobe on the lowsideby comparison with typical recoveryphases.Thedebt reduction processwhich privatehouseholdsin theUSarecurrentlyundergoingand the consolidation of government financesinseveral European countries, in particular, are dampening economicactivityin theshort term.Nevertheless, the recovery should graduallygain somestrength.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 203However,it isby nomeanscertain that this moderatelypositivescenariofor the international economy will become reality.Theinternational environment continuesto be highly uncertain. TheEuropean sovereign debt problem still presentsthebiggest risk.It is unclear whetherthemeasurestaken sofar will really succeed indefusingthesituation permanently.Consequently, the sovereign debt crisis still has the potential to seriouslyaffect the international financial system as well as international economicdevelopment.What doesthis international environment mean for theSwisseconomy?Theyear 2012islikelyto beanother difficult one.At CHF 1.20against theeuro, theSwisscurrencyis still overvalued andpresentsmajor challengestoour economy.Many companieshavebeen forced toreduce their prices,whichhasloweredtheir turnover in nominal terms.Companiesexposedtointernational competition, withconsiderabledepth of production in Switzerland, in particular, are facingpressure ontheir profit margins.An additional factor is the muted outlookfor the internationaleconomy.CombinedwiththecontinuedhighlevelofuncertaintywithrespecttotheEuropean debt problem, thisis likely tolimit the willingnessto invest inSwitzerland.However,therearereasonsfor acertaindegreeofconfidenceasfar asoureconomy isconcerned.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 204For instance, the low level of interest ratesis still having a stimulatingeffect on theeconomy. Domesticdemand continuesto be supportedbyhigh immigration.In addition, therepercussionsof the high Swissfranc valueare not onlynegative.For example, importedpreliminary productsfor companies andconsumer goodsfor householdshave become cheaper.Finally, Swissfirmsand their employeeshave made huge effortstodealwith this difficult situation.Overall, the SNB expectsmoderateeconomic growth of closeto 1%fortheyear 2012.This modest economic momentum is likelyto be reflectedin a moderateincreasein unemployment over thecourseof the next few quarters.Theexpected economicactivityis lowerthan wouldbe the casefornormal capacityutilisation.This meanstherewill be noinflationarypressure from this source.Our conditional inflation forecast of mid-March2012showsthat thereisnorisk of inflation in Switzerland in theforeseeablefuture.Theforecast alsomakesit clearthat thethreat of a deflationarytrend hasbeen kept in check.Inflationratesare only temporarily negative.Nevertheless, themonetary policychallengesfor the SNB remain veryconsiderable.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 205I wouldnow like togointoa littlemore detail on our reflectionsonmonetarypolicy, particularlywith respect totheminimum exchangerate.Reflectionson Swissmonetary policyAfter beingannouncedon 6September 2011, theminimum exchangeratewasrapidlyattained.When our pressreleasewasissued, at exactly10 am, theeuro wastradingat a littleover CHF 1.12.Withinminutes,theexchangerate exceededthe CHF 1.20mark.Seen from the outside, thismay have createdthe impression that aminimum exchangerate can simplybe generatedby pressinga buttonandthat such an exchangerateis a normal monetarypolicy measurewhichis straightforward toimplement.That is far from beingthecase.Aminimum exchangerate is an extrememeasure, only tobe introducedin a situation of massiveovervaluation, withthe aim of avertingthe worstdevelopments.It isneitherapanaceacapableofsolvingall theproblemsfacingtheSwisseconomy, nor can it simplybe implementedfor any desiredlevel, free ofanyrisk.On the contrary.Aminimum exchangerate can onlybe successfullyimplemented if thereis a cleareconomic justificationfor itsintroduction, such asa massiveovervaluation resultingfrom adversedevelopmentson the foreignexchangemarket.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 206Withinthe framework of a system of flexibleexchangerates,it is alsoimportant that it be internationallyaccepted, and that it isnot seenasacompetitivedepreciation.Finally, a vital element in thesuccessful implementation of such anexchangerate isthe central bank‘scredibility, in other words, thebeliefthat thecentral bank will indeed defend the minimum exchangerate, ifneed be.Financial marketsare constantlychangingtheir assessment of risks.Asituationmayalsooccur inwhichthemarketdecidestotestthedefenceof the minimum exchangerate.Consequently, theSNB is present in theforeign exchangemarket at alltimesand is alwayspreparedtopurchaseunlimitedquantitiesof eurosatCHF 1.20per euro, in order toenforcetheminimum exchangerate.When tradingtook placeat lessthan CHF 1.20per euro, it wasonlyfor afew secondsand resulted from market idiosyncrasies.Since6September,thebestrateinthemarket