Basel 3 May 2012
Upcoming SlideShare
Loading in...5
×
 

Basel 3 May 2012

on

  • 521 views

Basel iii Compliance Professionals Association (BiiiCPA) ...

Basel iii Compliance Professionals Association (BiiiCPA)
http://www.basel-iii-association.com

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.

Receive (at no cost) the New Member Orientation newsletters:
http://www.basel-iii-association.com/New_Member_Orientation_Newsletters.html

Subscribe to Receive (at no cost) Basel II / Basel III Related News, Alerts, Opportunities, Updates, our Monthly Newsletter and Limited Time Offers for our Basel II / Basel III Training and Certification Programs:
http://forms.aweber.com/form/42/1586130642.htm

Statistics

Views

Total Views
521
Views on SlideShare
521
Embed Views
0

Actions

Likes
0
Downloads
2
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

Basel 3 May 2012 Basel 3 May 2012 Document Transcript

  • Basel iii Compliance ProfessionalsAssociation (BiiiCPA)1200G Street NW Suite800Washington, DC 20005-6705USA Tel:202-449-9750Web: www.basel-iii-association.comDear Member,Crying is not a sign of weakness. You may let out your tears!Assuming full implementationof the Basel III requirementsasof 30June2011, includingchangestothe definitionof capital andrisk-weightedassets, and ignoringphase-in arrangements,Group 1bankswouldhavean overall shortfall of €38.8 billion for the CET1minimum capital requirement of 4.5%, whichrisesto€485.6billion for aCET1target level of 7.0% (ie including thecapital conservation buffer);the latter shortfall already includesthe G-SIB surchargewhereapplicable.As a point of reference, the sum of profitsafter tax prior to distributionsacross the same sample of Group 1banksin the second half of 2010 andthefirst half of 2011was€356.6billion.Under the same assumptions, thecapital shortfall for Group 2 banksincludedin the Basel III monitoring sample is estimated at €8.6 billionfor the CET1minimum of 4.5% and €32.4 billion for a CET1 target levelof 7.0%.Thesum of Group 2bank profitsafter tax prior todistributionsin thesecond half of 2010and the first half of 2011was€35.6 billion.Quantitative impact study results published by the BaselCommittee, 12April 2012TheBasel Committeepublished theresultsofitsBasel III monitoring exercise.Thestudyis based on rigorousreportingprocessesset up by the Committee toperiodicallyreview theimplicationsof theBasel III standardsfor financial markets.Atotal of 212banksparticipated in the study,including103Group1banks(ie thosethat haveTier 1capital in excessof €3 billion and areinternationallyactive) and 109Group 2banks(ie all other banks).
  • While the Basel III frameworksetsout transitional arrangementstoimplement thenew standards, themonitoring exerciseresultsassumefull implementationof thefinal Basel III packagebasedondata asof 30June2011(ie theydonot take account of thetransitional arrangementssuch asthephasein of deductions).No assumptionsweremade about bank profitabilityor behaviouralresponses,suchaschangesin bank capital or balance sheetcomposition.For that reason the resultsof thestudyare not comparable to industryestimates.Basedon data asof 30June 2011and applying the changestothedefinitionof capital and risk-weightedassets,the averagecommonequityTier 1capital ratio(CET1) of Group 1bankswas7.1%, ascomparedwith theBasel III minimum requirement of 4.5%.In orderforall Group1bankstoreachthe4.5%minimum, anincreaseof€38.8 bi llion CET1 wou ld be requ ired .Th e ove rall sh ortfall inc reases t o €485.6 billion toachieveaCET1 target level of 7.0% (ie including thecapital conservationbuffer);this amount includesthe surchargefor global systemically importantbankswhereapplicable.As a point of reference, thesum of profitsafter tax and prior todistributionsacrossthesamesampleof Group 1banks in thesecondhalf of 2010and the first half of 2011was €35 6.6 billion .For Group 2banks, the averageCET1ratio stood at 8.3%.In order for all Group 2banksin thesampletomeet thenew 4.5% CET1ratio, the additional capital needed is estimatedtobe €8.6 billion.Theywouldhave required an additional €32.4 billion toreach a CET1target 7.0%; the sum of these banks profitsafter tax and prior todistributionsin thesecondhalf of2010andthefirsthalf of2011was€35.6billion.TheCommitteealsoassessedthe estimatedimpact of the liquiditystandards.Assuming banksweretomake nochangestotheir liquidityrisk profileor fundingstructure, asof June2011, theweightedaverage LiquidityCoverageRatio(LCR) forGroup 1bankswouldhavebeen90% whiletheweightedaverage LCR for Group 2bankswas83%.Theaggregate LCR shortfall is €1.76trillion whichrepresents
  • sampleof institutionsin each jurisdiction.approximately3% of the €58.5 trilliontotal assetsof the aggregatesample.TheweightedaverageNet StableFundingRatio(NSFR) is94%forbothGroup 1and Group 2 banks.Th e aggregate sh ortfall of req u ired st ab le fu nd in g is €2 .78trillion.Banks haveuntil 2015tomeet the LCR standard and until 2018to meettheNSFR standard, whichwill reflect anyrevisionsfollowingeachstandards observation period.As noted in a January 2012pressstatement issuedby theGroup ofGovernorsand Headsof Supervision, the Basel Committees oversightbody, modificationstoa few keyaspectsof the LCR arecurrentlyunderinvestigationbut will not materiallychange the frameworksunderlyingapproach.TheCommitteewill finaliseand subsequentlypublish itsrecommendationsin theseareasby the end of 2012.Banks that are below the 100% required minimum thresholds can meetthese standards by, for example, lengthening the term of their fundingor restructuring business models which are most vulnerable to liquidityrisk in periodsof stress.It should be noted that the shortfallsin the LCR and the NSFR are notadditive, as reducing the shortfall in one standard may also reduce theshortfall in theother standard.Resultsof the Basel III monitoring exercise asof 30 June 2011April 2012Executive summaryIn 2010,the Basel Committeeon BankingSupervision conducted acomprehensivequantitativeimpact study(C-QIS) using data asof 31December2009toascertainthe impact on banks of the Basel IIIframework,published in December 2010.TheCommitteeintendsto continuemonitoring the impact of theBaselIII frameworkin order togather full evidenceon itsdynamics.Toservethispurpose, a semi-annual monitoring frameworkhasbeen setup on therisk-basedcapital ratio, theleverageratio and theliquiditymetricsusingdata collectedby national supervisorson a representative
  • Basel III requirementsbased on data asof 30 June 2011.This report summarisesthe aggregate resultsof the latest Basel IIImonitoringexercise,using data asof 30June 2011.TheCommitteebelievesthat theinformation contained in the reportwill providethe relevant stakeholderswitha useful benchmark foranalysis.Information for thisreport wassubmitted by individual banksto theirnational supervisorson a voluntary and confidential basis.Atotal of 212 banksparticipated in thestudy, including103Group 1banksand 109Group 2 banks.Members‘coverageof their banking sector is very high for Group 1banks,reaching 100% coveragefor some jurisdictions,whilecoverageiscomparatively lowerfor Group 2banksand varied acrossjurisdictions.TheCommitteeappreciatesthesignificant effortscontributed by bothbanksand national supervisorsto this ongoingdata collection exercise.Thereport focuseson thefollowingitems:- Changesto bank capital ratiosunder thenew requirements,andestimatesof any capital deficienciesrelativetofullyphased-inminimum and target capital requirements(toincludecapitalchargesfor global systemically important banks– G-SIBs);- Changesto thedefinitionof capital that result from the new capitalstandard, referred toascommon equityTier 1(CET1), includingareallocationof deductionstoCET1, and changestothe eligibilitycriteria forAdditional Tier 1and Tier 2 capital;- Increasesin risk-weightedassetsresultingfrom changesto thedefinitionof capital, securitisation, tradingbook and counterpartycredit risk requirements;- Theinternational leverageratio; and- Twointernational liquiditystandards– the liquiditycoverageratio(LCR) and thenet stablefunding ratio(NSFR).With the exception of the transitional arrangementsfor non-correlationtradingsecuritisationpositionsin the tradingbook, this report doesnottake intoaccount any transitionalarrangementssuchasphase-in ofdeductionsand grandfatheringarrangements.Rather, the estimatespresented assume full implementationof the final
  • No assumptionshave been made about banks‘profitabilityorbehaviouralresponses,such aschangesin bank capital or balancesheetcomposition, sincethis date or in the future.For thisreason theresultsare not comparable tocurrent industryestimates,whichtend to be based on forecastsand considermanagement actionsto mitigatethe impact, and incorporateestimateswhereinformation is not publicly available.Theresultspresented in thisreport arealsonot comparabletothepriorC-QIS,whichevaluatedthe impact of policy questionsthat differ incertainkeyrespectsfrom the finalisedBasel III framework.As one example, theC-QIS did not consider the impact of capitalsurchargesfor global systemicallyimportant banks.Capital shortfallsAssuming full implementationof the Basel III requirementsasof 30June2011, includingchangestothe definitionof capital andrisk-weightedassets, and ignoringphase-in arrangements,Group 1bankswouldhavean overall shortfall of €38.8 billion for the CET1minimum capital requirement of 4.5%, which rises to €485.6 billion for aCET1 target level of 7.0% (ie including the capital conservation buffer);thelatter shortfall already includesthe G-SIB surchargewhereapplicable.As a point of reference, the sum of profitsafter tax prior to distributionsacross the same sample of Group 1banksin the second half of 2010 andthefirst half of 2011was€356.6billion.Under the same assumptions, thecapital shortfall for Group 2 banksincludedin the Basel III monitoring sample is estimated at €8.6 billionfor the CET1minimum of 4.5% and €32.4 billion for a CET1 target levelof 7.0%.Thesum of Group 2bank profitsafter tax prior todistributionsin thesecond half of 2010and the first half of 2011was€35.6 billion.Further detailson additional capital needsto meet theBasel IIIrequirementsare included in Section 2.Capital ratiosTheaverageCET1 ratiounder the Basel III frameworkwould declinefrom 10.2% to7.1%for Group 1banks and from 10.1%to8.3% for Group2banks.
  • LCR and 1January 2018for the NSFR.TheTier 1capital ratiosof Group 1bankswoulddecline, on averagefrom 11.5% to 7.4% and total capital ratioswoulddecline from 14.2% to8.6%.As withtheCET1ratios, thedeclinein other capital ratiosiscomparatively lesspronouncedfor Group 2banks; Tier 1capital ratioswoulddecline on averagefrom 10.9% to8.6% and total capital ratioswoulddecline on averagefrom 14.3% to10.6%.Changesin risk-weighted assetsAs compared tocurrent risk-weightedassets,total risk-weightedassetsincreaseon averageby 19.4% for Group 1banksunder the BaselIIIframework.This increaseis driven largely by chargesagainst counterpartycreditrisk and tradingbook exposures.Securitisation exposures, principally those risk-weighted at 1250% underthe Basel III framework (which were previously 50/ 50 deductions underBaselII), are alsoa significant contributor totheincrease.Banks that have significant exposures in theseareasinfluencetheaverageincreasein risk-weightedassetsheavily.As Group 2 banks are lessaffected bythe revised counterpartycredit riskand trading book rules, these banks experience a comparatively smallerincreasein risk-weightedassetsof only 6.3%.Even within thissample, higher risk-weightedassetsare attributedlargelytoGroup 2bankswithcounterparty and securitisationexposures(ie thosesubject toa 1250%riskweighting).Leverage ratioTheweightedaveragecurrent Tier 1leverageratiofor all banks is 4.5%.For Group 1banks,it is somewhat lowerat 4.4% while it is 5.0% forGroup 2banks.TheaverageBasel III Tier 1leverageratiofor all banks is 3.5%. TheBaselIII averagefor Group 1banksis3.4%, and theaverageforGroup 2banksis 4.2%.Liquidity standardsBoth liquiditystandards are currentlysubject toan observation periodwhichincludesareview clausetoaddressanyunintendedconsequencesprior totheir respectiveimplementation datesof 1January 2015for the
  • calculationof risk-weightedassets(RWA), the calculationof a leverageBasel III monitoring resultsfor the end-June2011reportingperiod givean indicationof theimpact of the calibration of thestandardsandhighlight several keyobservations:Atotal of103Group1and102Group2banksparticipatedin theliquiditymonitoringexercisefor the end-June 2011reference period.TheweightedaverageLCR forGroup 1banksis90% whiletheweightedaverageLCR for Group 2banksis 83%.Theaggregate LCR shortfall is €1.76trillion whichrepresentsapproximately3% of the €58.5 trilliontotal assetsof the aggregatesample.TheweightedaverageNSFR is 94% for both Group 1and Group 2banks.Theaggregate shortfall of required stablefunding is€2.78trillion.General remarksAt its12September 2010meeting, theGroup of Governors and HeadsofSupervision(GHOS), theCommittee‘soversight body, announcedasubstantial strengtheningof existingcapital requirementsand fullyendorsedthe agreementsit reached on 26July2010.Thesecapital reformstogether withtheintroduction of twointernational liquiditystandards, delivered on thecore of theglobalfinancial reform agendapresentedtotheSeoul G20 Leaderssummit inNovember 2010.Subsequent to the initial comprehensivequantitativeimpact studypublishedin December 2010,the Committeecontinuestomonitor andevaluatetheimpact of thesecapital and liquidityrequirements(collectivelyreferredto as―Basel III‖) on a semi-annual basis.This report summarisesresultsof the latestBaselIII monitoringexerciseusing 30June 2011data.Scope of the impact studyAll but one of the 27 Committeemember jurisdictionsparticipatedinBasel III monitoring exerciseasof 30June 2011.Theestimatespresented are based ondata submitted by theparticipatingbankstonational supervisorsin reportingquestionnairesin accordancewiththe instructionspreparedby the CommitteeinSeptember 2011.Thequestionnaire covered componentsof eligiblecapital, the
  • ratio, and componentsof theliquiditymetrics. The resultswereinitiallysubmittedtothe Secretariat of the Committeein October 2011.Thepurposeof the exerciseis toprovidethe Committeewithanongoing assessment of the impact on participatingbanksof the capitaland liquidityproposalsset out in thefollowingdocuments:- Revisionsto the Basel II market risk frameworkand Guidelinesforcomputing capital for incremental risk in the tradingbook;- EnhancementstotheBasel II framework whichincludetherevisedrisk weightsfor re-securitisationsheld in the banking book;- Basel III: Aglobal framework for more resilient banksand thebankingsystem aswell asthe Committee‘s13January2011pressreleaseon lossabsorbencyat the point of non-viability;- International frameworkfor liquidityrisk measurement, standardsandmonitoring; and- Global systemicallyimportant banks:Assessment methodology andtheadditional lossabsorbency requirement.Sample of participating banksAtotal of 212 banksparticipated in thestudy, including103Group 1banksand 109Group 2 banks. Group 1banksarethosethat haveTier 1capital in excessof €3 billion and are internationallyactive.All other banksare considered Group 2banks.Banks wereasked toprovidedata asof 30June 2011at theconsolidatedlevel.Subsidiariesof other banksare not includedin the analysestoavoiddoublecounting.Table1showsthe distributionof participationby jurisdiction.For Group 1banksmembers‘coverageof their banking sector wasveryhigh reaching100% coveragefor some jurisdictions.Coverage for Group 2 bankswascomparatively lowerand varied acrossjurisdictions.
  • Not all banks provideddata relatingto all parts of the BaselIIIframework.Accordingly, a small number of banksare excluded from individualsectionsof the BaselIII monitoring analysisdue toincompletedata.MethodologyTheimpact assessment wascarried out by comparing banks‘ capitalpositionsunder Basel III tothe current regulatory frameworkimplemented by thenational supervisor.With the exception of transitional arrangementsfor non-correlationtradingsecuritisationpositionsin thetradingbook, Basel III resultsarecalculatedwithout consideringtransitional arrangementspertainingto
  • positionscould be attributedtodifferinginterpretationsof the rules,thephase-in of deductionsand grandfatheringarrangements.Reported averageamountsin this document havebeen calculatedbycreatinga composite bank at a total sample level, whicheffectivelymeansthat thetotal sample averagesare weighted.For example, the averagecommon equityTier 1capital ratio is thesumof all banks‘common equityTier 1capital for the total sample dividedbythe sum of all banks‘risk-weightedassetsfor the total sample.Tomaintainconfidentiality, many of theresultsshownin thisreport arepresentedusing box plots charts.Thesechartsshowthedistributionof resultsasdescribedbythemedianvalues(thethin red horizontal line) and the75th and 25th percentilevalues(definedby the blue box).Theupper and lower end pointsof the thin bluevertical linesshow thevalueswhich are1.5timesthe rangebetweenthe 25th and the75thpercentile abovethe75th percentile or belowthe25thpercentile, respectively.Thiswouldcorrespondtoapproximately99.3%coverageif thedatawerenormallydistributed.Thered crossesindicateoutliers.Toestimatethe impact of implementingthe Basel III frameworkoncapital, comparisonsaremadebetweenthoseelementsof Tier 1capitalwhicharenot subject to a limit under thenational implementationofBasel I or Basel II, and CET1 under Basel III.Data qualityFor thismonitoring exercise, participatingbanks submittedcomprehensiveand detailed non-publicdata on a voluntary andbest-effortsbasis.As withthe C-QIS, national supervisorsworked extensivelywith bankstoensuredataquality, completenessandconsistencywiththepublishedreporting instructions.Banks are included in the variousanalysesthat followonlyto the extenttheywereable to providesufficient qualitydata tocompletetheanalyses.For theliquidityelements,data qualityhasimproved significantlythroughout the iterationsof the BaselIII monitoring exercise, althoughit is still thecasethat some differencesin banks‘reported liquidityrisk
  • common equitydeductionsare fullyphasedin and all non-qualifyingrather than underlying differencesin risk.Most notablyindividual banks appear tobe usingdifferentmethodologiestoidentifyoperationalwholesaledepositsandexclusionsof liquid assetsdue tofailure to meet theoperational requirements.Interpretation of resultsThefollowingcaveatsapplytotheinterpretationof resultsshownin thisreport:Theseresultsare not comparable to thoseshown in the C-QIS, whichevaluated theimpact of policy questionsthat differ in certain keyrespectsfrom the finalisedBaselIII framework.As one example, theC-QIS did not consider the impact of capitalsurchargesfor G-SIBsbasedon the initial list of G-SIBs announced bytheFinancial StabilityBoard in November 2011.Onemember country, Switzerland, hasalready implementedcertainelementsof the Basel III frameworkpertainingto new rulesfor marketrisk and enhancementstothe treatment of securitisationsheld in thebankingbook (often referred to collectivelyas―Basel 2.5‖).For banks in this country, the resultsincluded in this report reflect theimpact of adopting the BaselIII requirementsrelativeto theBasel IIand Basel2.5frameworksalreadyin place.Thenew rules for counterparty credit risk are not fullyaccounted for inthereport, asdata for capital chargesfor exposurestocentralcounterparties(CCPs) andstressedeffectiveexpectedpositiveexposure(EEPE) could not be collected.Theactual impact of thenew requirementswill likely be lower thanshownin this report giventhe phased-inimplementation of therulesand interim adjustmentsmade by thebanking sectorto changingeconomicconditionsand the regulatory environment.For example, theresultsdo not consider bank profitability, changesincapital or portfoliocomposition, or other management responsesto thepolicy changessince30June 2011or in the future.For thisreason, theresultsare not comparable toindustryestimates,which tend to bebasedon forecastsand considermanagement actionstomitigatethe impact, aswell asincorporateestimateswhereinformation is not publicly available.TheBaselIII capital amountsshownin thisreport assume that all
  • capital instrumentsare fully phasedout.As such, theseamountsunderestimatetheamount of Tier 1capital andTier 2 capital held bya bank astheydonot give any recognitionfor non-qualifying instrumentsthat are actuallyphased out over nineyears.Thetreatment of deductionsand non-qualifying capital instrumentsalsoaffects figuresreportedin the leverageratiosection.Theunderestimationof Tier 1capital will becomelessof an issueastheimplementationdateof theleveragerationears.In particular, in 2013, the capital amountsbased on the capitalrequirementsin placeon the Basel III monitoring reportingdate willreflect the amount of non-qualifying capital instrumentsincludedincapital at that time.Theseamountswill thereforebe more representativeof the capital heldbybanks at the implementation dateof the leverageratio.Capital shortfallsand overall changesin regulatory capitalratiosTable2 showsthe aggregate capital ratiosunder the current and BaselIII frameworksand the capital shortfallsif Basel III werefullyimplemented, both for thedefinitionof capital and the calculationofrisk-weightedassetsasof 30 June 2011.
  • Ascomparedtocurrent CET1,theaverageCET1capitalratio ofGroup1bankswouldhavefallenby nearlyone-third from 10.2% to 7.1% (adeclineof 3.1percentage points) whenBasel III deductionsandrisk-weightedassetsaretaken intoaccount.Thereduction in theCET1 capital ratio of Group 2banksis smaller(from 10.1%to 8.3%), whichindicatesthat the new frameworkhasgreater impact on larger banks.Resultsshow significant variation acrossbanksasshown in Chart 1.Thereduction in CET1ratios is driven by thenew definition of eligiblecapital, by deductionsthat werenot previouslyapplied at the commonequitylevel of Tier 1capital in most jurisdictions(numerator) and byincreasesin risk-weightedassets(denominator).Banks engagedheavily in trading or counterparty credit activitiestendtoshowthe largest denominator effectsastheseactivitiesattractsubstantivelyhigher capital chargesunder the new framework.Tier 1capital ratiosof Group 1banks wouldon averagedecline4.1percentagepointsfrom 11.5% to 7.4%, and total capital ratiosof thissamegroup woulddeclineon averageby 5.6percentagepointsfrom14.2% to 8.6%.As withCET1, Group 2 banks show a more moderatedecline in Tier 1capital ratiosfrom 10.9% to8.6%, and a declinein total capital ratiosfrom 14.3% to10.6%.
  • TheBasel III frameworkincludesthefollowingphase-in provisionsforcapital ratios:For CET1,thehighest form of lossabsorbing capital, theminimumrequirement will be raisedto4.5% and will be phased-in by 1January2015;For Tier 1capital, the minimum requirement will be raised to6.0% andwill be phased-in by1January2015;For total capital, theminimum requirement remainsat 8.0%;Regulatoryadjustments(ie possiblystrictersetsof deductionsthatapplyunder Basel III) will be fullyphased-inby 1January 2018;An additional 2.5% capital conservation buffer abovethe regulatoryminimum capital ratios, whichmust be met with CET1, will bephased-in by 1January 2019;andTheadditional lossabsorbencyrequirement for G-SIBs, which rangesfrom 1.0% to 2.5%, will be phased in by 1January2019.It will be applied asthe extension of thecapital conservation buffer andmust be met with CET1.TheAnnex includesa detailed overview of all relevant phase-inarrangements.Chart 2 and Table2 provideestimatesof the amount of capital thatGroup 1and Group 2 bankswouldneed between 30June 2011and 1January 2019in addition to the capital theyalreadyheld at thereportingdate, in order tomeet the target CET1, Tier 1,and total capital ratiosunder Basel III assuming fullyphased-in target requirementsanddeductionsasof 30June 2011.Under theseassumptions,the CET1capital shortfall for Group 1bankswith respect to the 4.5% CET1 minimum requirement is€38.8billion.TheCET1shortfall withrespect to the 4.5% requirement for Group 2banks,wherecoverageofthesectorisconsiderablysmaller,isestimatedat €8.6 billion.For a CET1 target of 7.0% (ie the 4.5% CET1 minimum plusthe 2.5%capital conservation buffer, plusany capital surcharge for G-SIBsasapplicable),Group 1banks‘shortfall is€485.6billionandGroup2banks‘shortfall is €32.4 billion.Thesurchargesfor G-SIBs are a bindingconstraint on 24 of the28G-SIBs included in this Basel III monitoring exercise.As a point of reference, the aggregatesum of after-taxprofitsprior todistributionsfor Group 1and Group 2banks in the same samplewas
  • €356.6billion and €35.6 billion, respectively in thesecond half of 2010andthe first half of 2011.Assuming the4.5% CET1minimum capitalrequirementswerefullymet(ie, there wereno CET1 shortfall), Group 1bankswouldneed anadditional €66.6 billion to meet the minimum Tier 1capital ratiorequirement of 6.0%.Assuming banks alreadyhold 7.0% CET1capital, Group 1banks wouldneed and an additional €221.4billionto meet the Tier 1capital targetratio of 8.5% (ie the6.0% Tier 1minimum plusthe 2.5% CET1capitalconservation buffer), respectively.Group 2banks wouldneed an additional €7.3billion and an additional€16.6billion tomeet theserespectiveTier 1capital minimum and targetratio requirements.AssumingCET1andTier1capitalrequirementswerefullymet(ie,therewerenoshortfallsin eitherCET1orTier 1capital), Group 1bankswouldneedan additional€119.3billion tomeet theminimum total capital ratiorequirement of 8.0% and an additional €223.2billionto meet the totalcapital target ratio of 10.5% (ie the8.0% Tier 1minimum plusthe 2.5%CET1capital conservationbuffer), respectively.Group 2banks wouldneed an additional €5.5billion and an additional€11.6billion to meet theserespectivetotal capital minimum and targetratio requirements.As indicatedabove, no assumptionshavebeen madeabout bank profitsor behavioural responses, such aschangesbalancesheetcomposition, that will serve to ameliorate the impact of capital shortfallsover time.
  • reduction in Group 2 bank grossCET1.Impact of the definition of capital on Common Equity Tier 1capitalAs noted above, reductionsin capital ratios under theBasel IIIframeworkare attributed in part tocapital deductionsnot previouslyappliedat the common equitylevel of Tier 1capital in mostjurisdictions.Table3 showsthe impact of variousdeduction categorieson the grossCET1capital (ie, CET1beforedeductions) of Group 1and Group 2banks.In the aggregate, deductionsreducethegrossCET1of Group 1banksunder the Basel III frameworkby 32.0%.Thelargest driver of Group 1bank deductionsisgoodwill, followedbycombineddeferred tax assets(DTAs) deductions, and intangiblesotherthan mortgage servicingrights.ThesedeductionsreduceGroup 1bank grossCET1by15.4%, 4.9%, and3.6%, respectively.Thecategorydescribedasother deductionsreducesGroup 1bank grossCET1by 3.0% and pertain mainlyto deductionsfor provision shortfallsrelativetoexpectedcredit lossesand deductionsrelatedtodefinedbenefit pension fund schemes.Holdingsof capital of other financial companiesreducethe CET1ofGroup 1banksby 2.9%.Thecategory―Excessabove15%‖ referstothedeductionof theamountbywhichtheaggregate of the three itemssubjecttothe 10% limit forinclusionin CET1 capital exceeds15%of a bank‘sCET1, calculatedafter all deductionsfrom CET1.These15% threshold bucket deductionsreduce Group 1bank grossCET1by 2.1%. Deductionsfor MSRsexceedingthe 10% limit have aminor impact on Group 1CET1.DeductionsreducetheCET1 ofGroup 2banksby26.9%. Goodwillisthelargest driver of deductionsfor Group 2 banks, followedby holdingsofthecapital of other financial companies, and combined DTAsdeductions.ThesedeductionsreduceGroup 2bank CET1by10.5%, 4.4%, and4.3%, respectively.Other deductions,whichare driven significantlyby deductionsforprovision shortfallsrelative to expectedcredit losses, result in a 3.5%
  • Deductions for intangibles other than mortgage servicing rights anddeductions for itemsin excess of the aggregate 15% threshold basketreduceGroup 2 bank grossCET1by 2.5% and 1.8%, respectively.Deductionsfor mortgage servicingrightsabovethe 10% limit have noimpact on Group 2 banks.Changesin risk-weighted assetsOverall resultsReductionsin capital ratiosunder the BaselIII frameworkare alsoattributedto increasesin risk-weightedassets.Table4providesadditionaldetail on thecontributorstotheseincreases,toincludethefollowingcategories:Definition of capital:Thesecolumns measurethe change in risk-weighted assetsasa result of proposedchangesto the definition of capital.Thecolumn heading ―other‖includesthe effectsof lowerrisk-weightedassetsfor exposuresthat arecurrentlyincludedin risk-weightedassetsbut receivea deduction treatment under Basel III.Thecolumn heading―50/50‖ measuresthe increasein risk-weightedassetsapplied to securitisation exposurescurrentlydeducted under theBasel II framework that are risk-weightedat 1250% under Basel III.Thecolumn heading―threshold‖ measuresthe increaseinrisk-weightedassetsforexposuresthat fall belowthe10%and15%limitsfor CET1 deduction;
  • Counterparty credit risk (CCR):This column measurestheincreasedcapital chargefor counterpartycredit risk and thehigher capital charge that resultsfrom applying ahigher asset valuecorrelationparameter againstexposurestofinancialinstitutionsunder the IRB approachestocredit risk.Not included in CCR are risk-weightedasset effectsof capital chargesfor exposuresto central counterparties (CCPs) or anyimpact ofincorporatingstressedparameters for effectiveexpectedpositiveexposure (EEPE);Securitisation in the banking book:This column measurestheincreasein the capital chargesfor certaintypesof securitisations(eg, resecuritisations)in the banking book;andTrading book:This column measurestheincreasedcapital chargesfor exposuresheldin thetrading book toincludecapital requirementsagainst stressedvalue-at-risk,incrementaldefault risk, and securitisationexposuresinthetradingbook.Risk-weightedassetsfor Group 1banks increaseoverall by 19.4% forGroup 1banks.This increaseis toa largeextent attributedto higher risk-weightedassetsfor counterparty credit risk exposures,whichresult in an overallincreasein total Group 1bank risk-weightedassetsof 6.6%.Thepredominant driver behind this figure is capital chargesforcounterpartycredit risk asthehigher asset value correlation parameterresultsin an increasein overall risk-weightedassetsof only 1.0%.Tradingbook exposuresand securitisationexposurescurrentlysubjecttodeduction under Basel II, alsocontribute significantlytohigherrisk-weightedassetsat Group 1banksat 5.2% for each category.
  • Securitisationexposurescurrentlysubject to deduction, counterpartycredit risk exposures, and exposuresthat fall below the10% and 15%CET1eligibility limitsare significant contributorstochangesinrisk-weightedassetsfor Group 2 banks.Changesin risk-weightedassetsshowsignificant variationacrossbanksasshownin Chart 3.Again, these differencesare explainedin largepart by theextent ofbanks‘counterpartycredit risk and trading book exposures, whichattract significantlyhigher capital chargesunder Basel III ascomparedtocurrent rules.Impact of the revisions to the Basel II market risk frameworkTable5 showsfurther detail on theimpact of the revised tradingbookcapital chargeson overall risk-weightedassetsfor Group 1banks.Thesample analysed here issmallerthan theone in Table4asnot alltheGroup 1banksprovided data on market risk exposures.For thisreduced sample of banks, tradingbook exposures resultedin a6.1% increasein total risk-weightedassets.Themain contributorsto this increaseare stressed value-at-risk(stressedVaR), non-correlationtrading securitisationexposuressubjectthestandardisedmeasurement method (column heading―SMM
  • non-CTP‖), and theincremental risk capital charge(IRC), whichcontribute2.2%, 1.7%, and 1.4%.Lesssignificant contributors totheincreasein overall risk-weightedassetsare capital chargesfor correlation tradingexposures.Increasesin risk-weightedassetsare partiallyoffset by effectsrelated topreviouscapital charges24 and changestothe standardisedmeasurement method (SMM).Impact of the ruleson counterparty credit risk (CVA only)Credit valuation adjustment (CVA) risk capital chargeslead to a 7.3%increasein total RWAfor thesubsampleof 77bankswhichprovidedtherelevant data (6.6% on thefull Group 1sample).Alargerfractionofthetotaleffect isattributabletotheapplicationof thestandardisedmethod thantotheadvanced method.Theimpactson Group 2banksare smallerbut still significant, addingup toan overall 2.9% increasein RWAover a subsample of 63banks(2.2% for the full Group 2 sample), totallyattributableto thestandardisedmethod. Further detailed are provided in Table6.
  • Findingsregarding the leverage ratioTheresultsregarding theleverageratioare provided using twoalternativemeasuresof Tier 1capital in the numerator:BaselIII Tier 1,whichisthefullyphased-inBaselIII definition ofTier 1capital, and Current Tier 1, whichisTier 1capital eligibleunder theBasel II agreement (thephase-inperiod of Basel III begins in 2013).Total exposures of Group 1banks accordingtothedefinition of thedenominatorof theleverageratio were€59.2 trillion while totalexposuresfor Group 2 bankswere€5.6 trillion.Oneimportant element in understandingtheresultsof theleverageratiosection istheterminologyused to describea bank‘sleverage.Generally, when a bank is referred to ashaving more leverage, or beingmore leveraged, this refers toa multiple(eg 33times) asopposed toaratio (eg 3%).Therefore,a bank witha high level of leveragewill have a low leverageratio.Chart 4presentsleverageratiosbased on Basel III Tier 1and currentTier 1capital.Thechart providesthis information for all banks, Group 1banks andGroup 2banks.
  • Theweightedaveragecurrent Tier 1leverageratiofor all banks is 4.5%.For Group 1banks,it is somewhat lowerat 4.4% while it is 5.0% forGroup 2banks.TheaverageBasel III Tier 1leverageratiofor all banks is 3.5%. TheBaselIII averagefor Group 1banksis3.4%, and theaverageforGroup 2banksis 4.2%.Theanalysisshowsthat Group 2banksare generallylessleveragedthanGroup 1banks, and thisdifferenceincreasesunder Basel III when therequirementsare fullyphased in.It is likely that a portion of thiseffectis due tothe changesin thedefinitionof capital, which, asseen in Section 2, are likely toaffectGroup 1banksto a greater extent than Group 2 banks.Under the current Tier 1leverageratio, 17 bankswouldnot meet the 3%Tier 1leverageratiolevel, includingsix Group 1banks and 11Group 2banks.Under the Basel III Tier 1leverageratio, 63 bankswouldnot meet the3% Tier 1leverageratiolevel, including36 Group 1banksand 27Group2banks.LiquidityLiquidity coverage ratioOneof thetwostandardsintroduced bythe Committeeisa 30-dayliquiditycoverageratio (LCR) whichis intendedtopromoteshort-termresiliencetopotential liquiditydisruptions.TheLCR hasbeen designedtorequire global banks tohave sufficienthigh-qualityliquid assetsto withstanda stressed 30-dayfundingscenario specifiedby supervisors.TheLCR numerator consistsof a stock of unencumbered, high qualityliquidassetsthat must be availabletocover any net outflow, whilethedenominatoris comprised of cash outflowslesscashinflows(subject toa cap at 75% of outflows) that are expectedto occur in a severe stressscenario.103Group 1and 102Group 2banks providedsufficient data in the 30June2011Basel III monitoring exercisetocalculatethe LCR accordingtothe BaselIII liquidityframework.TheweightedaverageLCR was90% for Group 1banks and 83% forGroup 2banks. Theseaggregate numbersdo not speak totherangeofresultsacrossthe banks.
  • Chart 5below givesan indicationof thedistribution of bank results;thethick red lineindicatesthe 100% minimum requirement, the thin redhorizontal linesindicatethemedian for the respectivebank group.45% of thebanksin the BaselIII monitoring samplealreadymeet orexceedthe minimum LCR requirement and 60% have LCRs that are ator above75%.For thebanks in thesample, Basel III monitoringresultsshow ashortfall ofliquidassetsof €1.76trillion(whichrepresentsapproximately3%of the€58.5trilliontotal assetsof theaggregate sample) asof 30June2011, if banksweretomake nochangeswhatsoevertotheir liquidityriskprofile.This number isonlyreflectiveof the aggregate shortfall for banks thatare below the 100% requirement and doesnot reflect surplusliquidassetsat banks above the100% requirement.Banks that are below the 100% required minimum have until 2015tomeet the standard by scalingback businessactivitieswhichare mostvulnerable toa significant short-term liquidityshock or by lengtheningtheterm of their fundingbeyond 30days.Banks may alsoincreasetheir holdingsof liquid assets.Thekey componentsof outflowsand inflowsare shownin Table7.Group 1banksshow a notablylarger percentageof total outflows, whencomparedtobalancesheet liabilities,than Group 2 banks.Thiscanbeexplainedbytherelativelygreatercontribution of wholesalefundingactivitiesand commitmentswithin theGroup 1sample,whereas,for Group 2 banks, retail activities, which attract much lower
  • stressfactors,comprise a greater share of funding activities.Cap on inflowsThecomposition of high qualityassetscurrentlyheld at banks isdepictedin Chart 6.Themajorityof Group 1and Group 2banks‘holdings, in aggregate, arecomprised of Level 1assets;howeverthe sample, on whole, showsdiversityin their holdingsof eligibleliquid assets.WithinLevel 1assets,0% risk-weightedsecuritiesissuedor guaranteedbysovereigns,central banks and PSEs, and cash and central bankreservescomprisingsignificant portionsof thequalifying pool.Comparatively, within theLevel 2assetclass, themajorityof holdingsiscomprised of 20% risk-weightedsecuritiesissued or guaranteed bysovereigns, central banksor PSEs, and qualifying coveredbonds.
  • Cap on Level 2 assets€121billion of Level 2 liquid assetswereexcluded becausereportedLevel 2assetswereinexcessofthe40% capascurrentlyoperationalised.34banks currentlyreported assetsexcluded, of which24 (11% of thetotal sample) had LCRs below 100%.Chart 7 combinestheaboveLCR componentsby comparing liquidityresources(buffer assetsand inflows) to outflows.Note that the€800billiondifferencebetweentheamount ofliquidassetsandinflowsand theamount of outflowsandimpact of thecapdisplayedin the chart issmaller than the€1.76trilliongrossshortfall noted aboveasit is assumed here that surplusesat onebank can offset shortfallsatother banks.In practice the aggregate shortfall in theindustry is likelytoliesomewherebetweenthesetwonumbersdependingon how efficientlybanksredistributeliquidityaround thesystem.
  • Net stable funding ratioThesecond standard is thenet stablefunding ratio(NSFR), alonger-term structural ratio toaddressliquiditymismatchesand provideincentivesfor bankstouse stablesourcesto fund their activities.103Group 1and 102Group 2banks providedsufficient data in the30June2011BaselIII monitoringexercisetocalculatetheNSFR accordingtothe BaselIII liquidityframework.46% of thesebanksalready meet or exceedtheminimum NSFRrequirement, withthree-quartersat an NSFR of 85% or higher.TheweightedaverageNSFR for each of the Group 1bank and Group 2samplesis 94%.Chart 8 shows the distribution of resultsfor Group 1and Group 2 banks;the thick red line indicatesthe 100% minimum requirement, the thin redhorizontal linesindicatethemedian for the respectivebank group.
  • Theresultsshowthat banks in the samplehad a shortfall of stablefundingof€2.78trillionat theendofJune2011, if banksweretomakenochangeswhatsoevertotheir fundingstructure.This number isonlyreflectiveof the aggregate shortfall for banks thatare below the 100% NSFR requirement and doesnot reflect anysurplusstablefunding at banks above the 100% requirement.Banks that are below the 100% required minimum have until 2018tomeet thestandard and can takea number of measurestodoso,includingby lengtheningtheterm of their fundingor reducingmaturitymismatch.It should be noted that the shortfallsin the LCR and the NSFR are notnecessarilyadditive,asdecreasingtheshortfall in onestandard mayresult in a similar decreasein the shortfall of the otherstandard, dependingon thestepstaken to decreasetheshortfall.
  • EBA, ESMA and EIOPA publish tworeportson MoneyLaunderingTheJoint Committeeof thethree European SupervisoryAuthorities(EBA, ESMA and EIOPA) haspublishedtworeportson theimplementationofthethirdMoneyLaunderingDirective[2005/ 60/ EC](3MLD).The―Report on the legal, regulatory and supervisoryimplementationacrossEU MemberStatesinrelationtotheBeneficialOwnersCustomerDueDiligencerequirements‖analysesEU MemberStates‘currentlegal, regulatory and supervisoryimplementationof the anti - moneylaundering/ counterterrorist financing(AML/CTF) frameworksrelatedtothe application bydifferent credit and financial institutionsofCustomer Due Diligence(CDD) measureson their customers‘beneficial owners.Thereport sought to identify differencesin the implementation of theDirectiveand to determine whethersuch differencescreatea gap in theEU AML/ CTF regime that could be exploited by criminalsfor moneylaunderingand terrorist financingpurposes.The―Report on the legal and regulatory provisionsand supervisoryexpectationsacrossEU Member Statesof Simplified Due Diligencerequirementswherethe customersare credit and financial institutions‖providesan overview of EU Member States‘legal and regulatoryprovisionsand supervisoryexpectationsin relationto the applicationofSimplifiedDue Diligence(SDD) requirementsof the 3MLD.Thereport focusesexclusivelyon oneparticularsituationof lowriskwhereSDD is applicable,namely wherethe customer isa credit orfinancial institutionsituated in a EU/ EEA state or in a country thatimposesequivalent AML/CFT requirements.Both reportscome totheconclusionthat there are significantdifferencesin the implementationacrosstheEU MemberStates,andthat some of thesedifferencescould createundesirableeffectson thecommon EuropeanAnti MoneyLaundering Regime.Thereportsfind that some of thesedifferencesare not duetotheDirective‘sminimum harmonisation approach, but insteadappear tostem from different national interpretationsof the Directive‘srequirements.
  • EIOPA - European Insuranceand Occupational PensionsAuthorityBoth reportsalsocall on theEuropean Union to consider addressingtheseproblems.The Joint CommitteeTheJoint Committeeis a forum for cooperationthat wasestablished on1stJanuary2011, withthegoal of strengtheningcooperationbetweentheEuropean BankingAuthority (EBA), European Securitiesand MarketsAuthority(ESMA) andEuropeanInsuranceand Occupational PensionsAuthority (EIOPA), collectivelyknown asthe threeEuropeanSupervisoryAuthorities (ESAs).Throughthe Joint Committee, the three ESAscooperateregularlyandcloselyand ensure consistencyin their practices.In particular, theJoint Committeeworksin theareasof supervisionoffinancial conglomerates,accounting and auditing, microprudentialanalysesof crosssectoraldevelopments, risksand vulnerabilitiesforfinancial stability, retail investment productsand measurescombatingmoneylaundering. In addition tobeing a forum for cooperation, theJoint Committee alsoplays an important role in the exchangeofinformation withthe European Systemic RiskBoard (ESRB) and indevelopingtherelationshipbetweentheESRB and the ESAs.InterestingAbbreviationsAML – Anti MoneyLaunderingAMLTF – Anti-MoneyLaunderingTaskForce of the EBA, ESMA andEIOPAAML Committee– The Joint Committeeof theEuropean SupervisoryAuthorities‘Sub CommitteeonAnti MoneyLaunderingCDD - Customer Due DiligenceCPMLTF – EU CommitteeonthePreventionofMoneyLaunderingandTerrorist FinancingCTF – Counter Terrorist FinancingEBA - European BankingAuthorityEC – European CommissionEEA - European EconomicArea