forthesaleof eurosagainstSwissfrancshasnever fallenbelow CHF 1.20.TheSNB wasthusableto successfullyenforcetheminimum exchangerate evenunder extremely difficult conditions.Theseconsiderationsclearlyshow that the introduction of a minimumexchangerate isassociatedwithrisks.Under certain circumstances,implementingsuch a rate can lead toavery considerableexpansion of foreign currencyreserves.TheSNB is prepared to bear the risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 207Indeed, in summer 2011, thesituation had become soacutethat, by earlySeptember, theSNB felt that there wasnolonger anyalternativetointroducinga minimum exchangerate.Doingnothingwouldhave had an extremelynegativeimpact on oureconomy.Even at a rateof CHF 1.20per euro, theSwissfranc remainsovervalued.We are acutely awarethat considerablechallengesstill remain for theSwisseconomy, despitethe minimum exchangerate.Oneparticularreasonfor this is thefact that theinternationaleconomy isrecoveringat onlya moderate pace.In addition, there isa very high level of uncertainty in the internationalenvironment.An appreciationof theSwissfrancat thecurrent timewouldagain exposeSwitzerland toconsiderable risksand, oncemore, endanger both pricestability and thestabilisationof the economy.Given this situation, theSNB will enforce theminimum exchangeratewith the utmostdetermination.If developments in the international economy are worse than foreseen, orif the Swissfranc does not weaken further as expected, renewed downsiderisksfor price stabilitycould emerge.Should the economicoutlook and the threat of deflationrequire it, theSNB is prepared at any time totake further measures.As you will probably have deduced from this account, seen from today‘svantage point, interest rates in Switzerland are likely to remain low for awhile yet.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 208This expansionarymonetary policy isindispensablefrom the point ofview of theeconomyasa whole.In that it hassignificantlyreducedthe threat to theeconomyand thethreat of a deflationarytrend, the current monetary policy isalsocontributingto financial stability– in theshort term.Both a deep recessionand a deflationarytrend wouldposea threat tothebankingsystem.In the longer term, a period of low interestratescarriesthe riskthatimbalanceswill build up.In Switzerland, the current low-interest-rateperiod hasnow lastedforover three years.We are – in fact – currentlyobservingincreasingsigns of adversedevelopmentsintheSwissmortgageandrealestatemarket for residentialproperty.Theexplanatorypowerof fundamental factorsin explainingthedevelopmentsin residential realestatepricesis decreasingsteadily, whilethevolume of mortgage loansin comparison toGDP hasnever been sohigh.Should theseimbalancesincreasefurther, considerableriskstofinancialstability could emerge.Giventhissituation, theSNB hasstronglyadvocatedtheintroductionofacountercyclical capital buffer in Switzerland.Thisbuffer wouldnot beapermanent increasein equityrequirementsforbanks.It is only to be activatedtemporarily in theevent of excessivegrowth indomesticmortgagelending.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 209As soon aslendinggrowthweakensagain, thebuffer can be deactivated.An instrument of thiskind wasexamined in detail last year by a workinggroup headedby theFederal Department of Finance, towhichbothFINMA and theSNB alsobelonged.Thegroup proposed that the buffer be introduced rapidlysothat asuitableinstrument wouldbein place,in casetheimbalancesin theSwissmortgageand real estatemarket increasedfurther.Concluding remarksLadiesand Gentlemen, asyou will havegatheredfrom my remarkstoday,thechallengesfacingtheSNB havenot diminished.Consequently, it isall the more important that weare abletodevote ourcompleteattention toour tasks, now and in the future.TheSNB‘smonetary policy decisionsare directedpurely and solely atfulfillingits statutorymandate.It is our responsibilityto ensure price stability.In doing so, wetake accountof thedevelopment of the economy andmake a contributionto the stabilityof thefinancial system.TheSNB pursuesa monetary policy that servesthe interestsof thecountry asa whole,and wefulfil thismandate asan independent centralbank.Todo this, wecontinuetorely on the total commitment of our staff,whom I wouldlike tothank – alsoin thename of my colleague,Jean-Pierre Danthine– for their hard work and their solidaritywiththeSNB.We thank our shareholdersfor their continuingsupport.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 210And wethank you all fortakingsuchagreatinterestintheactivitiesoftheSNB.Finally,wewouldalsolike tothank ourformercolleagueandChairmanoftheSNB GoverningBoard, Philipp Hildebrand, for thegoodcollaborationweenjoyed over theyears.We very much regret his resignationand thecircumstancesleadingup toit.Thank you for your attentionNotesMandateTheSwissNational Bank conductsthecountry‘smonetary policy asanindependent central bank.It is obligedby Constitutionand statutetoact in accordancewith theinterestsof the country asa whole.Its primary goal is toensure price stability, while taking dueaccount ofeconomicdevelopments.In sodoing, it createsan appropriate environment for economicgrowth.Price stabilityPrice stabilityisan important conditionfor growthand prosperity.Inflationand deflation, by contrast, impair economicactivity.Theycomplicate decision-makingby consumersand producers,lead tomisallocationsof labour and capital, result in income and assetredistributions,and put the economicallyweakat a disadvantage.