  • EDD – Enhanced Due DiligenceESMA - European Securitiesand MarketsAuthorityEU – European UnionFATF – FinancialAction Task ForceID - IdentityML – MoneyLaunderingMS – Member Stateof the European UnionSDD - Simplified Due DiligenceTF – Terrorist FinancingUBO – Ultimate BeneficialOwnerWG – WorkingGroup3rd MLD - Third MoneyLaunderingDirective(2005/60/ EC)
  • BIS - Peer review of supervisory authorities implementation ofstresstesting principles-April 2012Stresstestingisanimportant toolused bybankstoidentify thepotentialfor unexpectedadverse outcomesacrossa rangeof risks and scenarios.In 2009, the Committeereviewedtheperformanceof stresstestingpracticesduring thefinancialcrisisand publishedrecommendationsforbanksand supervisorsentitled Principlesfor sound stresstestingpracticesand supervision.As part of its mandateto assessthe implementationof standardsacrosscountriesand tofoster thepromotion of good supervisory practice, theCommitteesStandardsImplementationGroup (SIG) conducted apeerreview during 2011of supervisoryauthorities implementationof theprinciples.Thereview foundthat stresstestinghasbecome akey component of thesupervisoryassessment processaswell asa tool for contingencyplanningand communication.Countriesare, however,at varying stagesof maturityin theimplementationof theprinciples;asa result, more workremainstobedone to fullyimplement the principlesin many countries.Overall, the review found the 2009stresstestingprinciplesto begenerallyeffective.TheCommittee, however, will continuetomonitor implementationoftheprinciplesand determinewhether,in thefuture, additionalguidancemight be necessary.Peer review of supervisory authorities‘ implementation ofstresstesting principles, April 2012Executive summary
  • This report summarisestheBasel Committee‘speer review on howsupervisoryauthoritieshave implemented the Committee‘s2009Principlesfor sound stresstestingpracticesand supervision.Theglobal financial crisis and the 2009stresstesting principlesStresstestingis an important tool for bankstoidentify unexpectedadverseoutcomesacrossa rangeof risks. It plays a particularlyimportant role in:- providingforward-lookingassessmentsof risk;- overcominglimitationsof modelsand historicaldata;- supportinginternaland external communication;- feeding intocapital and liquidityplanningprocedures;- informing the settingof banks‘risk tolerance;and- facilitating thedevelopment of risk mitigation or contingencyplansacrossa range of stressedconditions.In 2009, the Committeereviewedtheperformanceof stresstestingpracticesduring thecrisisand found weaknessesin variousareas.Basedon thefindings,and aspart of itseffortsto incorporatelessonsfrom thecrisisin supervisorypractices,the Committee publishedrecommendationsfor banks and supervisorsentitledPrinciplesforsoundstresstestingpracticesand supervision.Theguidance setsout a comprehensiveset of principlesfor the soundgovernance,designandimplementationofstresstestingprogrammesatbanks.Theprinciplesalsoestablishedhigh-levelexpectationsfor therole andresponsibilitiesof supervisorsin evaluatingstresstestingpractices.Scope of the reviewAs part of its mandateto assessthe implementationof standardsacrosscountries,during 2011theCommittees StandardsImplementationGroup undertook a peer review of supervisory authorities‘implementationof theprinciples.Thereview wasconducted via an off-sitesurvey of supervisoryauthorities.All Committeemember countries and one non-member countryparticipatedin the review.Thereview focused primarily on progressin supervisoryprocessesused
  • In contrast, a few countries wereconsideredtobe advanced.toimplement the principles.It wasnot designedtoprovideadetailedcountry-by-country assessmentor toassessthe adequacyof banks stresstestingprogrammes.Increasingly, supervisorystresstestsarebeing used toset minimumcapital requirements, determineexplicit capital buffersor tolimitcapital distributionsby banks.This recent development wasnot extensively consideredin theprinciplesand asa result wasnot a key focusof the review.Key findingsProgressoverviewIn the period since the principleswere issued, stresstesting has becomea key component of the supervisory assessment processas well as a toolfor contingencyplanningand communication.Many of the countriesparticipatingin this peer review havebeenworkingtoimplement and refinestresstestingframeworksandmethodologies at thesametime astheir economiesand bankingsystemshave been affectedby a high degree of global economic andfinancial uncertainty.Althoughmanysupervisoryauthoritiesandbankshadoperationalstresstestingframeworksin place, existingguidanceand ruleshad toberevisedand new expectationsput in placeto broaden and deepen stresstestingcapabilitiesat both banksand supervisory authorities.Thereviewfound that countriesareat varyingstagesof maturity in theirimplementationof theprinciples.Nearlyhalf of thecountries wereconsideredtobe at an earlystage.Thesecountriesshowedsome progresstowardimplementingtheprinciples,but theymay not haveissued or finalisedprudentialrequirementson enterprise-widestresstestingsincethe principleswerepublished.Theygenerallyhad not conducted regular on-siteor off-sitereviewsotherthanin thecontext ofrisk-specificmodellingrequirementssuchasfor market risk, and had conducted industry-wide stresstestsinfrequently, or onlyaspart of International MonetaryFund FinancialSectorAssessment Program (FSAP) reviews.
  • internaltask forcesfor stresstesting.For thesecountries,the surveyresponsesprovided evidenceof arigorousregular review processthat included a combination of on-siteand off-siteassessments,some review and feedbackon detailed stresstestingmodelsusedby banks, evidenceof follow-upactionsand awell-embeddedsupervisorystresstestingprogrammethat wasnotlimitedtoexternallyimposedscenarios.Theremainder of countries werefound tofall betweentheabove twogroups.Thesecountrieshave issuedsome formal requirementsor guidanceconsistent withthe principles,are generallyperformingregularsupervisorystresstestson largebanksin their jurisdictionsand arereviewingstresstestingin thecontext of annual internal capitaladequacyassessment process(ICAAP) reviewsand specific riskreviews.Thesecountrieshave more todo in deepeningtheir stresstestingprogrammes,includingissuingupdated requirementsand conductingmore detailed on-siteand off-sitereviewsof banks stresstestingcapabilities.Remaining challengesand examplesof good practicesThemost commonoverall supervisoryapproachwasto conduct somereviewof banks stresstestingaspart of regularICAAP assessmentsandin thecontext of specific riskswhereongoingsupervisory review ofexposure modellingis now routine, notablymarket and liquidityrisks.Conductingmore detailed, comprehensivereviewsof banksenterprise-widestresstesting governanceand modellingasenvisionedin theprinciplesrequires expert skillsand resourcing at both banksandsupervisors,and asa result hasnot yet becomestandard practice inmanycountries.Asignificant development in the last several yearshasbeen theincreaseduse of supervisorystresstests.Amajorityof countriesnow regularlyconduct mandated stresstestswith prescribedscenarios acrossthe largebanksin theirjurisdictions,although for some countries, thisis limitedto theFSAPstresstests.Anumber of countriesnoted theresource-intensivenature ofindustry-wide stresstests.In particular, themore advancedcountriesnote that resourcing at bothsupervisoryauthoritiesand bankstosupport stresstestingischallenging, with a trend towardsestablishingspeciallystaffed unitsor
  • andmagnitudeof keyrisks.Many, however, found that these exercises have been helpful in terms ofenhancing the visibility of stress testing and providing a structured basisfor dialoguewithbanks on their capabilities.It wasnotedthat industrydialoguearoundmandatedstresstestshadledtoimprovementsin bank capabilities.Thefollowingtypesof practicesare alsoassociatedwithrelatively moreadvancedcountries:- plansfor, or completed horizontal or thematicreviewsof, stresstestingeither at an enterprise-widelevel or for specificportfolios;- engagement withboards of directorson stresstestingscenarios andgovernance;- review of detailed evidenceof howbanksare using stresstestoutcomesin their decision-makingand risk-appetitesetting;- well-articulatedplansfor improving their stresstesting supervisionprogrammes;- involvement of both generalist and specialist supervision staff; and- publicationof the resultsand provision of consistent feedback tobanks.While not a primary focusof thepeer review, many countriesprovidedviewson areasfor improvement in stresstestingpracticesat banks.Theseresponsesfocusedfairlyconsistentlyonareassuchasgovernanceandtheuse of stresstestingin bank decision-making, data andinformation technologyinfrastructure, severityof scenariosandfirm-widemodellingchallenges.Thereview found theprinciplesto be generallyeffective.TheCommittee, however, will continuetomonitor implementationoftheprinciplesand determinewhether,in thefuture, additionalguidancemight be necessary.IntroductionStresstestingis an important tool for banks toidentify unexpectedadverseoutcomesacrossa rangeof risks.Thefinancial crisishighlighted significant weaknessesin banks stresstestingprogrammesthat contributed to failurestoidentify thenature
  • As a result, the Committee engaged with the industry in examiningstress testing practices and, in May 2009, the Committee publishedrecommendations for banks and supervisors entitled Principles forsoundstresstestingpracticesand supervision.Theguidance set out a comprehensive set of principlesfor thesoundgovernance,designandimplementationof stresstestingprogrammesatbanks.Theprinciplesestablishedexpectationsfor the roleand responsibilitiesof supervisorsin evaluatingstresstesting practices. Overall, theguidanceincludesfifteenprinciplesfor banksand six principlesforsupervisors.As part of its mandateto assessthe implementationof its standardsacrosscountries,the CommitteesStandards ImplementationGroupundertook a peer review of supervisoryauthorities‘implementation oftheprinciples.Theobjectivesof thisreview wereto:- assesstheextent towhichtheprincipleshavebeenimplementedin arigorousand consistent manner acrosstheCommittees memberauthorities;- identify and providefeedback on factorsthat aremost critical to theeffectiveimplementationof the principles;and- assessthe effectivenessof theprinciplesthemselves.An important element of thereview wasthe context in whichtheprinciplesare beingimplemented.Many of the countriesparticipatingin this peer review have beenworkingtoimplement and refinestresstestingframeworksandmethodologies at thesametime their economiesand banking systemshavebeen affected by a high degreeof global economicand financialuncertainty.Althoughmanysupervisoryauthoritiesandbankshadoperationalstresstestingframeworksin place, existingguidanceand ruleshad toberevisedand new expectationsput in placeto broaden and deepen stresstestingcapabilitiesat both banksand supervisors.This is beingdone in a stressedenvironment and is alsobeingconducted at a time when stresstesting infrastructure, includingtheabilitytocollect appropriatedata, developmodelsandaggregateresults,is evolving.As a result, the current environment hasprovided a useful earlytest ofhow countriesare putting theprinciplesintopractice.
  • Morebroadly, it wasevident that countriesare implementingstresstestingregimesand activitiesin different ways that may reflect theirindividualsituationsandnot all will followthesame progression or pathin implementingtheprinciples.Thereview wasintended todeliver feedback on good supervisorypractice tohelp supervisorsimplement standardsmore effectively.Indeed, several countries havereported significant progresssubsequenttothe completion of thepeer review survey, particularlywithregard tosupervisorystresstestingpractices.MethodologyThepeer review wasconducted through a questionnairewhichwasdistributedtoCommitteemember countriesin September 2011.Analysis of the responseswasconducted by a workinggroup ofrepresentativesofsupervisoryauthoritieswithexpertiseinstresstesting.The questionnaire focused primarily on the implementation activities ofsupervisors and consisted of both factual multiple choice questions andfree-form responses.Thereview team used the information providedby eachcountryand, whererelevant, sourcedocumentsdemonstrating itsimplementationof the principles,to assessand compare theprogressmadeacrosscountries.Giventheoff-siteandhigh-levelnatureof thereview,it wasnot intendedtoproducea definitiveassessment of individual countriesimplementationof theprinciples,but, rather, to allowan overall view ofprogressacrosscountries.Adetailed report wasprovided tothe StandardsImplementation Groupandtothe Committee.The review focused primarily on the implementation of principles 16-21for supervisors, asit wasnot within the scope of the peer review toassesscomplianceby bankswithprinciples1-15on stresstesting practices.However,countrieswereinvited to provide their viewson theeaseandeffectivenessof implementation for each of theprinciplesfor banksintheir jurisdiction.In their responses, supervisory authoritieswereaskedtofocusonsupervisionof thelargestbanksin their jurisdiction, although somealsoaddressedtheir supervisoryexpectationsfor stresstesting at smallerbanks.
  • Assessment of principlesfor supervisorsOverall maturity of implementationFor purposesof assessingand comparingimplementation of theprinciples,participatingcountries werestratified asbeing in anearly, intermediateor advanced state of implementation.Theseassessmentswerebased on indicatorsof maturitydeveloped forthispurposebythereviewteam, aswellasthequalityandthoroughnessof the questionnaireresponses.Countriesin theearlycategory (nearlyhalf of respondents) showedsomeprogresstowardsimplementingtheprinciples;however, theymaynothaveissued or finalised prudential requirementson enterprise-widestresstestingsincethe principleswerepublished.Thesecountriesgenerallyhad not conducted regular on-site or off-sitereviewsother than in the context of risk-specific modellingrequirementssuchasfor market risk,andhaveconductedindustry-widestresstestsinfrequently, or onlyaspart of FSAP reviews.In contrast, a few countries wereclassifiedasadvanced. For thesecountries,the review team saw evidenceof a rigorousregular reviewprocessthat included a combination of:- on-siteand off-siteassessments;- some review and feedback on detailedstresstestingmodelsused bybanks;- evidenceof follow-upactions;and- a well-embeddedsupervisory stresstestingprogramme that wasnotlimitedtoFSAP or regionally-imposed scenarios.Theremainderof countries (approximatelyhalf of respondents) fell intotheintermediatecategory.Thesecountrieshave issuedsome formal requirementsor guidanceconsistent withthe principles,weregenerallyperformingregularsupervisorystresstestson their largebanks and werereviewingstresstestingin thecontext of annual ICAAP reviewsandspecific riskreviews.Thesecountrieshave more todo in deepeningtheirprogrammes,includingissuingupdated requirementsand conductingmore detailed on-siteand off-sitereviewsof banks stresstestingcapabilities.Notably, several countrieshave reportedsignificant progresssubsequenttothecompletionofthepeerreviewsurvey, particularlywith regard tosupervisorystresstestingpracticesand alsoin somecasesissuanceofstresstestingrequirementsor guidance.
  • anyimpedimentstoimplementing theprinciples.Specific areasof supervisoryactivityin relationtothe principlesarediscussed in more detail below.Prudential frameworkThereview found that all countrieshavein placeprudentialrequirementsrelatingto stresstesting.In manycasestheserequirementswereimplementedasacomponent ofBasel II, namely theICAAP requirements, or otherwisepre-date theprinciples.In addition, a largemajorityof the respondentsstated that theyhadissuedspecific rulesor guidanceimplementingtheprinciples.However,approximatelyone-third of respondentshasnot issuedanyrules or guidanceon stresstesting post-2009, and thuswouldnot beconsideredtohave implemented the principlesexplicitly.Thesecountriesrelyon other rules relatingto stresstesting, particularlyunder the Basel II credit or market risk requirements.In termsof future plans,a number of countries acrossdifferent levelsofmaturityare in theprocessof, or are planningtostrengthen or finaliseguidanceor regulations.In some cases,key elementsof theprincipleshavebeen incorporatedintothe Pillar 2 requirementsand in other casesas(non-mandatory)guidancefor banks.Somecountries issuedinformal guidancebased generallyon theprinciplesor on other regional guidelines.Anumber of countriesare still in theearlyphasesof issuingprudentialexpectationsfor enterprise-widestresstesting.At least a few countries have not yet issuedrequirementsrelating toBasel II ICAAPs, whichwasthemost common meansof implementingtheprinciples.Other countrieshave already updated their rulesand adapted theprinciplesor other guidelinesfor their owncircumstances.Thesewouldbe consideredtohave a more mature supervisionframeworkfor stresstesting.Afew other countrieshave issued their owngood practiceguidelineswhichincorporatetheprinciplesaswell askeyfindingsfromsupervisoryactivitiesand industrydialogue.Roughlythree-quartersofrespondentsreportedthat therehavenot been
  • regularlycovered stresstestingfor firm-widerisks,general credit risks,However,resourcing and other supervisoryprioritieswerenoted asaconstraint by a number of other countries.Anumber of countriesasserted that becausetheir banks or bankingsystemsare not complex, some of the aspectsof the principlesare notrelevant (eg structuredproductsand highlyleveraged counterparties).Further, banks in some jurisdictionsgenerallydo not have theinfrastructureand skillsto be ableto complywithsophisticatedstresstestingrequirements.Supervisory reviewPrinciple16 recommendsthat supervisorsshould make regular andcomprehensiveassessmentsof banks stresstestingprogrammes.Thereview found that supervisoryauthoritiesusea combination ofon-siteand off-sitereviewstoassessbanks‘stresstestingpractices.Most countriesindicatedthat theyhaveconductedsome form of on-sitereview of stresstestingat banks.For specific risk areas(primarilymarket, liquidityand tosome extentcredit risk), there are well establishedsupervisory review programmes.Almost three-quartersof countriesindicatedthat theyperform extensiveregular review of firm-widestresstestingpractices.Themost common approachfor assessingfirm-widestresstestingisthrough annual ICAAP reviews, which generallycover capital planningaswell asother matters.Given the scope of ICAAP reviews, it may be difficult toassessall of theprinciplesduring a routineICAAP review.Indeed, a few countries indicated that theyconduct horizontal orthematic reviewsspecificallyon firm-widestresstesting includingtheprinciples,whichisconsidereda more advanced practice.Thefrequencyof on-sitereviewsof firm-widestresstesting variedacrosscountries.About one-third of countries conducted less-than-annual reviews (every2-4 years) while roughly half of responding countries reported that theyconduct annual or more frequent on-site reviewsof stresstesting.Somesupervisorshave conducted a one-timereview of theprinciplesthrough self-assessments,questionnaires,or benchmarkingstudiesacrossa range of banks.In termsof thescope of supervisoryreview,supervisory activities
  • retail mortgagesand corporatecredit risks,market risk, bankingbookinterest rate risk and liquidityrisk.Authoritiesreported that areassuch asoperational risk, overseasoperations,aswell asspecific portfoliossuch ascommercialpropertyand sovereign risks,receivelesscoverage.Supervisoryauthoritiesin most countriesreported conductingannual ormore frequent review of board and senior management reportingofstresstest results.Use of stresstestingin loanlossprovisioningwasreviewedregularly byabout half of the countries.Therole of stresstestingtohelp set riskappetiteand identify riskconcentrationswereareasthat werelesscommonly reviewed;thisis anarea wheresupervisoryand bank practiceis at a very earlystage.Review of contingencyplansfor operational risk is the surveyed arealeast likely tohave been assessed by supervisorsin thecontext of stresstesting.Somecountries noted different requirementsor expectationsof stresstesting acrossbanks, mainlydependingon the banks‘systemicimportance(includingsize, complexityand relevancetoeconomy) andrisk profile.Most emphasised that supervisorshaveproportionately differentexpectationswhenconducting stresstestingreviewsof smaller banks.Several countries(particularlythoseat the more advanced stagesofimplementationof theprinciples)indicatedthat theyareplanning toincreasetheexpectationsof smallerinstitutionswithrespect tostresstestinggoing forward.Supervisory actionPrinciple17indicatesthat supervisorsshouldtakeactionondeficienciesin banks stresstestingprogrammes.Thereview found that the twomost common areasfor supervisoryfollow-upwereimproving governanceprocessesfor stresstesting anduseof additional (in particular, more severe) scenarios.Many countrieseither regularlyor occasionallyimposed requirementstoimprove data or model validation processes.Theleast common supervisory follow-upaction indicatedin theresponseswasto require thebank toreview or changelimitsorexposures(lessthan half of the countriesreported takingthisactionregularly).
  • stresstesting.Principle19encouragessupervisorstoconsidertheresultsof stresstestsin assessingcapital adequacyand in settingprudential buffersfor capitaland liquidity.Alargemajorityof countriesindicated that theysometimesor regularlyimposecapital or liquidityrequirementsasa result of stresstestingdeficiencies.In particular, use of stressscenariosfor setting liquidityrequirementsappearsto be fairlywellestablished, particularlyascountries worktowardimplementingtheBasel III liquidityframework, whichis basedon stressedcashflows.Nearlyall of thecountriesindicatedregular review of liquiditystresstesting.Use of stresstestsfor settingminimum capital requirements,determiningexplicit capital buffersor for limitingcapital distributionsbybanks isa more recent development that wasnot extensivelyconsideredin theprinciplesand asa result wasnot a key focusof thereview.Asmall number of countriesindicated that stresstestinghasbecome akey tool for setting or assessing capital requirements.Somecountries haveissuednew requirementsin the past year or sospecificallyrelated totheuseof stresstestsin assessingcapitaladequacy.While useof stressteststoset formal minimum capital requirementsisnot common, useof standard supervisorystressscenariosasabenchmarkingtool isincreasinglyprevalent.Othercountriestooktheviewthat stresstestresultsarejust onefactorinassessinghow much capital is needed tooffset the risk of unexpectedlosses.In a number of countries, and even thosewithfairly advanced stresstestingsupervision programmes, stresstesting wasseen asone of severaltoolsin assessingcapital adequacyand there wasa reluctancetoplaceprimary relianceon stresstest scenario outcomes.This may reflect theevolving natureof supervisory and bank practices.Supervisory resourcingAs stresstesting is a fairlynew and specialisedarea of supervision, thereview found that resourcingand capabilitiesfor stresstestingsupervision werekeychallengesfor many supervisoryauthorities.Onlya few countrieshave establishedunitsspecificallydedicatedto
  • area of focus in their future plans.Most countriesare primarily relying on separateteamsof staff toconduct supervisorystresstestsand, in manycases,alsotoreview stresstestingpracticesat banks.Theseteamsalsoperform other tasksin additiontoreviewingorconductingstresstesting.Typically, a set of speciallytrainedsupervisorsis responsibleforcoordinatingwith bankswithrespect to the collectionof data for stresstestingand reviewingand consolidatingthestresstest information.Oftenan inter-departmental team isused to conduct thestresstests.In general, it wasnotedthat staff withavariety of different backgroundscanbeuseful in stresstesting, includingmacro-surveillanceeconomists,risk specialistsand modellingexperts, aswell asgeneralistsupervisorswhoaremost familiarwithindividualinstitutionsoraccountingexperts.Similarly, most countriesutiliseboth risk specialistsand generalistsupervisorsin reviewingstresstesting practicesat banks.In most countries, generalist supervisorsare involved in the review ofstresstestingpractices;however, theyarenot generallyinvolved inconductingsupervisorystresstests.At the same time, some countriesnoted that wherestresstesting isallocatedtoa separate unit, it can bemore difficult to ensure that stresstestingisembeddedwithin routinesupervisionand that stresstestoutcomesare understood and used by the generalist supervisors.This wasseen asan evolving challenge.Themore advancedcountries, in particular, noted a general lack ofspecialisedstresstesting resources.Indeed, somecountriesfound that prioritisationof supervisoryworkisamajor issueaskey individualsinvolved oftenhaveother responsibilities.Most countriesindicatedtheyhad establishedsome form of trainingprogrammeon stresstestingfor supervisors.In many cases,the trainingwasof a quitegeneral nature and in somecaseslimitedtopresentation of the resultsof supervisorystresstestsorhigh-level discussion in the context of introductorytraining on Pillar 2approaches.A few countries provide quite advanced training programmes, includingcase studies, and some offer training to other countries supervisorsor tobanksin their jurisdiction.Not surprisingly, severalcountriesnotedthat stresstestingtrainingisan
  • consideredtobeamoreadvanced practicefor supervisors,asit requiresSupervisory stresstestingPrinciple20recommendsthat supervisorsshould considerimplementingstresstest exercisesbased on common scenarios.It is clearthat there has been a significant increasein the use ofsupervisorystresstestsin recent years.In fact, all countriesindicatedthat theyconduct some form ofsupervisorystresstest.As a result, progressin this area canbe considered more advancedgenerallythan some other aspectsof theprinciples.Portfolio-levelstresstestswerereported by more than half of thecountries.In recent years, this hasincluded specificstresstestson, forexample,housing loanportfolios, consumer debt, sovereign risksandliquidityrisk.Somecountries indicatedthat they conduct very frequent sensitivitytestingfor specificrisks, for example,applying market risk andliquidityshockson a regular basis.In termsof firm-widestresstestsbased on a common scenario, therewasa rangeof experience.Afew countries have performed FSAP stresstestsonly.While thesestresstestsprovide an important basisand experiencefordesigningsupervisory stresstests,in many casestheytended to be ledbytheFSAP mission team and thenational central bank, and did nothavea supervisory focus.About one-third of countrieswerenot running stresstestson afirm-widebasis.In a couple of countries,firm-widestresstestswereconducted by the(non-supervisory) central bank, although withsome involvement by thesupervisoryauthority.Many countriesconduct both bank-run and supervisor-runstresstests.This can involve thesupervisoryauthorityrunningthe same scenariousingsupervisoryor public data in order to benchmark banks resultsfrom thebank-run stresstest. Some countries run both regional andcountry-specific stresstests.Directingbanks torun a stresstest usinga common scenariois
  • banksis a more advanced practiceasit allowsbetter benchmarkingofmore detailed understandingof bank modellingcapabilitiesand anabilityto assesstheresults.About half of the countries have conducted bank-run, firm-wide stresstests (outside of the FSAP process), of which about half conduct theseon an annual basis.Supervisory assessment and challengeTheoverall assessment and challengeof the reasonablenessof banksstresstest scenariosand outputsisa difficult area for supervision.In many countries, the models, assumptionsand approachesused areevolving, and banksare at varying degreesof sophistication.At a general level, the review found a rangeof supervisorymethodsforchallengingthe scope and resultsof banks‘stresstestsand scenarios.Themost widelyused method wasto compare outputswithhistoricalexperience,such asa pastsevere recession.However,in countrieswithlittlehistoryof financial crisis,thisapproachmay be more difficult.Anumber of countriesconductedtheir ownparallel stresstestson bankfinancial data to benchmark resultsproduced by banks or placedhighrelianceon reasonablenesschecksbased on supervisors‘understandingof portfolios.Peer comparisonswerevery useful in countries wherebankssubjecttostresstestingare comparablein size and scope.Somecountries facilitatethis by requiringbanks toreport theresultsoftheir stresstestsin a standardisedmanner.Anumber of countriesalsoplacemoderate to high relianceon banksowninternal model validation reporting.Independent review by external auditorsor consultantscan be oneelement of the assessment and challengeprocessfor some countries.But more than half of countries indicatedtheydonot rely at all onindependent review of stresstesting resultsaspart of their supervisionactivities.Another supervisorytrend is that supervisoryauthoritiesare moreactivelyreviewingscenarioschosen by the banksin their internal stresstesting and, for example, the banks‘ICAAPs.Monitoring or keepinga systematic inventory of scenariosused by
  • tested.peer banks‘internal view of stressed conditionsand possiblevulnerabilities.Several countriesmaintain adatabaseof scenarios used by theirbanks, and othershaveplansto dothis.Over half of the countriesperiodicallyreview thescenariosusedbybanksin their internal stresstesting.Afew countries in theearlier stagesof maturitywerenot regularlyreviewingscenariosused by banks.Supervisoryauthorities in several countriesindicated that theyhaveperformed reversestresstests,that is, stresstestsdesignedtobesufficientlysevere that theychallengetheviabilityof thebank.However,reverse stresstesting hasnot becomea common supervisorypractice.In fact, thesupervisorystresstestsappear tobethevehicle for assessingtheimpact of more severe scenarios.In terms of the choice of scenario for supervisory stresstests, the mostcommon approach was to look to a previous severe recession or inputfrom thecentral bank.Also very common wastotarget thescenario toknownvulnerabilities.About half of the countries have usedexternallyprescribed scenarios(for example, from a regional authority or FSAP process).Dialogue with public and private sectorsStresstestingis increasinglypart of thepublic debateon thestrengthandtransparencyof supervision.Supervisoryauthorities have regular discussionswithbanking industryriskofficersorhold occasionalseminars,workshopsorroundtableswithbanksto exchangeexperienceson stresstestingmethodologiesand useof results.In somecases, thishasresultedinpublicationoflocalindustryguidancebased on the Committees principles.Somesupervisorsalsohave a formal processfor coordinatingwith otherofficial organisationswithintheir country.In some cases,a formal committeeof regulatorsand other authorities(includingthe central bank) discussessystemic vulnerabilitiesandprovidesinput intostresstesting programmesand the scenariosto be
  • dialogueonscenarioselection, dynamicsof models,reportingtemplatesAnumber of other supervisorscoordinatewiththeir central bank inconductinga quantitativemacroeconomic stresstest, includingconsiderationof potential systemic issuesthat may be caused by banks‘management reactionsto a common stressscenario.Regional-level coordinatingbodieshavealsobecome increasinglyimportant.Effective supervisory approachesThereview highlighteda number of different supervisoryapproachesthat appear tohavebeen more effectiveand arereflectiveof moreadvancedprogress.Oneof themost effectivetoolsin advancingstresstesting practiceshasbeen thesignificantlyheightened focuson industry-widesupervisorystresstests.Many countriesfound that thisprocesshashelpedfocuson commonexpectations,provideastructuredapproachfordialogueonbetterstresstestingpractices,and identify gapsin banks stresstestinginfrastructure.By challengingthelossresultsreportedby banks on theprescribedscenarios, supervisorshave motivated banks tojustify their resultsandhenceimprove their internalassessment of key risk areas.In contrast, there wassome evidencethat countries that have onlyconducted supervisorystresstestsor supervisoryreviewof stresstestingpracticeswithout leveragingthesetwoaspectstogether havenot madeasmuch progressin implementingthe principles.In addition, countriesthat addressbank stresstestingpracticesthroughtheICAAP review processhave generallyfound this tobe an effectivemechanism, althoughperiodic horizontal or thematicreviewsthat allowdetailed comparison of practicesacrossbanksis a more advancedapproachthat is in useor under considerationin some countries.A formal self-assessment process conducted in some countries helpedbanks identify where their practices are consistent with the principlesandwheregapsexist in stresstestingprogrammes.Opendialoguewithbankswasalsoseen asakey element of an effectivesupervisoryprogramme.Annual meetingswith banks can includediscussionsof riskdevelopmentsand best practicesin stresstesting that effectivelycreateincentivesfor bankstostrengthen their ownpractices.Another approach highlightedby some countrieswastoengage in
  • adequacyand liquiditywasevident in a few countries, withsome alsoanddata capabilities, and overall robustnessof thestresstest at thehighest level of bank management.Several countrieshaveissued publicationsdescribingobserved goodpracticesarising from benchmarking or initial implementationreviewsof the principles.This type of guidanceallowsbanks tobenchmark themselvesagainsttheir localpeers.Banks, and to some extent regulators,areincreasinglyusingstresstestingasa meansof communicatingtheir risk profiles tothemarket.However,disclosurerequirementsand practicesvary considerably bycountry.Many countriesnow publish aggregatesummaries of stresstestsresultsin their regular financial stabilityreports,and in some casesoutcomesfor individual banks.Somebanks now routinely provide stresstest resultsaspart of theirfinancial results.Future plansMost supervisoryauthoritiesdescribed future enhancementsto theirstresstestingsupervisionprogrammes.Those countries in the early phases of maturity are planning toissue, finalise or update rules on stress testing and to commencereview and assessment of stresstestingpractices.Someare alsoconductingsupervisorystresstestsfor the first time.Thosesupervisoryauthorities in intermediatetoadvanced stagesofmaturityplan to focuson deepeningtheir current on-siteand off-sitereview programmes, with the aim of better assessing how stresstestoutcomesare used in bank decision-makingand risk appetitesetting.Stresstestingresultsare expectedtohave a greater impact oncontingencyplanningincludingrecoveryand resolution.Additional supervisory workis planned for identifying and assessinghowbanksare integratingstresstestsresultsin thedevelopment of riskappetiteand overall risk management.Some supervisors will also use horizontal reviews across multiple banksto assess these areas as well as to benchmark banks‘ internal stress testscenarios and assumptions.Greater focuson the use of stresstest outputsin assessing capital
  • incorporatingstresstest resultsintobusinessand strategicdecisions.planningmore explicit consideration of stresstest outcomesin settingcapital buffers.Principlesfor BanksAs the peer review focused on supervisory implementation, anassessment of stresstestingpracticesat bankswasnot within thescopeof this review.Nevertheless, manycountriesprovided high-level commentsonprogressof banksin their jurisdictionsthat werereasonablyconsistentandmay be of broader interest.In particular, all countriesreported significant improvementsin stresstestingcapabilitiesat banks sincepublication of the principles.Authoritiesnoted an overall improvement in the rigor and qualityofstresstestingand thequalityof information presentedin ICAAPs.Risk-specific stresstesting, particularlyregardingmarket and liquidityrisk, wasfound tobe reasonablywell developed.Morerecently, bankshave focused increasinglyon centralised,firm-widestresstestingthat encompassesa broader rangeof risks, butmanycountries note this area is still evolving.Bankshavestrengthenedtheir resourcing, withsomebanksnowhavingset up dedicatedstresstestingunits.Banks are using a broader range of scenarios, includingthosethat aremore severe and complex.However, as noted below, many countries indicated that banks‘scenarios continue to be less severe than supervisors might findappropriate.Banks generallyareestablishingstronger governanceframeworkswithclear linesof responsibilityfor stresstesting, and some banksare givingmore importancetostresstest resultsin their decisionmaking.Somecountrieshaveseenanimprovement in datasystemsandabilitytoadapt to new vulnerabilitiesand specific scenarios.Thelevel of documentation hasalsoimproved.Countries responsesto thereview surveyhighlightedthefollowingcommon areasof future improvement in bank stresstestingpractices.Integrating resultsinto decision-making.Anumber of countriespointed tochallengesbankshave in
  • Stresstestingtoolsare still immature and some countries felt that inmanycasesthe bankstake a compliance-orientedapproachin order tomeet regulatory requirements.GovernanceThere is a sensethat banks need to have a better understanding of stresstesting limitations, assumptions, and uncertainties by users of stress testresults,includingsenior management and the board of directors.Severity of scenariosAnumber of countriessawa need for firmsto deepen the severityofscenarios.Supervisorsin thesecountriesremain concernedthat banks internalstresstest scenariosdo not plausiblyreflect potential severe scenariosand outcomes.Data and IT infrastructure.Anumber of countriesnoted that data and IT systems remain a keyimpediment toimplementingeffectivestresstesting programmes.Accumulation of sufficient data for modellingpurposesis a challengefor banks in some countries and aggregatinginformationacrossthebank remainsan issue.Generally, some manual intervention isneeded to support thebanks‘current IT and data infrastructuretorun regular stresstests.Modelling issuesTranslatingand calibratingscenariosintostressoutcomescontinuestobean area wherebanks capabilitiesarechallenged.Multiplerisk classimpactsgenerallyhave not been modelled in asophisticated manner, although some banks attempt to take intoaccount correlationsbetweenrisks.Incorporatingfeedback effectsand system-wideinteractionsremainsvery difficult.Another technical area cited is the identification and aggregation ofcorrelated risks and integration between credit, market and liquidityrisks.
  • ConclusionsThecurrent environment hasprovided asoundtest of howcountriesareputtingintopracticetheCommittees2009principlesfor stresstestingsupervision.There is clearlyroom for further progressamong the supervisorycommunityin the supervisionof stresstesting.Many countries in the early to intermediate stages of implementationare working to finalise their prudential requirements for stress testingand implement regular review programmes that cover enterprise-widestresstestinggovernance, capabilitiesand models.Even those countriesconsideredtobe in the advancedphaseofimplementationof theprinciplesfelt that there are many remainingchallengeswithrespect totheir own stresstestingprogrammes.Authoritiesare continuing withtheir effortsto embed theuse of stresstestingwithin their supervisory programmes.In many cases,this requires additional resourcesand trainingfor bothgeneralist and specialist supervision staff.Stresstestinginfrastructure, includingtheabilityto collect appropriatedata, develop modelsand aggregateresults,continuesto evolve.Explicit considerationof stresstest outcomesin assessingliquidityandmarket riskcapital requirementsis well establishedin supervisoryframeworks.Stresstestinghastraditionallynot featured asprominentlyinassessment of overall bank capital adequacybut practicesare evolvingin this area.Thepeer review hashighlightedthat there are different supervisoryapproachesand it is difficult to statewhichis most effective.Acombination of supervisory stressteststogether withinvolvement ofgeneralist and specialist supervision staff in reviewsof banks‘stresstestingpracticesat anenterprise-widelevel oftencharacterisesthemorewell developed supervisoryprogrammes.Moreadvancedcountriesare encouraging development of morerigorouspracticesat banksby conductinghorizontal and thematicreviews, publishingthe resultsand providingfeedback to banks.Finally, while thereview found theprinciplesthemselvestobegenerallyeffectivein settinghigh-level expectations,theCommitteewill continue
  • tomonitor implementationof the principlesand determinewhether, inthefuture, additional guidancemight benecessary.1 Stress testing should form an integral partof the overall governance and riskmanagement culture of the bank. Stresstesting should be actionable, with theresults from stress testing analysesimpacting business decisions of the boardand senior management. Board and seniormanagement involvement in the stresstesting programme is essential for itseffective operation2 A bank should operate a stress testingprogramme that promotes risk identificationand control; provides a complementary riskperspective to other risk managementtools; improves capital and liquiditymanagement; and enhances internal andexternal communication.3 Stress testing programmes should takeinto account of views from across theorganisation and should cover a range ofperspectives and techniques.4 A bank should have written policies andprocedures governing the stress testingprogramme. The operation of theprogramme should be appropriatelydocumented.5 A bank should have a suitably robustinfrastructure in place, which is sufficientlyflexible to accommodate different andpossibly challenging stress tests at anappropriate level of granularity.6 A bank should regularly maintain andupdate its stress testing framework. Theeffectiveness of the stress testingprogramme, as well as the robustness ofmajor individual components, should beassessed regularly and independently.7 Stress tests should cover a range of risksand business areas, including at the firm-wide level. A bank should be able tointegrate effectively, in a meaningfulfashion, across the range of its stresstesting activities to deliver a completepicture of firm-wide risk.8 Stress testing programmes should cover arange of scenarios, including forward-looking scenarios, and aim to take intoaccount system-wide interactions andfeedback effects.9 Stress tests should feature a range ofseverities, including events capable ofgenerating the most damage whetherthrough size of loss or through loss ofreputation. A stress testing programmeshould also determine what scenarioscould challenge the viability of the bank(reverse stress tests) and thereby uncoverhidden risks and interactions among risks.10 As part of an overall stress testingprogramme, a bank should aim to takeaccount of simultaneous pressures infunding and asset markets, and the impactof a reduction in market liquidity onexposure valuation.11 The effectiveness of risk mitigationtechniques should be systematically