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 211TheSNB equatesprice stabilitywitha rise in thenational consumerpriceindex of lessthan 2% per annum.Deflation– i. e. a protracteddeclinein price levels– is considered to beequallydetrimental toprice stability.TheSNB takesitsmonetary policy decisionson the basisof an inflationforecast.Implementation of monetary policyTheSNB implementsitsmonetary policyby steeringliquidityon themoneymarket and therebyinfluencingthe interestratelevel.Thethree-month Swissfranc Libor servesasitsreferenceinterestrate.In addition, since6 September 2011, a minimum exchangeratefor theeuroagainstthe Swissfranchasalsoapplied.Cash supply and distributionTheSNB is entrusted withthenote-issuingprivilege.It suppliesthe economy withbanknotesthat meet high standardswithrespect toqualityand security.It is alsochargedby theSwissConfederationwiththetask of coindistribution.Cashlesspayment transactionsIn the field of cashlesspayment transactions,the SNB providesservicesfor paymentsbetweenbanks.Thesearesettledin the interbank payment system (SIC system) via sightdeposit accountsheld with theSNB.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 212Asset managementTheSNB managesthe currencyreserves, the most important componentof itsassets.Currencyreservesengenderconfidencein theSwissfranc,helptopreventand overcome crises, and may be utilised for interventionsin the foreignexchangemarket.Financial system stabilityTheSNB contributesto the stability of the financial system.Withinthe context of this task, it analysessourcesof risk tothe financialsystem, overseessystemically important payment and securitiessettlement systems and helpsto promotean operational environment forthefinancial sector.International monetary cooperationTogether withthefederal authorities,theSNB participatesininternational monetary cooperationand providestechnical assistance.Banker to the ConfederationTheSNB actsasbanker tothe Confederation. It processespaymentson behalf of the Confederation, issuesmoneymarket debt register claimsandbonds, handlesthesafekeepingof securitiesand carriesout moneymarket and foreign exchangetransactions.StatisticsTheSNB compiles statisticaldata on banks and financial markets,thebalanceof payments, direct investment, the international investmentBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 213positionand theSwissfinancial accounts.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 214TheBaseliii ComplianceProfessionalsAssociation (BiiiCPA) is thelargest associationof Basel iii Professionalsin theworld. It is a businessunit of theBasel ii ComplianceProfessionalsAssociation (BCPA), whichis alsothe largest associationof Basel ii Professionalsin theworld.Basel III SpeakersBureauTheBasel iii ComplianceProfessionalsAssociation (BiiiCPA) hasestablished the Basel III Speakers Bureau for firmsand organizationsthat want toaccessthe Basel iii expertise of Certified BaseliiiProfessionals(CBiiiPros).TheBiiiCPAwill be the liaisonbetweenour certified professionalsandtheseorganizations,at nocost. We stronglybelievethat this can be agreat opportunityfor both, our certified professionalsand theorganizers.Tolearnmore:www.basel-iii-association.com /Basel_iii_Speakers_Bureau.htmlCertified Basel iii Professional (CBiiiPro)Distance Learning and Online Certification Program.Theall-inclusivecost is $297What is included in this price:A. The official presentationsweuse in our instructor-led classes(1426 slides)You can find the coursesynopsis at:www.basel-iii-association.com/ Course_Synopsis_Certified_Basel_III_Professional.htmlBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 215B. Up to 3 Online ExamsThere is onlyone exam you need topass, in order tobecomea CertifiedBasel iii Professional (CBiiiPro).If you fail, you must studyagain theofficial presentations,but you donotneedtospendmoneytotryagain. Upto3examsareincludedintheprice.Tolearnmore you may visit:www.basel-iii-association.com/ Questions_About_The_Certification_And_The_Exams_1.pdfwww.basel-iii-association.com/ Certification_Steps_CBiiiPro.pdfC. Personalized Certificate printed in full color.Processing, printingand posting toyour office or home.Tobecome a CertifiedBaseliii Professional (CBiiiPro) you must followthestepsdescribedat:www.basel-iii-association.com/ Basel_III_Distance_Learning_Online_Certification.htmlBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 216Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com