  • 12 The stress testing programme shouldexplicitly cover complex and bespokeproducts such as securitised exposures.Stress tests for securitised assets shouldconsider the underlying assets, theirexposure to systematic market factors,relevant contractual arrangements andembedded triggers, and the impact ofleverage, particularly as it relates to thesubordination level in the issue structure.13 The stress testing programme should coverpipeline and warehousing risks. A bankshould include such exposures in its stresstests regardless of their probability of beingsecuritised.14 A bank should enhance its stress testingmethodologies to capture the effect ofreputational risk. The bank should integraterisks arising from off-balance sheetvehicles and other related entities in itsstress testing programme.15 A bank should enhance its stress testingapproaches for highly leveragedcounterparties in considering itsvulnerability to specific asset categories ormarket movements and in assessingpotential wrong-way risk related to riskmitigation techniques.16 Supervisors should make regular andcomprehensive assessments of abanks stress testing programme.17 Supervisors should require management totake corrective action if materialdeficiencies in the stress testingprogramme are identified or if the results ofstress tests are not adequately taken intoconsideration in the decision-makingprocess.18 Supervisors should assess and ifnecessary challenge the scope and severityof firm-wide scenarios. Supervisors mayask banks to perform sensitivity analysiswith respect to specific portfolios orparameters, use specific scenarios or toevaluate scenarios under which theirviability is threatened (reverse stresstesting scenarios).19 Under Pillar 2 (supervisory review process)of the Basel II framework, supervisorsshould examine a banks stress testingresults as part of a supervisory review ofboth the banks internal capital assessmentand its liquidity risk management. Inparticular, supervisors should consider theresults of forward-looking stress testing forassessing the adequacy of capital andliquidity.20 Supervisors should consider implementingstress test exercises based on commonscenarios.21 Supervisors should engage in aconstructive dialogue with other publicauthorities and the industry to identifysystemic vulnerabilities. Supervisors shouldalso ensure that they have the capacity andskills to assess a banks stress testingprogramme.
  • April 2012Resultsof the Basel III monitoring exercise asof 30 June 2011Toassesstheimpact of thenew capital and liquidityrequirementsset out in theconsultativedocumentsof June and December 2009,both theBasel Committeeon BankingSupervision and the Committeeof European BankingSupervisors(CEBS) conducted a so-calledcomprehensivequantitativeimpact study(C-QIS) for their member jurisdictionsbasedon data asof 31December 2009.Themain resultsof both impact studieshavebeenpublishedin December 2010.After finalisat ion of th e regulatory framework (referred to as ―Basel III‖)inDecember2010,theimpact of thisnew frameworkis monitored semi-annuallybyboth the Basel Committeeat a global level and theEuropean BankingAuthority (EBA, formerlyCEBS) at theEuropean level, using data provided byparticipatingbankson a voluntary and confidential basis.This report summarisesthe resultsof thelatestmonitoring exerciseusingconsolidateddata of Europeanbanks asof 30June 2011. Atotal of 158bankssubmitteddatafor thisexercise,consistingof48Group1banksand 110Group2banks.[Group 1banksare thosewith Tier 1capit al in ex cess of €3 b n andinternationallyactive.All other banks are categorised asGroup 2banks]Member countries‘coverageof their banking system wasveryhigh for Group 1banks,reaching 100% coveragefor many jurisdictions(aggregate coverageintermsof Basel II risk-weightedassets:98.5%), whilefor Group 2banksit waslowerwith a larger variation acrossjurisdictions(aggregate coverage:35.8%).Furthermore,Group 2 bank resultsare driven by a relatively small number oflargebut non-internationallyactivebanks,ie theresultspresentedin thisreportmay not be asrepresentativeasit is thecasefor Group 1banks.[There are 19Group 2 banksthat have Tier 1capital in excessof €3billion.Thesebanksaccount for 64.3% of total Group 2RWA.]
  • Sincethe new EU directiveand regulation are not finalisedyet, no EU specificrules are analysed in this report.Accordingly, this monitoring exerciseiscarried out assumingfullimplementationof theBaselIII framework, ie transitionalarrangementssuchasphase-inof deductionsand grandfatheringarrangementsare not taken intoaccount.Theresultsarecomparedwiththerespectivecurrent national implementationoftheBasel II framework.In addition, it is important to note that the monitoring exercise is based on staticbalance sheet assumptions, ie capital elementsare only included if the eligibilitycriteria have been fulfilledat thereportingdate.Plannedmanagement actionstoincreasecapital or decreaserisk-weightedassetsare not taken intoaccount (―static balancesheet assumption‖).This allowsfor identifying effectivechangesin banks‘capital base instead ofidentifying changeswhichare solely based on changesin underlying modellingassumptions.As a consequence, monitoring results are not comparable to industry estimatesas the latter usually include assumptions on banks‘ future profitability, plannedcapitaland/ orfurthermanagement actionsthat mitigatetheimpactofBaselIII.In addition, monitoringresultsare not comparableto C-QIS results,whichassessed the impact of policy proposalspublished in 2009that differedsignificantlyfrom thefinal Basel III framework.Theactual capital and liquidityshortfallsrelatedtothenew requirementsbythetimeBaselIII is fullyimplementedwill differ from thoseshownin this report asthebanking sectorreactsto thechangingeconomic and regulatory environment.Themonitoring exerciseprovidesan impact assessment of thefollowingaspects:- Changesto banks‘capital ratios under Basel III, and estimates of any capitalshortfalls. In addition, estimates of capital surchargesfor global systemicallyimportant banks(G-SIBs) are included, whereapplicable;- Changestothedefinitionof capitalthat result fromthenewcapitalstandard,referred to ascommon equity Tier 1(CET1), includingmodifiedruleson capital deductions, and changesto theeligibility criteria for Tier 1and total capital;- Changesin the calculationof risk-weightedassets(RWA) resultingfromchangestothe definitionof capital, securitisation, trading book andcounterpartycredit risk requirements;
  • - Thecapital conservation buffer;- Theleverageratio;and- Twoliquiditystandards – the liquiditycoverageratio(LCR) and thenetstablefunding ratio(NSFR).Key results - Impact on regulatory capital ratios and estimated capitalshortfallAssuming full implementationof theBaselIII frameworkasof 30June 2011(i.e.without takingintoaccount transitional arrangements), theCET1capital ratiosof Group 1banks wouldhavedeclined from an averageCET1ratio of 10.2%(withall country averagesabovethe 7.0% target level) to an averageCET1ratioof 6.5%.80%of Group 1bankswouldbeat orabovethe4.5%minimum while44% wouldbeat or above 7.0% target level.TheCET1capital shortfall for Group 1banks is €18bn at a minimumrequirement of 4.5% and €242bn at a target level of 7.0% (includingthe G-SIBsurcharge).As a point of reference, the sum of profits after tax prior to distributions acrossthe Group 1 sample in the second half of 2010 and the first h alf of 2011 was€102 bn.With respect totheaverageTier1andtotalcapitalratio,monitoring resultsshowa declinefrom 11.9%to6.7% and from 14.4% to 7.8%, respectively.Capital shortfallscomparingto theminimum ratios(excl. thecapitalconservation buffer) amount for €51bn (Tier 1capital) and €128bn (totalcapital).Takingintoaccount the capital conservation buffer and thesurcharge forsystemically important banks, the Group 1banks‘capital shortfall risesto €361bn (Tier 1capital) and €485bn (total capital).For Group 2banks, the averageCET1ratio declinesfrom 9.8% to 6.8% underBaselIII, where87% of thebankswouldbe at or abovethe4.5% minimum and72%wouldbe at or above the7.0% target level.TherespectiveCET1shortfall is approx. €11bn at a minimum requirement of4.5% and €35 bn at a target level of 7.0%.Thesum of profitsafter tax prior todistributionsacrossthe Group 2sampleinthesecond half of 2010and the first half of 2011was€17 bn.
  • Main driversof changesin banks‘ capital ratiosFor Group 1banks,the overall impact on theCET1ratio can be attributedinalmost equal partstochangesin the definition of capital and to changesrelatedtothe calculationof risk-weightedassets:while CET1declinesby 22.7%, RWAincreaseby21.2%, on average.For Group 2banks, while the change in thedefinition of capital resultsin adeclinein CET1 of 25.9%, the new ruleson RWA affect Group 2banks far less(+6.9%), which may be explained bythe fact that thesebanks businessmodelsare lessreliant on exposurestocounterparty and market risks(whichare themain driversof theRWAincreaseunder thenew framework).Reductions in Group 1and Group 2 banks‘ CET1are mainly driven by goodwill(-17.3% and -14.8%, respectively), followed by deductions for holdings of capitalof other financial companies(-4.4% and -7.0%, respectively).As to the denominator of regulatory capital ratios, themain driver is theintroductionof CVA capital chargeswhichresult in an averageRWAincreaseof8.0% and of 2.9% for Group 1and Group 2 banks, respectively.In addition to CVA capital charges, trading book exposures and the transitionfrom Basel II 50/50 deductions to a 1250% risk weight treatment are the maincontributorsto theincreasein Group 1banks‘RWA.As Group 2 banksare in general lessaffected by therevised counterparty creditrisk rules, these banksshow a much lowerincreasein overall RWA (+6.9%).However,even withinthis group, the RWA increaseis driven by CVAcapitalcharges,followedbychangesrelatedtothetransitionfromBaselII 50/50capitaldeductionstoa 1250% risk weight treatment, and totheitemsthat fall below the10/15% thresholds.Leverage ratioMonitoring resultsindicatea positivecorrelationbetweenbank size and thelevel of leverage, sincethe averageLR is significantlylowerfor Group 1banks.Assuming full implementationof Basel III, Group 1banksshow an averageBasel III Tier 1leverageratio(LR) of 2.7%, while Group 2 banks‘leverageratiois 3.4%.41%of participatingGroup 1and 72% Group 2 banks wouldmeet the 3% targetlevel asof June 2011.If ahypothetical current leverageratiowasalreadyin place,Group1andGroup2banks‘LR wouldbe4.0% and 4.7%, respectively.
  • Liquidity standardsAtotal of156Group1andGroup2banksparticipatedin theliquiditymonitoringexercisefor the end-June2011reporting period.Group 1bankshavereported an average LCR of 71%while theaverageLCR forGroup 2banks is 70%.The aggregate Group 1 and Grou p 2 shortfall of liq u id assets is at app rox . €1.2 trillion whichrepresents3.7% of the approx. €31trillion totalassetsof theaggregate sample.Group 1banks reported an average NSFR of 89% (Group 2banks:90%). Tofullfil the minimum standard of 100% on a total basis, banksneed stablefundingof approx. €1.9trillion.Both liquiditystandards are currentlysubject toan observation period whichincludesa review clausetoaddressany unintended consequencesprior totheirrespectiveimplementationdates.1. General remarksIn September 2010,the Group of Governorsand Headsof Supervision(GHOS), the Basel Committeeon Banking Supervision‘soversightbody, announced a substantialstrengtheningofexistingcapitalrequirementsandfullyendorsedtheagreementsreached on 26July 2010.Sincethebeginningof 2011, the impact of thenew requirementsrelated to thesecapital reformsand the introduction of twointernational liquiditystandardsismonitoredand evaluatedby the BaselCommitteeon Banking Supervision on asemi-annual basisfor itsmember jurisdictions.At European level, this analysisis conducted by the European BankingAuthority(EBA), alsobasedon theBaselIII reform packageastheCRD IV, theEuropeanequivalent to theBasel III framework, hasnot yet been finalised.This report presentsthe resultsof thelatest monitoring exercisebased onconsolidateddata of Europeanbanks asof 30June 2011. Themonitoringexerciseprovidesan impact assessment of thefollowingaspects:- Changesto banks‘capital ratios under Basel III, and estimates of any capitalshortfalls. In addition, estimates of capital surcharges for global systemicallyimportant banks(G-SIBs) are included, whereapplicable;- Changes to the definition of capital that result in a new capitalstandard, referred to as common equity Tier 1 (CET1), a reallocation ofregulatory adjustmentsto CET1and changes to the eligibility criteria forTier 1and total capital,
  • - Changesin the calculationof risk-weightedassetsdueto changestothedefinitionofcapital, tradingbook, securitisationandcounterpartycredit riskrequirements,- Thecapital conservation buffer of 2.5%,- Theintroduction of a leverageratioand- Theintroduction of twointernational liquiditystandards– theLiquidityCoverage Ratio(LCR) and the Net StableFunding Ratio (NSFR)Therelated policydocumentsare:- Revisionsto the Basel II market risk framework9and Guidelinesforcomputing capital for incremental risk in thetradingbook;- EnhancementstotheBasel II framework11which includetherevisedriskweightsfor re-securitisationsheld in thebankingbook;- Basel III: Aglobal framework for more resilient banksand thebankingsystem aswell astheCommittee‘s13 January pressreleaseon lossabsorbencyat the point of non-viability;- International frameworkfor liquidityrisk measurement, standardsandmonitoring;and- Global systemically important banks:Assessment methodology and theadditional lossabsorbency requirement.1.1. Sample of participating banksThereport includesan analysis of data submitted by 48Group 1banksfrom 16countriesand 110Group 2 banks from 18countries.Table1showsthedistributionof participationby jurisdiction.
  • Coverageofthebankingsectorishigh, reaching100%of Group1banksinsomecountries(aggregate coveragein termsof Basel II risk-weightedassets:98.5%).Coverage of Group 2banksis lowerand varies acrosscountries(aggregatecoverage:35.8%).Group 2 resultsare drivenby a relativelysmall number of banks sufficientlylargeto be classifiedasGroup 1banks, but that have been classifiedasGroup 2banksby their supervisor becausethey are not internationallyactive.1.2. Methodology―Composite bank‖ weighting schemeAverage amountsin thisdocument havebeen calculatedby creatingacompositebank at atotal sample level, whichimplies that thetotal sampleaveragesare weighted.For example, theaveragecommon equityTier 1capital ratio is thesum of allbanks‘common equityTier 1capital for thetotal sampledividedby thesum ofall banks‘risk-weightedassetsfor thetotal sample.
  • Box plotsillustrate the distribution of resultsToensure data confidentiality, most chartsshowbox plotswhichgive anindicationof the distribution of the resultsamong participatingbanks.Thebox plotsare defined asfollows:1.3. Interpretation of resultsTheimpact assessment wascarried out by comparing banks‘capital positionsunder Basel III tothe current regulatory framework.With the exception of transitional arrangementsfor non-correlationtradingsecuritisationpositionsin thetradingbook, resultsarecalculatedassumingfullimplementationof Basel III ie without consideringtransitional arrangementsrelatedtothe phase-in of deductionsand grandfatheringarrangements.This impliesthat the Basel III capital amountsshown in thisreport assume thatall common equity deductions are fully phased in and all non-qualifying capitalinstrumentsare fullyphasedout.As such, these amounts underestimate the amount of Tier 1capital and totalcapital held by a bank as they do not give any recognition for non-qualifyinginstrumentsthat areactuallyphased out over a 10 year horizon.Thetreatment of deductionsand non-qualifying capital instrumentsunder theassumption of full implementationof BaselIII alsoaffects figures reported intheleverageratio section.Thepotential underestimationof Tier 1capital will become lessof an issueastheimplementationdate of the leverageratio approaches.In particular, in 2013, the capital amounts based on the capital requirements inplace on the Basel III implementation monitoring reporting date will reflect theamount of non-qualifying capital instrumentsincluded in capital at that time.
  • These amountswill therefore be more representative of the capital held bybanks at the implementation date of the leverage ratio (for more detail seesection 5).In addition, it isimportant to note that themonitoringexerciseis basedonstatic balancesheet assumptions, ie capital elementsare onlyincluded if theeligibilitycriteria have been fulfilledat thereportingdate.Plannedbank measurestoincreasecapital or decreaserisk-weightedassetsarenot taken intoaccount.This allows for identifying effective changes in bank capital instead ofidentifying changes which are simply based on changes in underlyingmodellingassumptions.As a consequence, monitoring results are not comparable to industry estimatesas the latter usually include assumptions on banks‘ future profitability, plannedcapital and/ ormanagement actionsthat mitigatetheimpact of Basel III.In addition, monitoringresultsarenotcomparabletopriorC-QIS results,whichassessed the impact of policy proposalspublished in 2009that differedsignificantlyfrom thefinal Basel III framework.Asoneexample,theC-QIS didnot considertheimpact of capitalsurchargesforG-SIBs based on theinitial list of G-SIBs announced by the Financial StabilityBoard in November 2011.Toenablecomparisonsbetweenthe current regulatoryregime and Basel III,common equityTier 1elementsaccordingto thecurrent regulatoryframeworkaredefinedasthoseelementsof current Tier 1capital whicharenot subject toalimit under the respectivenational implementation of BaselII.1.4. Data qualityForthismonitoringexercise,participatingbankssubmittedcomprehensiveanddetailed non-publicdata on a voluntaryand best-effortsbasis.National supervisorsworkedextensivelywith banksto ensuredata quality,completenessand consistencywiththepublishedreportinginstructions.Banks are included in the variousanalysesthat followonlyto theextent theywereable toprovidedata of sufficient qualityto completetheanalyses.2. Overall impact on regulatory capital ratiosand estimated capitalshortfallOneof thecore intentionsof the Basel III frameworkis to increasetheresilienceof the banking sector bystrengtheningboth thequantityand qualityof regulatory capital.
  • Therefore,higher minimum requirementshavetobe met and stricter rulesforthedefinition of capital and the calculationof risk weightedassetsapply.As the Basel III monitoring exerciseassumesfull implementationof Basel III(without takingintoaccount any transitional arrangements), it comparescapital ratiosunder current ruleswithcapital ratios that bankswouldshow ifBasel III werealready fullyin force at thereportingdate.In this context, it is important to elaborateon the implicationsthe assumptionof full implementationof BaselIII hason the monitoring results.The Basel III capital amountsreported in thisexercise assume that all commonequity deductions are fully phased in and all non-qualifying capital instrumentsare fullyphasedout.Thus, theseamountsmay underestimatetheamount of Tier 1capital and totalcapitalundercurrent rulesheldbybanksastheydonot giveanyrecognitionfornon-qualifying instrumentswhichare actuallyphasedout over a 10 year horizon.Table2 showsthe overall changein common equityTier 1(CET1), Tier 1andtotal capital if BaselIII werefullyimplemented, asof 30June 2011.For Group 1banks,the impact on the averageCET1ratio is a reduction from10.2% to 6.5% (a declineof 3.7percentagepoints) whilethe averageTier 1andtotal capital ratio woulddeclinefrom 11.9% to 6.7% and from 14.4% to 7.8%respectively.Contrarytothe current framework,for Group 2banks averagecapital ratiosarehigher than for Group 1.Thefollowingchart givesan indicationof the distributionof resultsamongparticipatingbanks.It includesthe respectiveregulatoryminimum requirement (thick red line), theweightedaverage (depicted as―x‖) and the median (thin red line), ie the valueseparatingthe higher half of a samplefrom the lowerhalf (that meansthat 50%of all observationsare belowthisvalue, 50% are above).
  • 80% of Group 1banks wouldbe at or above the4.5% minimum requirementwhile44% wouldbeat or abovethe7.0% target level, ie it isexpectedthat in thenext years bankswill put in placeseveral measurestoincreasehighqualitycapital.With respecttoGroup2banks,87%reportedCET1ratiosat orabove4.5%while72%wouldbe at or above the7.0% target level.Thereduction in CET1ratios is driven both by a new definitionof capitaldeductions(numerator) and by increasesin risk-weightedassets(denominator).Banks engagedheavily in trading or in activitiessubject tocounterparty creditrisk tend toshow thelargest denominator effectsastheseactivitiesattractsubstantiallyhigher capital chargesunder the new framework.For Group 1banks, the aggregate impact on the CET1ratio can be attributed inalmost equal parts to changes in the definition of capital and to changes relatedto the calculation of risk-weighted assets: while CET1 declines by 22.7%, RWAincreaseby21.2%, on average.For Group 2banks, while thechange in thedefinition of capital resultsin a declinein CET1 of 25.9%, the new ruleson RWAaffect Group 2banksfar less(+6.9%), whichmay be explainedby the fact that thesebanks businessmodels are lessreliant on exposuressubject tocounterpartycredit risk and market risk (whichare themain driversof
  • requirementsis expected.theRWAincreaseunder the new framework).TheBasel III frameworkincludesthefollowingphase-in arrangementsfor capital ratios:- For CET1,the highest form of lossabsorbing capital, theminimumrequirement willberaisedto4.5% andwill bephasedin by1January2015.Deductionsfrom CET1 will be fullyphased in by 1January2018;- For Tier 1capital, theminimum requirement will be raised to6.0%andwill be phasedin by 1January 2015;- An additional 2.5% capital conservationbuffer abovethe regulatoryminimum capital ratios, whichmust be met with commonequity, after the application of deductions,will be phased in by 1January2019;and- Theadditional lossabsorbencyrequirement for G-SIBs, whichranges from 1.0% to 2.5% and must be met withcommonequity, after theapplicationof deductionsand asanextension of thecapital conservation buffer, will be phased in by 1January2019.Table3 and Chart 2 provide estimatesof the additional amount of capital thatGroup1andGroup2bankswouldneedbetween30June2011and1January2022tomeetthetarget CET1, Tier 1andtotal capitalratiosunderBaselIII assumingfullyphased-in target requirementsand deductionsasof 30June 2011.For Group 1banks,the CET1capital shortfall is €18 bn at a minimumrequirement of 4.5% and €242bn at a target level of 7.0%.With respect totheTier 1andtotal capitalratios, thecapitalshortfall comparingtothe minimum ratiosamount for €51bn and €128bn respectively.For Group 2banks, the CET1capital shortfall is €11bn at a minimumrequirement of 4.5% and €35bn at a target level of 7.0%.TheTier 1and total capital shortfall calculatedrelativetothe 4.5% minimumamount for €18and €22bn, respectively.Thesurchargesfor G-SIBs are a bindingconstraint for 12of the 13 G-SIBsincludedin this monitoringexercise.It shouldbementioned, that theshortfall figuresarenot comparable tothoseoftheEBA recapitalisationexercisesincethe capital definitionsand thecalculationof the risk-weightedassetsdiffer.Given theseresults,a significant effort by banksto fulfil the risk-based capital
  • 3. Impact of the new definition of capital on Common EquityTier 1As noted above, reductionsin capital ratios under the BaselIII framework areattributedin part tocapital deductionspreviouslynot applied at thecommonequitylevel of Tier 1capital.Table4 showsthe impact of variousdeduction categorieson the grossCET1capital (i.e. CET1 before applying deductions)of Group 1and Group 2banks.
  • In the aggregate, deductionsreducegrossCET1 of Group 1banksby37.2%with goodwill beingthemost important driver, followedby holdingsof capitalof other financial companies.Deductionsfor definedbenefit pension obligationsand provisioningshortfallsrelativetoexpectedlossestend tobe the largest contributorstootherdeductionsacrossmost countries.For Group 2banks, averageresultsare similar:CET1 deductionsreducegrossCET1by37.4%duein particular togoodwill, and again followedbyholdingsofcapital of other financial companies asthe second most important driver.However,it shouldbenotedthat theseresultsaredrivenbylargeGroup2banks(definedasthosewithTier1capital in excessof €3billion). Without consideringthesebanks,the overall declineof grossCET1duetodeductionswouldbe22.6%.Mortgageservicing rightsrelateddeductionshave no impact, for both groups.4. Changesin risk-weighted assetsReductionsin capital ratiosunder Basel III are alsoattributed to increasesinrisk-weightedassetsasshownin Table5for the followingfour categories:Definition of capital:Here wedistinguishthree effects:Thecolumn heading ―50/50‖ measurestheincreasein risk-weightedassetsapplied tosecuritisationexposurescurrentlydeducted under the Basel II frameworkthat are risk-weightedat 1250% underBaselIII.Thenegativesignin column―other‖indicatesthat thiseffectreducestheRWA.This relief in RWAismainlytechnical sinceit is compensated by deductionsfrom capital.
  • affect RWA by 2.2% each.Thecolumnheading―threshold‖ measuresthe increasein risk-weightedassetsfor exposuresthat fall below the10% and 15% limitsfor CET1deduction;Counterparty credit risk (CCR):This column measuresthe increasedcapital chargefor counterpartycredit riskand thehigher capital chargethat resultsfrom applying a higher assetcorrelationparameter againstexposurestofinancial institutionsunder theIRBapproachestocredit risk.The effects of capital charges for exposures to central counterparties (CCPs) orany impact of incorporating stressed parameters for effective expected positiveexposure (EEPE) are not included;Securitisation in the banking book:This column measuresthe increasein the capital chargesfor certain typesofsecuritisations(e.g. resecuritisations)in thebankingbook; andTrading book:This column measurestheincreasedcapital chargesfor exposuresheld in thetradingbook toincludecapital requirementsagainst stressed value-at-risk,incremental risk capital charge, and securitisationexposuresin the tradingbook (seesection 4.2 for more details).4.1. Overall resultsRisk-weightedassetsfor Group 1banks increaseoverall by 21.2% whichcan bemainlyattributed to higher risk-weightedassetsfor counterparty credit riskexposures(+8.0%), followedby changesduetothenew RWAtreatment ofcurrent Basel II 50/50capital deductions(+5.9%) and thenew trading bookrules (+4.2%).Themain driver behind thecapital chargesfor counterpartycredit riskis thechargefor credit valulation adjustments(CVA) while thehigher assetcorrelationparameter resultsin an increasein overall risk-weightedassetsofonly1.2%.For Group 2banks, aggregate RWAincreaseoverall by 6.9%. The smallerincreaserelativetoGroup 1banks isasexpectedsinceGroup 2bankstend tohavelessexposure tomarket riskand counterparty exposures.However,even for Group 2banks, CCR capital charges(2.9%) are the maincontributortothe changein RWAfor Group 2 banks.MovingBaselII 50/50deductionsto a 1250% risk weight treatment andincreasesin RWA attributableto itemsthat fall belowthe 10/ 15%thresholds
  • Chart 3 givesan indicationof thedistributionof theresultsacrossparticipatingbanksand illustratesthat the dispersionis much higherwithinthe Group 1bank sampleascompared toGroup 2 banks.4.2. Market risk-related capital chargesTable6presentsdetailsontheimpact oftherevisedtradingbookcapitalchargeson overall risk-weightedassetsfor Group 1banks.Group 2banks arenot presented separatelybecausethe market riskrequirementshave a very minor influenceon overall Group 2bankrisk-weightedassets. Some of thesebanksdonot have anytradingbooksat all and arethereforenot subject toanyrelated capital charges.Stressed VaR (2.1%), the incremental risk capital chargeor ―IRC‖(1.2%), and thecapital chargefor non-correlationtradingsecuritisationexposuresunder thestandardisedmeasurement method or ―SMM
  • non-CTP‖ (0.7%) are thethree most relevant driversbehind theincrease.Increasesin risk-weightedassetsare partiallyoffset by effectsrelated topreviouscapital charges(resultingfrom the event risk surchargeandpreviousstandardised or VaR-basedchargesfor the specific risk capitalrequirementsof securitisations), and thechangestopositionstreatedwith standardised measurement methods(column ―SMM‖).4.3. Impact of the rules on counterparty credit risk (CVA only)Credit valuation adjustment (CVA) risk capital chargeslead to a 7.8%increaseintotal RWAfor thesubsampleof 36bankswhichprovidedtherelevant data (6.8% for the full Group 1sample).Alargerfractionofthetotaleffect isattributabletotheapplicationof thestandardisedmethod thantotheadvanced method.Theimpactson Group 2 banksare smallerbut still significant, addingup toan overall 3.5% increasein RWAover a subsample of 57banks(2.3% for the full Group 2 sample), totallyattributableto thestandardisedmethod.Further details are provided in Table7.
  • 5. Leverage RatioAsimple,transparent, non-riskbasedleverageratiohasbeenintroducedin theBasel III framework in order toact asa crediblesupplementarymeasure tothe risk based capital requirements.It is intendedtoconstrainthebuild-up of leveragein thebankingsectorandtocomplement the riskbasedcapital requirementswitha non-riskbased ―backstop‖ measure.Fortheinterpretationoftheresultsoftheleverageratiosectionit isimportant tounderstand theterminology used to describe a bank‘sleverage.Generally, when a bank is referred to ashaving more leverage, or being moreleveraged, thisrefersto a multipleof exposuresto capital (i.e. 50times) asopposedto a ratio (i.e. 2.0%).Therefore,a bank witha high level of leveragewill have a low leverageratio. 155Group1andGroup 2banksprovidedsufficient datatocalculatetheleverageratio accordingto theBasel III framework.In total, aggregate Tier 1capital accordingto Basel III (numerator of theleverageratio) is €0.76trillion for Group 1bankswhile the total aggregateexposure accordingto the definitionof the denominator of theleverageratiois€27.69trillion.For Group 2banks, the corresponding figuresare €0.16trillion (Tier 1capital)and €4.59 trillion (total exposure).Toillustratethe impact of the new capital framework, a hypothetical currentleverageratiois shown assumingthe leverageratiowasalreadyin place.This hypothetical ratio is based on the current definition of Tier 1capital.It is important to recognize that the monitoringresultsmay underestimate theamount of capital that will actuallybe held by thebank over thenext few years.Thereason is asfollows. The Basel III capital amountsreported in thismonitoringexerciseassumethat all common equitydeductionsarefullyphasedin and all non-qualifying capital instrumentsare fully phased out.Thus,theseamountsceterisparibusunderestimatetheamount of Tier 1capitaland total capital under current rulesheld by banks astheydonot give anyrecognitionfor non-qualifying instrumentswhichareactuallyphased out over anineyear horizon.In thisexercise,CommonEquityTier 1,Tier 1capitalandtotal capital could bevery similar if all (or most) of thebanks‘Additional Tier 1and Tier 2instrumentsareconsiderednon-qualifying under Basel III.
  • As the implementationdate of the leverageratioapproaches, this will becomelessof an issue.With respect to the total sampleof banks, the averageBasel III Tier 1leverageratio is 2.8%.Group 1banks‘averageBasel III LR is 2.7% while for Group 2 bankstheleverageratiois significantlyhigher at 3.4%.Assuming full implementationof Basel III at 30June 2011, 41.3% of Group 1bankswouldmeet the calibrationtarget of 3% for the leverageratiowhile 80%wouldbe at or abovethe4.5% minimum requirement for therisk-basedCET1ratio.RegardingGroup 2 banks,71.6% show a leverageratioat or above thetargetlevel while 87% reported CET1 ratiosat or abovethe CET1minimumrequirement of 4.5%.Using Tier 1capital accordingto current rulesin thenumerator, the leverageratio is 4.1% for the total sample.For Group 1banksit is 4.0% (Group 2: 4.7%).Comparing the averageresultsfor Group 1and Group 2 banks, monitoringresultsindicatea positivecorrelation betweenbank sizeand the level ofleverage,sincetheaverageLR issignificantlylowerfor Group 1banks.Chart 4 givesan indicationof thedistributionof the resultsacrossparticipatingbanks.Thethick red linesshow thecalibration target of 3% while the thin red linesrepresent the 50th percentile19(the―median‖), ie thevalue separatingthehigherhalf ofasamplefromthelowerhalf (it meansthat 50% ofall observationsfall below thisvalue, 50% areabove this value).Theweightedaverageis shownas―x‖. For further information on themethodologysee section 1.2.
  • Table8 showsthe averageBaselIII leverageratiosand thecapital shortfallunder the assumption that banksalready fulfill therisk-basedcapitalrequirementsfor theTier 1ratioof 6% and 8.5%, respectively.Theshortfall istheadditionalamount of Tier 1capital that bankswouldneedtoraise in order tomeet the target level of 3% for theleverageratio (i.e. after therisk-basedminimum requirementshave been met).Assuming that bankswitha risk-basedTier 1ratiobelow6% wouldhave raisedcapital to fulfill theminimum requirement of 6%, 52% of Group 1banks and21%of Group 2banks wouldnot meet the calibrationtarget of 3% for theleverageratio.Theadditional shortfall related to the leverageratiorequirement wouldbe €95bn (Group 1) and €12bn (Group 2), respectively.Assuming that bankswitha risk-basedTier 1ratiobelow8.5% wouldhaveraisedcapital to meet the minimum requirement of 8.5%, 17% of both Group 1and Group 2bankswouldshow a leverageratiobelow the 3% target level.Theadditional shortfall wouldbe €17bn and €10bn for Group 1and Group 2banks,respectively.
  • 6. Liquidity1. Liquidity Coverage RatioOneof thenew minimum standardsis a 30-dayliquiditycoverageratio(LCR)whichis intended to promoteshort-term resiliencetopotential liquiditydisruptions.TheLCR hasbeen designedtorequire bankstohave sufficient high-qualityliquidassetsto withstanda stressed30-dayfunding scenario specified bysupervisors.TheLCR numerator consistsof a stock of unencumbered, high qualityliquidassetsthat must be availabletocover any net outflow,whilethe denominatoriscomprised of cash outflowslesscashinflows(subject to a cap at 75% of totaloutflows)that are expected to occur in a severestressscenario.157 Group 1and Group 2 banks provided sufficient data in the mid-2011 BaselIII implementation monitoring exercise to calculate the LCR according to theBasel III liquidityframework.TheaverageLCR is 71%for Group 1banks and 70% for Group 2banks.Theseaggregatenumbersdonot speakof therangeof resultsacrossthebanks.Chart 5below givesan indicationof thedistribution of bank results;the thickred lineindicatesthe100% minimum requirement, thethin red horizontal linesindicatethemedianfor the respectivebank group while themean value isshownas―x‖.34% of thebanksin thesamplealready meet or exceed theminimum LCRrequirement and 39% have LCRs that are at or above85%.
  • Forthebanksin thesample,monitoringresultsshowashortfall of liquidassetsof €1.15 t rillion (whichrepresents3.7% of the €31trillion total assetsoftheaggregate sample) asof 30June 2011, if bankswereto make nochangeswhatsoevertotheir liquidityrisk profile.This number isonlyreflectiveof the aggregate shortfall for banks that arebelow the100%requirement and doesnot reflect surplusliquidassetsat banksabovethe 100% requirement.Banks that are below the 100% required minimum have until 2015tomeet theminimum standard by scalingback businessactivitieswhichare mostvulnerable toa significant short-term liquidityshock or by lengtheningtheterm of their fundingbeyond 30 days.Banks may alsoincreasetheir holdingsof liquid assets.Thekey componentsof outflowsand inflowsare presented in Table9.
  • Group 1banksshow a notablylarger percentageof total outflows, whencomparedtobalancesheet liabilities,than Group 2 banks.This can be explained by the relativelygreater contributionof wholesalefundingactivitiesand commitmentswithin the Group 1sample, whereas,forGroup 2banks, retail activities,whichattract much lowerstressfactors,comprise a greater share of fundingactivities.Cap on inflowsTwoGroup 1and 21Group 2banks reported inflowsthat exceeded thecap. Of these, 7 fail tomeet the LCR, sothe cap is binding on them.Composition of highly liquid assetsThecomposition of high qualityliquid assetscurrentlyheld at banks isdepictedin Chart 6.Themajorityof Group 1and Group 2banks‘holdings, in aggregate, arecomprised of Level 1assets;howeverthe sample, on thewhole, showsdiversityin their holdingsof eligibleliquid assets.
  • WithinLevel 1assets,0% risk-weightedsecuritiesissuedor guaranteedbysovereigns,central banks and PSEs, and cash and central bankreservescomprisesignificant portionsof thequalifying pool.Comparatively, within theLevel 2assetclass, themajorityof holdingsiscomprised of 20% risk-weightedsecuritiesissued or guaranteedbysovereigns, central banksor PSEs, and qualifying coveredbonds.Cap on Level 2 assets€53billionof Level 2liquid assetswereexcludedbecausereportedLevel2assetswerein excessof the 40% cap.40banks currentlyreported assetsexcluded, of which80.0% (20.4% ofthetotal sample) had LCRs below 100%.Chart 7 combinestheaboveLCR componentsby comparing liquidityresources(buffer assetsand inflows) to outflows.Note that the€900billiondifferencebetweentheamount ofliquidassetsandinflowsandtheamount of outflowsandimpact ofthecap displayedin thechart issmaller thanthe€1.15trillion grossshortfall notedaboveasit is assumed herethat surplusesat onebank can offset shortfallsatother banks.In practice the aggregate shortfall in theindustry is likelytoliesomewherebetweenthesetwonumbersdependingon how efficientlybanksredistributeliquidityaround thesystem.
  • 6.2. Net Stable Funding RatioThesecond standard is thenet stablefunding ratio(NSFR), a longer-termstructural ratiotoaddressliquiditymismatchesand toprovideincentivesforbanksto usestablesourcesto fund their activities.156Group 1and Group 2banksprovided sufficient data in themid-2011BaselIIIimplementationmonitoringexercisetocalculatetheNSFR accordingtotheBasel III liquidityframework.37% of thesebanksalready meet or exceedtheminimum NSFRrequirement, with 70% at an NSFR of 85% or higher.TheaverageNSFR for eachof theGroup 1bank and Group 2samplesis89% and 90%, respectively.Chart 8 shows the distribution of resultsfor Group 1and Group 2 banks;the thick red line indicatesthe 100% minimum requirement, the thin redhorizontal linesindicatethemedian for the respectivebank group.
  • Theresultsshowthat banks in the samplehad a shortfall of stablefundingof€1.93trillion at the end of June 2011, if banks wereto make nochangeswhatsoevertotheir funding structure.[The shortfall in stablefundingmeasuresthe difference betweenbalance sheetpositionsafter theapplication of availablestablefundingfactorsand theapplication of required stablefundingfactorsforbankswherethe former is lessthan thelatter. ]Thisnumberisonlyreflectiveof theaggregateshortfall forbanksthat arebelowthe100% NSFR requirement and doesnot reflect any surplusstablefunding atbanksabovethe 100% requirement.Banks that are below the 100% required minimum have until 2018tomeet thestandardand can take anumber of measurestodoso,includingbylengtheningtheterm of their fundingor reducingmaturitymismatch.It should be noted that the shortfallsin the LCR and the NSFR are notnecessarilyadditive,asdecreasingtheshortfall in onestandard may result in asimilar decreasein the shortfall of the other standard, dependingon thestepstaken to decreasetheshortfall
  • 81AbbreviationsC-QISCCPsCCRCET1CRDCRMCTPCVADTAEBAEEPEGHOSG-SIBISGIRCLCRLRMSRNSFROBSPFEPSERWABasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.comquantitative impact studycentral counterpartiescounterparty credit riskcommonequity tier 1capital requirementsdirectivecomprehensive risk modelcorrelation trading portfoliocredit value adjustmentdefferedtax assetsEuropean BankingAuthorityeffective expectedpositive exposureGroup of Governorsand Headsof Supervisionglobal systemically important banksImpactStudy Groupincremental risk chargeliquidity coverage ratioleverage ratiomortgage servicing rightsnet stable funding ratiooff-balance sheetpotential future exposurepublic sector entitiesrisk-weighted assets
  • 82SMMVaRBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.comstandardised measurement-methodvalue at risk
  • 83Learning more about SupervisoryAgenciesBaFin - Bundesanstalt für FinanzdienstleistungsaufsichtBundesrepublik Deutschland (Federal Republic of Germany)Sinceit wasestablishedin May2002, the Federal Financial SupervisoryAuthority (Bundesanstalt für Finanzdienstleistungsaufsicht - knownasBaFin for short) hasbrought the supervisionof banks and financialservicesproviders, insuranceundertakingsand securitiestradingunderoneroof.BaFin isan independent public-lawinstitutionand is subject to the legalandtechnical oversight of the Federal Ministryof Finance.It is funded by feesand contributionsfrom the institutionsandundertakingsthat it supervises.It is thereforeindependent of theFederal Budget.OrganisationBankingSupervision, InsuranceSupervision and SecuritiesSupervision/ Asset Management are threedifferent organisational unitswithinBaFin – theso-calledDirectorates.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 84InternationalThelargenumberofplayersoperatingontheglobalfinancialmarketshasbeen increasingsteadily for many years now.Even though there isnolegal framework that is bindinginternationally, marketsare still expandingacrossborders.Financial supervision, however, is still largely inward-looking, sincesovereignpowersusuallyend at thenational border.FunctionsBaFinoperatesinthepublicinterest.Itsprimaryobjectiveistoensuretheproperfunctioning,stability andintegrityoftheGermanfinancialsystem.Bank customers,insurancepolicyholdersand investorsought to be abletotrust the financial system.BaFinhasover 1,900employeesworkingin Bonnand Frankfurt am Main.Theysupervisearound 1,900banks, 717financial servicesinstitutions,approximately600insuranceundertakingsand 30 pensionfundsaswell asaround 6,000domesticinvestment fundsand 73 assetmanagement companies (asof March2011).Under itssolvencysupervision, BaFin ensuresthe abilityofbanks,financial servicesinstitutionsand insuranceundertakingstomeet their payment obligations.Through itsmarket supervision, BaFin alsoenforcesstandardsofprofessional conduct whichpreserve investors trust in thefinancialmarkets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 85As part of its investor protection, BaFin alsoseeksto preventunauthorisedfinancial business.Legal basisBaFin‘s By-Laws represent amajor set of preceptsfor how it acts.Theycontain regulationsgoverningits structure and organisationand itsrightsand obligations.Theyalsogovern thefunctionsand powersof BaFin‘s supervisorybody, itsAdministrative Council (Verwaltungsrat), and details of itsbudget.BaFin alsobasesthewayin whichit carries out itssupervisoryactivitieson theMissionStatement it gaveitselfshortly after it wasestablished.According to this MissionStatement, BaFin‘sfunctionis tolimit riskstotheGerman financial system at both thenational and international levelandtoensurethat Germanyasa financial centre continuesto functionproperlyand that itsintegrityispreserved.As part of the Federal administration, BaFin issubject to thelegal andtechnicaloversight of the Federal Ministryof Finance, withtheframeworkof whichthe legalityand fitnessfor purpose of BaFinsadministrativeactionsare monitored.BaFin TextSolvency IIAmong other things, SolvencyII – theproject to reform the Europeanlegal frameworkfor insurancesupervision – harmonisesthe solvencycapital requirementsfor insurancefirmsand groups.Followingtheadoption of the SolvencyII Directivein November2009, the focusin 2010wason developing the implementingmeasuresthat are Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 86tobe adoptedand on performing the fifth quantitativeimpact study(QIS5).It is currently planned to make the initial amendments to the Solvency IIDirective at the end of 2011byway of the OmnibusII Directive, for whichtheEuropean Commission presented a proposalon 19 January 2011.This containsamendmentsto twokeyareasof legislation.Firstly, it amendsdirectivesgoverning insuranceand securitiesprospectusestoreflect the new EU ruleson financial market supervisionand in particular thenew EU financial supervisory authoritiesthat beganworkon 1January 2011.For example, EIOPAis incorporatedintotheSolvencyII DirectiveasthesuccessortoCEIOPS.Provision is alsomadefor the bindingsettlement of disputesby EIOPA.Secondly, theproposalcontainsamendmentstotheSolvencyII Directive.Forexample,theDirectiveprovidesfortheimplementationofSolvencyIItobe postponedby twomonthsuntil 1January2013.TheOmnibusII Directivealsoenablesthe European Commission tospecify transitional requirementsfor individual elementsof theFrameworkDirective, withdifferent maximum transition periodsbeingset for each area.TheOmnibusII Directiveis of considerablesignificancefor thecontinuing evolution of Solvency II.For technical reasons,the European Commission cannot present theofficial draft of the SolvencyII implementingmeasuresuntil after theOmnibusII Directive hasbeen adopted.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 87TheOmnibusII Directivewill thereforehave a significant influenceontheongoing workon theimplementingmeasures.Implementing measuresTheSolvencyII DirectivegivestheEuropean Commission theauthoritytoadopt implementingmeasuresfor particularareas.Theseareintended toadd detail tothe Directiveand henceimprove theharmonisation and consistencyof supervisionin Europe.In spring 2010,CEIOPSsubmitted itsproposalsin this areatotheCommission, whichat the end of 2010presented an initial informal fulldraft of the implementingmeasuresbased on theproposals.In 2011, thisdraft will be discussedfurther withthe member states, withspecific considerationbeing given tothefindingsof QIS5.Theofficial draft of the SolvencyII implementingmeasureswill not bepresentedby theCommission and discussedwiththeCouncil and theParliament until after the OmnibusII Directivehasbeen adopted.Impact studiesTheQIS5studyconductedbytheCommissionintheyear underreviewisbased on the SolvencyII Directiveand reflectstheimplementingmeasuresdeveloped up until that time.Theobjectivewasto test thequantitativeimpact of SolvencyII in detail.Europeaninsurancefirmsandgroupswereaskedtotakepart in thestudybetweenJulyand November 2010.Theresultsreceivedfrom solofirms wereinitiallyevaluated by thenationalsupervisoryauthorities,whilethedatareceivedfrom groupswereanalysed by CEIOPSor EIOPA.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 88All resultsand findingswereincorporatedintoa European report, whichEIOPA presented to theCommission in March2011.In addition, BaFin published a national report.Theresultsof thestudywill have a major influenceon the discussionregardingtheSolvencyII implementingmeasuresGuidelines for supervisorsIn future, the provisionsof the Directiveand theimplementingmeasuresadopted by the European Council and theEuropean Parliament will becomplementedbyguidelinesfor supervisorsadoptedbyEIPOA, withtheaim beingtofurther harmonise supervisory practice in Europe.Thefour existingCEIOPSand EIOPAworkinggroupsbegan workontheseguidelinesin the year under review.In addition, EIOPAwill develop bindingstandards(on thedesign of theyield curve, for example).Oneof theworkinggroups, the Financial RequirementsExpert Group(FinReq), hasthreeareasof work:capital requirements(SCR/ MCR), thestatement of technical provisionsand own funds.Among other things,it hasdrawn up initial proposalsfor guidelinesrelatedtothe procedure tobe followedfor the approval ofundertaking-specific parametersfor usein calculatingthe solvencycapital requirement and the recognitionof ancillaryown funds.In cooperation with the Groupe Consultatif, a forum of Europeanactuarial associations, it is also developing actuarial standards forcalculatingtechnical provisions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 89TheInternal Governance,SupervisoryReview and Reporting ExpertGroup (IGSRR) is responsiblefor the requirementsfor publicdisclosureand supervisory reportingby undertakings,capital addonsand thevaluation of assetsand liabilities,and isdeveloping guidance forsupervisorsonwhat thesupervisoryprocessmaylooklike underSolvencyII.In doing so, it isfocusingspecificallyon the evaluation of theownriskand solvency assessment (ORSA) and the templatesfor future reportingtosupervisors.On a closelyrelatedtopic, consideration is beinggiventohow and whichdata may in future be exchanged electronicallybetween nationalsupervisoryauthoritiesand withEIOPA.In 2010, the Internal Models Expert Group (IntMod) developed guidanceon the use test and on calibration, showing supervisors and the insuranceindustryhow theycan fulfil thefuture requirements.TheGroup alsodrew up general guidelineson hitherto less-discussedtopics, such asthe inclusion of profit and lossattribution in the internalmodel.Thefourth CEIOPS/ EIOPAworking group, the InsuranceGroupsSupervisionCommittee(IGSC), is drawingup guidanceon practicalcooperation in the collegesand in coordinatingmeasures.Theworkinggroup isalsodevelopingharmonised approachesforidentifying, reportingand assessingrisk concentrationsand intragrouptransactions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 90Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 91Thematic review on risk governanceQuestionnaire for national authoritiesTheglobal financialcrisishighlighteda number of corporategovernancefailures and weaknessesin financial institutions,includinginappropriateBoard structuresand processes,weakriskgovernancesystems, andundulycomplex or opaque firm organisational structuresand activities.Many of theseshortcomingshavebeen highlightedand documented invariousreportsthat have been issuedsince2008.TheOctober 2011FSBSupervisoryIntensityand Effectiveness(SIE)progressreport totheG20 notesthat much progresshasbeen made incorporategovernance at both the supervisoryand firm levels,particularlyfor SIFIs.However, effective risk appetite frameworks that are actionable andmeasurable by both firms and supervisors have not yet been widelyadopted.TheSIE report concludesthat more intensesupervisoryoversight isneeded to evaluatethe effectivenessof improved governance, particularlyrisk governancethat is critical to ensuringa strong risk managementculturein firms.Thereport recommendsthat theFSBconduct a thematic review on riskgovernanceto assesspracticesat firms, focusing on the risk committeesof executiveBoards, aswell asthe risk management functions(e.g. theChief Risk Officer organisation) and independent assessment functions(e.g. theChiefAuditor function), and on how supervisorsassesstheireffectiveness.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 92In light oftherecommendationof theSIE report, andtheimportanceandcross-sectoralnature of thetopic, the FSB Standing CommitteeonStandardsImplementation(SCSI) agreed, in itsconferencecall on 10November 2011, to undertake a peer review on risk governancein early2012.SCSI members alsoagreed that the peer review wouldonlycover banksandbroker-dealers;insurersand other non-bank financial institutionswouldnot be covered.There is currentlynosinglecomprehensiveset of principlesandstandardsthat fullyaddressand integratecorporate and risk governancerequirements.Thereview thereforewill not assesscompliancewithany specificstandard, but will use existingstandardsand recommendations(asappropriate) in order to evaluate progressaswell asidentify goodpracticesand remaininggapsin firms‘risk governance frameworks,andin theassessment of those frameworksby supervisoryauthorities.Theprimary source of information for the peer review will be theresponsesprovided tothisquestionnaire, and a questionnaire for firmstobedeveloped in March.Thepeer review will focus on the rolesand interplay betweenthe firm‘sBoard members that oversee risk management, the enterpriseriskmanagement functionand relevant aspectsof theprocessfor assessingtheriskgovernanceframework,processesand practices, either byinternalaudit or by third parties(e.g. external auditors, consultants).In particular, thepeer review will focuson:Board responsibilities and practicesTheBoard isresponsiblefor ensuringthat thefirm hasan appropriaterisk governanceframework given the firm‘s businessmodel, complexityand size.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 93How Boardsassumesuch responsibilitiesvariesacrossjurisdictionsandfor the purposesof this report, the risk committeereferstoa specialisedBoard committeeresponsiblefor advisingthe Board on the firm‘s overallcurrent and futurerisk appetiteand strategy, and for overseeingseniormanagement‘simplementationof that strategy.Risk management functionTheindependent risk management function is responsiblefor the firm‘sriskmanagement frameworkacrosstheentire organisation, ensuring thatthefirm‘s risk meetsthedesired risk profile asapproved by theBoard.Therisk management function is responsiblefor identifying, measuring,monitoring, recommendingstrategiestocontrol or mitigaterisks,andreporting on risk exposures.Independent assessment of the risk governance framework byinternal audit and third partiesTheindependent (e.g. from the businessunit and risk managementfunction) assessment of thefirm‘s risk frameworkplays a crucial roleintheongoing maintenanceof a firm‘s internalcontrol, risk managementand risk governance.It helpsa firm accomplish itsobjectivesby bringinga systematic,disciplined approach to evaluateand improve the effectivenessof riskmanagement, control and governanceprocesses.This may includeinternalprocesses,such asinternal audit, or externalprocessessuchasthird partyreviews(e.g. externalauditors,consultants).FSB member jurisdictionsare requestedtoprovidea consolidatednationalresponsetothequestionnaire,whichshouldincludedescriptionsof differenceswheretheseexist in oversight of riskgovernancewithinthejurisdiction(e.g. for banksvs. broker dealers,based on thesize, businessBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 94model, complexityof the firm), witha particularemphasis on anyframeworkor behaviouralchangesthat have occurred sincethe crisis.In order to limit the burden on FSB members and to avoid unnecessaryduplication of information collection efforts, authorities can attach linkstorelevant documents(whereavailable in English).Feedback should besubmittedby 11May 2012to fsb@bis.orgunder thesubjectheading ―FSB Thematic Peer Review on Risk Governance.‖Individual submissionswill not be made public.National authorities‘ approachtowardrisk governanceoversightPlease describe your jurisdiction‘s overall approach to assessing firms‘risk governance frameworks (e.g. legislation, regulation or supervisoryguidance)?Pleaseprovide linkstorelevant documents.Has your jurisdictionevaluated whethersuch guidanceis consistent withtheBCBSor OECD principleson corporate governance or otherrecommendationsprovided by the industry?How doesyour jurisdictionassessalignment or implementationof anylegislation, regulationor supervisoryguidancein the area of riskgovernance?How does your jurisdiction determine that your significant financialinstitutions have effective risk governance frameworks, policies andpractices?Pleasebrieflydescribewhetherfirmsin your jurisdiction have madechangesin responseto increasedsupervisoryand regulatoryoversight ofrisk governance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 95In addition, pleaseprovide examplesof any material changesin theeffectivenessof firms‘risk governance practicesover the lastfew years(e.g. decisionsregarding whether toreduce/ increasecertain businessactivitiesbased on the Board‘srisk strategy).During theglobal financial crisis,werethere weaknessesin youroversight of risk governancethat became apparent?Pleasesummariseanyinitiativesplannedtostrengthenyour jurisdiction‘soversight of firms‘risk governancepractices.Doesyour jurisdictionregularlyreviewwhetheryoursupervisory, regulatoryand enforcement authoritiesare sufficientlyresourced, independent and empoweredtodeal withrisk governanceweaknessesthat have been identified?Doesthisreviewincludean assessment of inter-agencyaswellasinternalcommunicationand decision-makingprocesses?Doesyour jurisdictionhavededicatedteamsof qualified personneltoassessfirms‘risk governance frameworks,or is oversight of riskgovernanceembeddedwithin other risk oversight functions(e.g.operational, market or credit risk)?What regulatory and supervisorytoolsare available in your jurisdictiontoincentivisefirmsto remediatedeficiencieswithintherisk governanceframework(e.g. restrictionson activities,capital charges, fines)?Pleasedescribeanyregulatory or supervisoryactionstaken toincentivisefirmsto remediateweaknessesand the firm‘s responses(if possiblein awaythat respectsnational confidentialityrules).How are relevant internalcontrol weaknessesand other significantinternalcontrol deficienciesfactored intotheassessment of riskgovernanceframeworks(e.g. a control deficiencythat allowssignificantunauthorisedtrading activities)?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 96Pleasedescribeanybilateral effortsinitiatedby supervisorsin otherjurisdictionsregardingthe supervisionof risk management policiesandpractices.Pleaseindicateinstanceswheresupervisoryworkplanshavebeen impacted asa result of thosemeetings.Board responsibilities and practicesRiskcommitteerefersto aspecialisedBoard committee responsibleforadvisingtheBoard on thefirm‘soverall current and future risk appetiteand strategy, and foroverseeing senior management‘s implementation ofthat strategy.Riskcommitteescomprisingmanagement membersthat residebelowtheBoard level (e.g. withinbusinessunits,management committees) donot fall in this definition.Dosupervisoryrequirementsor expectationsexist concerningthe roleand responsibilitiesof the Board for risk governance?If so, how have theserequirementsor expectationsbeen established (e.g.legislation, regulation, supervisoryguidance)?Dosupervisoryrequirementsor expectationsexist concerningthe roleand responsibilitiesof the risk committee?If so, how have theserequirementsor expectationsbeen established(e.g.legislation, regulation, supervisoryguidance)?Dosupervisoryrequirementsor expectationsexist concerningthegovernanceof the Board‘sown practices(and wheretheyexist, thepracticesof anyrelevant sub-committees)?If so, how have theserequirementsor expectationsbeen established (e.g.legislation, regulation, supervisoryguidance)?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 97Dosupervisoryrequirementsor expectationsexist concerningtheinformation that Boards (or any relevant sub-committees) are supposedtoreceive, or abletorequest, from the firm (e.g. CRO, risk managementfunction) and/ or third parties (e.g. external auditors,consultants)?If so, how have theserequirementsor expectationsbeen established (e.g.legislation, regulation, supervisoryguidance)?How doesyour jurisdictionassesswhethersupervisoryexpectationsorrequirementsconcerning the Board‘s responsibilitiesand practices(includingthe Board‘s useof sub-committees)are achievingdesiredoutcomes?Risk management functionDoesyour jurisdictionrequire firmsto haveanindependent seniorexecutive(e.g. a Chief RiskOfficer or equivalent) withdistinctresponsibilityfor therisk management function and the firm‘scomprehensiverisk management frameworkacrossthe entireorganisation?How doesyour jurisdictionassessthe stature, authorityandindependenceof theCRO (or equivalent) and the risk managementfunction?Pleaseoutlinewhat criteria areconsideredin your jurisdictionwhenassessingthe stature, authorityand independence.How doesyour jurisdictionevaluatethe qualificationsof theCRO andrisk management personnel?How doesyour jurisdictionevaluatethe hiringand performanceevaluationprocessof the CRO?What is your jurisdiction‘sapproach to regularlyassessingfirms‘overallrisk management policiesand practices?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 98How doesyour jurisdictionassessfirms‘implementationof effectiveriskappetiteframeworks?Are riskmeasuresclearlydefined, actionableandeffectivein enablingthefirm topursue itsstrategic objectivesand maintain the riskprofile assetout in the risk appetiteframework?Is the riskappetiteassessed globally, or for each type of risk (e.g.credit, market, liquidity, operational)?How doesyour jurisdictionregularly assessthe adequacyof firms‘riskmanagement resources(e.g. number, quality, effectiveness)?Doesyour jurisdictionreview the ―ownership‖ and accountability of riskmanagement resources?How doesyour jurisdictionassessthe roleand effectivenessof firms‘riskmanagement processfor(i) Approval of new productsand material modificationstoexistingones;(ii) Strategicplanning;(iii) Changesin systems, processes, businessmodels; and(iv)Majoracquisitions?What workhasbeen undertakenin your jurisdictiontoassesstheadequacy, timeliness,and independenceof information prepared byriskmanagement and providedtosenior management and the Board (or anyrelevant sub-committee)?How doesyour jurisdictionevaluatethe type and nature of risk reportingtothe Board (or anyrelevant sub-committee)?Doesit includeBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 99(i)themanner in which information is compiled;(ii)what thedecision-makingprocessis for informationtobeincludedintheBoard reporting; and(iii)who/ what part of the firm isresponsiblefor compiling this material?Doesyour jurisdictioncollect standardisedinformation from firmsoncertainrisk areasto(i) Compare firms‘acrossrisk dimensions;(ii) Identify the needtoinitiatepossiblesupervisory reviews;or(iii) Update supervisoryrisk management expectations?Doesyour jurisdictionassessthe effectivenessof firms‘forward-lookingstresstests, scenario analysis, contingencyarrangements,recoveryplans(e.g. raisingcapital or reducingexposures) and resolution plans(if any).If so, what criteria are used in this assessment?How does your jurisdiction incorporate market and macroeconomicconditions, cross-sectoral developments as well as changes in firms‘business and risk profile into your evaluation of the adequacy of riskmanagement and itsability torespond tochangingcircumstances?Towhat extent are therequirementsfor the riskmanagement functionadaptedto firm characteristics,suchassize, complexity, businessmodeland systemic importance?Assessment of the riskgovernanceframeworkDoes your jurisdiction require internal audit functions at firms to assessthe firm‘s risk governance framework at the enterprise level, legal entitylevel, and/ or for thelargest revenue-generatingbusinessunits?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 100If so, are therequirementsspecified in legislation, regulationorsupervisoryguidance?What aspectsof therisk governanceframeworkare internal auditorsorother internal functions(if independent) expectedtoassess?Are supervisoryrequirementsand expectationsspecified inlegislation, regulation or supervisoryguidance?Doesyour jurisdictionallowtheuseofthird parties(e.g. externalauditorsor other experts) toprovide an independent assessment of firms‘riskgovernanceframeworks?If so, doesyour jurisdictionimposeany limitationson certainaspectsofinternalaudit‘s responsibilitiesthat can be directedtowardthird parties(e.g. outsourced)?Are supervisoryrequirementsand expectationsspecified inlegislation, regulation or supervisoryguidance?What aspectsof therisk governanceframeworkare external expertsexpectedto assess?Are supervisoryrequirementsand expectationsspecified inlegislation, regulation or supervisoryguidance?Are internal audit reports, prudential reports, and/ or external expertreportsmonitored aspart of the supervisionof a firm‘s risk governanceassessment process?If so, pleasedescribe thetypes of reportsand frequencyof review.How doesyour jurisdictionevaluatethe qualificationsof theinternalauditorand internalaudit personnel?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 101How doesit evaluatethehiring and performance evaluation processofthechief auditor(or equivalent)?Where relevant, is thisevaluationprocessalsoapplied tothird parties?How doesyour jurisdictionconduct assessmentsof the governance offirms‘risk management at the enterpriselevel (e.g. through on-siteinspections,off-sitemonitoring, standard reportingmechanisms,supervisorycolleges)?Are escalation processesin placeto facilitate thecommunication ofspecific situations/ behavioursby individualswithina firm tothesupervisor(escalation processand/ or whistle-blowing)?Doesyour jurisdictionmonitor firms‘remediationof weaknessesidentifiedby the independent assessment of risk governancefunctions?If so, is themonitoring embedded in thesupervisoryprocessor based onfirms‘progressreports?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 102The Cayman IslandsMonetaryAuthority (CIMA) and theUnited StatesSecuritiesand Exchange Commission (SEC) haveentered into a memorandum of understanding (MOU)Theagreement concernsconsultation, cooperation and informationexchangerelated to thesupervisionand oversight of regulated entitiesthat operate on a cross-borderbasisin the USAand the Cayman Islands.TheMOU supplementstheInternational Organisation of SecuritiesCommissions(IOSCO) multilateral MOU on cooperation in securitiesregulation, to whichboth theSEC and CIM Aare signatoriesand whichfocusesmoreoncooperationonenforcement mattersbetweentheparties.TheCayman IslandsPremier and Ministerresponsiblefor Finance, theHon. McKeevaBush, OBE, JP,congratulatedCIM Aon theagreement.He commented:―ThroughthisMOU, CIM Ahasdemonstrated itscommitment tocontinuing to work with theSEC to fulfill their respectiveregulatorymandates.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 103It shows, too, the commitment of the Cayman Islandsto providingthehighestqualitydomicile for financial services.Thesigning of this MOU addsto thegrowinglist of internationalregulatoryand supervisorybodieswithwhichtheCayman Islandshasenteredagreementsand isa keyendorsement of our financial servicesregime.We are convincedthat this is not only good for ensuringstabilityandintegrityof the global financial system, but is good for businessfor thisjurisdiction.‖Mrs.Scotland explainedthat theprocessof negotiatingthe latestagreement wasenhanced by thesolid tiesthat thetwoauthoritieshaveestablished over time:―CIMAand the SEC have had a strong workingrelationship for manyyears. This hasenabledustocollaborateon several levels.For example, wehave been able toobtain informationfrom, and provideinformationto, theSEC that hasbeenvaluablein both regulators‘routinesupervisoryactivitiesaswell as, on occasion, in criminal investigationsthat have resulted in convictions.We have conducted joint on-site inspections of Cayman-regulated fundsand securities entities, and have worked together to provide training forCayman and regional regulators. ‖TheCIMA-SEC MOU is the 23rd cooperation and information exchangeagreement that CIM Ahaseffected withoverseasregulatoryauthoritiessince1998.CIMA‘s Chairman, Mr. George McCarthy, OBE, JP, said: ―theMonetaryAuthority iscommittedtocollaborationand cooperation withfinancialservicesauthorities in all the jurisdictionswithwhichCayman-regulatedentitiesdobusiness.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 104In additiontotheagreementsthat CIMA alreadyhasin place,weactivelyseek toformalise cooperationwith other regulators. This MOU withtheSEC is particularlyimportant asCayman is a major domicilefor hedgefundsand securitiesin whichUS institutionsand personsof high networthinvest. It will enablemore effectivesupervisionon both sides.‖TheMOU details the scope of consultation, cooperation and informationexchangebetweenCIM Aand the SEC; the proceduresfor carrying outon-siteinspectionsand for theexecution of requestsfor assistance;thepermissibleusesof information provided;the confidentialityofinformation, and theprocessfor onwardsharing of information in certaincircumstances.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 105Mario Draghi:Remarks at theAnnual Reception of theAssociation of German BanksSpeechby Mr MarioDraghi, President of theEuropean Central Bank, at theAnnualReceptionof theAssociation of GermanBanks, Berlin, 26 March2012Ladies and Gentlemen,I wouldlike totake this opportunitytoprovideyou withmy assessment of the current situationin theeuro area and shed light on recent signsof improvementsin theoverall outlook.I wouldparticularlylike to draw your attention tothe effectivenessof thepolicy measuresimplementedby the Eurosystem, theEU institutionsandnational authorities.And to remind you of the measuresthat weall must continueto pursueover the coming monthsand years withgreat diligencein order tocontinueon thispath of stabilisation.Thecurrent economic situationAsthisaudienceknowsverywell, in November lastyear, theprospectsfortheeuro area financial sectorwerevery bleak.Banks wereexperiencinga period of heightened stress.Theinter-bank market wasclosed except tothestrongest institutionsinthesafest countries, and fundingmarketswereimpaired.Unabletoraisefundsbeyond shortmaturities,manybankswerereducingmedium term lendingtothereal economy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 106At the same time came therequirement toincreasecapital ratiosto9%.This increasedthe risksof substantial deleveraging, includingtherisk ofbankscuttingback on loans,notablythoseto small and medium-sizedenterprises.We could seethe intensityof thedeleveragingpressuresin bank lendingsurveys and other data.In the fourth quarter of 2011, there wasa significant tighteningof creditstandardson loanstoboth companiesand households.There wasnodoubt that the euro area wason thebrink of a major creditcrunch, withpotentiallyadverse consequencesfor theeconomy andemployment.At that time, many observershad littleconfidencein thecapacityof theeuroarea toreversethesituation.Yet today, onlyfour monthson, thepicture looksdifferent.There aresignsof stabilisationin both financial marketsand overalleconomicactivity– albeit still at lowlevels.Conditionsin bank fundingmarketshave improved.For example, euroareabankshavealreadyissued about 70billion euroinseniorunsecured debt sofar thisyear, whichis well above the amounttheyissued in thewholesecond half of 2011.Banks aremeetingtheir new capital requirements. The capital planssubmittedtothe European BankingAuthority (EBA) indicateanintentionto exceed the benchmarksby more than 20%.EBA hasalsoconfirmed that there will be no stresstest this year.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 107Bank lendingis alsostabilising. Banksare starting to assesstheirfinancial situationmore positivelyand in many casestheir willingnesstomake loansis increasing.How hasthe picturechanged soclearlyin only four months?There aretwoparts to the answer.First, the doomsdaypredictionswerealwaysexaggerated. Not becausethesituation last November wasnot very serious.But becausethe willingnessof euro area authoritiestotakethemeasuresnecessarytorestorestability wasgreater than many commentatorsrealised.Second, euro area authoritieshaveproved their commitment tosafeguardingfinancial stabilitythrough a number of important policymeasures.TheEurosystem, the EU institutionsand national authoritieshave allplayed a rolein constructing a comprehensive and coherent responsetotheeconomic, financial and fiscalchallengesthat weface.Let me now explain the keyelementsof this responsein more detail.Thepolicy response of the EurosystemTheprimary explanationfor the improvement in sentiment over the lastfew monthshasbeen the measurestaken by theEurosystem – that is, weat the European Central Bank (ECB) and our colleaguesat thenationalcentral banksof the17countriesthat share the euro.Asyou know,sinceDecemberlastyear theEurosystem haslaunchedtwolong-term refinancingoperations– LTROs – with a maturityof threeyears.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 108While thetotal liquidityrequestedbybanksintheseoperationsamountedtoaround 1trillioneuro, thenet liquidityinjectionbytheEurosystem hasbeen around half a trillion eurobecause theother half hasbeen shiftedover from other operations.Let me beclearabout whyweimplementedthethree-yearLTROs.It wasnot tosupport sovereign debt markets.It wasalsonot tobolster bank profits.TheLTROs werespecificallydesignedtoprevent a credit crunch thatcould compromise themaintenanceof price stabilityin the euro area.With funding marketsclosed, banksneeded liquidityassuranceover themedium term toavoid pre-emptivedeleveragingandtocontinuelending.Tounderstand whytheseoperationswerenecessaryrequires a euro areawideperspective.It wouldbe misleading to judgethe urgencyfor action – or thenecessaryresponses– basedon thesituation in any one country or groupsofcountries.TheEurosystem actsin theinterestsof the euro area asa wholewith330millioncitizens.Thisistheperspectivethat alwaysinformsour decisions.Someobservershave raised questionsabout theseoperations.Thequestionstend tofall intothree categoriesand sincetheytouch onfundamental issues,I wouldlike tospend a moment respondingtothem.First, some wonderwhetherthere is reallyany transmission from theLTROstothe real economy.Theargument goesthat banks are simplytakingcheap liquidityandsettingup carry tradesor putting the liquidityback intoour depositfacility.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 109Thefactsshow that thisis an incompleteview.Over 800banksparticipatedin the FebruaryLTRO, compared witharound 500 in December. Thisnumber included 460banksfromGermany, most of them – literallyhundreds– being smaller banks.I cannottell you namesofthetownsand villagesinwhichthesebanksarelocated becauseoften theyare the onlybank in town and could be easilyidentified. But I can tell you this: that themoney is now closer tosmalland medium-sizedenterprisesthan it wasbefore.We cannot saythat this money will necessarilygotothesesmallerenterprisesbut it iscertainlyveryclosetothem.We have thisin mind becausenearlythreequartersof corporateemployment in theeuro area is in the small and medium-sized businesssector.ThebanksI am talkingabout areoneswhosemain businessislendingtotheMittelstandand therebysupportingthe real economy.It is alsonot accurateto claim that banksare returning the liquiditystraight back to theEurosystem.We know that banks using the deposit facility arenot identical to thoseborrowingfrom theEurosystem.This impliesthat even though thebulk of the liquidityis returnedeventually, it is beingdirected withinthe banking system asintended.Thesecond categoryof questioninvolvesconcernsthat somehaveexpressedthat the Eurosystem is exposingitself to excessiverisks.Criticspoint in particular tothedifferentiatedcollateral frameworkadopted by some national central bankstoallowbanks toparticipateinthethree-year LTROs.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 110Let me underscore that high haircutsare applied to theadditional creditclaims soasto ensure risk equivalencebetweenthiscollateral and theregular framework.Moreover,the main elementsof the riskmanagement frameworkappliedare common: theeligibility criteria and risk control measureswereapproved by the GoverningCouncil, and the Council will monitor theeffectivenessof the risk control framework on an ongoing basis.Hence, there is onlylimitednational discretion.I shouldalsoemphasisethat theEurosystem hasa longexperiencein theacceptanceof credit claimsin itscollateral framework.Moreover,the Eurosystem is being verycareful to manageany risksthatmay ensue from our current operations.We employa conservativerisk management framework.On the additional collateralpresented sofar, theaveragehaircut is53%.This meansthat on a nominal valueof 100euroweprovide 47 euroofliquidity.This showsyou how prudently such collateral is accepted.If over time the market valueor qualityof the collateral postedweretodecline, counterpartieswouldhavetoprovideadditional collateral orreturn part of the liquidity.This tooservestoprotect thefinancial soundnessof theEurosystem asawhole.Thethird kindofquestioncomesfromsomeobserverswhoworrythattheliquiditycreated by the LTRO will lead toinflationor asset pricedistortions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 111Here it isimportant todistinguishbetweendifferent conceptsofliquidity.We wouldexpect an impact on inflationand asset pricesonlyfollowingasustainedand strongincreasein moneyand credit – not followinganincreasein central bank liquidityper se.The tentative signs we are seeing of a stabilisation in money and creditgrowth do not signal increasing inflationary pressures over the mediumterm.For example, growthin monetary aggregatesremainsat lowlevels,withM3 increasingby 2.5% in January 2012, wellbelow theaveragegrowthrate of M3 in monetary union sofar, whichwas5.9%.Thesameistrueof thecounterpartsof M3 – loanstotheeuroareaprivatesectorincreasedby only 1.5% in January, compared with an averageof6.8% sincethe start of the euro.Market indicatorsof inflation expectationsoverall show no signsofinflationaboveour medium-term objective.Investorsoverall assumeabreak-eveninflationratein fiveyearsofaround1.7%.Looking further out at the inflation expectationsbetweenfive years andtenyears alsoshowsthat, adjusted for theusual risk premia, marketexpectationsof long-term inflationarefullyconsistent with our definitionof medium-term pricestability.Moreover,theEurosystem hasa rangeof tools at itsdisposaltoabsorbexcessliquidityif that is deemed necessaryin the future.Availabletoolsincludeincreasesin reserverequirementsand theconductof liquidityabsorbingoperationsincludingnot only short-term but alsolonger-term deposits.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 112Hence, there are toolsand theGoverning Council can usethem asneeded.Moreover,our balancesheet hasgrownand shrunk in thepast withoutcreatinginflation– for example, this wasevident over the courseof both2009and 2010.In other words,weare constantlyalert tothreatstomedium-term pricestability.Euro area citizenscan be certain that our objectiveisdeliveringpricestability over themedium term – and that wehaveall the necessarytoolstoachieveit.Theconsistent strong anchoringof inflation expectationsconfirmsthatour commitment is credible.Let me addressonefinal issue, and this concernsthedebatein thiscountry about Target2balances.It is important that this debate isframed correctly – in particular, bydistinguishingbetweensymptoms and causes.Target2isapayment system that reflectstheflowoffundswithintheeuroarea.ImbalanceswithinTarget2are a symptom of real and financialimbalancesbetweeneuro area countries.Restoring normality within Target2 requires not that we address thesymptom – the payment system – but that we addressthe cause: theunderlying imbalances.This is not the task of monetarypolicy. It is the taskof the nationalauthoritiesand EU institutionsthat are responsiblefor fiscal,economicand financial policies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 113Important progress has been made in recent months to strengthen thecredibility of these policies – and this has been recognised by financialmarkets.This is thesecond explanationfor the overall stabilisationwehavewitnessedsinceNovember – and it is somethingto which I will now turnbriefly.Policy responsesat the national and EU levelThesignature at thelast European Council of the InternationalTreaty, includingthe fiscal compact, isan important signal ofcommitment toreducingdeficit and debt levels.Enshriningbalanced budget rulesin national legislationcreatesa new―first lineof defence‖ againstfiscal imbalances.Like theSchuldenbremsein thiscountry, this legislation shifts theonusfor enforcement awayfrom Brusselsand ontonational institutions.Prevention isbetter than cure – and that is thespirit of thecompact.MemberStateshavealsotaken important stepstostrengthen euro areaand global firewalls.Theentry intoforce of theEuropean Stability Mechanismhasbeenadvancedand thepaying-in of capital will be acceleratedtoreach fulllendingcapacitysooner than originallyplanned.On top of this,euroarea countrieshavecommitted to providinganadditional 150billion euro tothe IMF.Seentogether,thesemeasuresrepresent acoherent strategytostrengtheneuroarea economicgovernance.Thefocusis not, assome commentatorsclaim, skewedtowardsfiscalconsolidation.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 114Stronger fiscalrules are one – albeit essential – element in a largerpackagethat addressesreal and financial imbalancesand providesasafetynet for countriesin financial difficulties.But stronger governancecannot be effectivewithout individual MemberStatesalsofulfillingtheir responsibilities.Here toowehave witnesseda number of positivedevelopmentsin recentmonths.Thenew governmentsin Spain and Italyhave showndeterminationtoaddresstheir twinchallengesof fiscaland macroeconomicimbalances.Thegovernment ofSpainremainscommittedtobringingitsdeficit below3% by 2013and taking the necessarymeasuresto ensure a rapid andsecure transition to this target from thehigh deficit in 2011.Thelatest review missionsconfirm that the Irish and Portugueseprogrammesare on track – with authoritiesin both countriesstronglycommitted to meetingtheir targetsand with a solid track record.It is important that observersrecognisethat thesereformsat thenationallevel will take time.Theyare addressingdeep-rootedobstaclestocompetitivenessandgrowth, and thepositiveeffectsmay not be visibleimmediately.But oncerealised, theywill put employment and growth on a new andmore sustainabletrack.The example of Germany shows the need for patience. The structuralreforms passed many years ago did not immediately feed through intohigher growth and employment.But now theyhave, and Germany is reapingthe benefitsand leadingthewayin Europe.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 115With a new governanceframework in place and strongcommitmentsfrom national governments, there are solid groundsfor trusting thatreforms will be implemented acrosstheeuro area asa whole.ConclusionLet me conclude. The turnaround wehave witnessedsinceNovember istheresult of every institutionof theeuro area fulfillingitsresponsibilities.No singleinstitutioncan carrytheburden of addressing a set ofchallengesthat are simultaneouslyeconomic, financial and fiscal.Everyone hasplayed their part.But let me emphasisethat the current stabilisationshould not make uspausein our responsestothesechallenges.Indeed, this isa timefor continued action.Thepresent situation providesa windowof opportunityfor governmentstoaccelerateeffortstoconsolidatebudgets, toboost employment and toenhancecompetitiveness– and to do sowith confidence.It alsocreatesa benign environment for banksto strengthentheirresiliencefurther – includingby retainingearningsand cutting dividendsandbonuses.Decisivepolicy measuresbrought about thestabilisation sincelastNovember.Now, further decisivepolicy measuresare requiredtostrengthen fiscalpositionsand competitiveness.Thesemeasureswill laythe foundationsfor future sustainableandbalancedgrowth in the euro area.Thank you.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 116CharlesI Plosser: Restoringcentral banksafter the crisisSpeechby Mr CharlesIPlosser,President andChiefExecutiveOfficer of the FederalReserveBank of Philadelphia, at theconferenceof theGlobalInterdependenceCenter / Bank ofFrance, Paris, 26March2012.* * *Theviewsexpressedtodayare myownand not necessarilythose of theFederal Reserve System or theFOMC.IntroductionI amdelightedtobeheretodayin thisbeautiful cityandtohavethehonortoserve on such a distinguishedpanel withfriendsand colleagues.David Kotok hasbeentheguidingforcebehindtheGIC conferencesoverthepast several years. He and his team at the GIC never fail togather aninterestingand knowledgeablegroup of peopleto discussimportanttopicsontrulyglobal issues.So, I want tothank him andtheGIC for theireffortsand contributions.I alsowant tothank our hosts, ChristianNoyerandthe Banquede France.I am goingto take a littledifferent tack on the subject matter of thisgathering.Rather than focuson what new orthodoxy weshould take awayfrom thefinancial crisis,I want toargue that weneed torestoresome of the oldorthodoxy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 117David did suggest that he wanted to have a conversation on importantissues, so I intend to be somewhat provocative in an effort to stimulatesuch conversation.As usual, I want to stressthat my viewsare my own and not necessarilythoseof my colleaguesin theFederal Reserve System.I will focusmy remarkson tworelated topics that have emerged asaconsequenceof thecrisis.Thefirst isthe relationbetweenmonetary policy and fiscalpolicy.Thesecond topic involvestherole of a central bank‘sbalancesheet asapolicy tool.Theseareissuesthat I believeare of fundamental importanceto theroleof central banksin our economies.The relationship between monetary and fiscal policiesLet me begin by sharing some thoughtson the appropriate relationshipbetweenmonetary and fiscal policies.In the wakeof thefinancial crisisand theensuingrecession, manycountriesaround theworldresponded with a significant increaseingovernment spending.Someof thisincreasecame about through what economistscallautomatic stabilizers.But there hasalsobeen a dramatic expansion in budget deficitsattributableto deliberate effortsto applyfiscal stimulusto improveeconomicoutcomes.This expansion in government spendinghas been very significant in theU.S., but it hasalsooccurred in other countries.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 118Sowhat doesthis have to dowithmonetary policy?Well, it turnsout, agreat deal.It is widelyunderstood that governmentscan financeexpendituresthrough taxation, debt – that is, future taxes– or printing money.In this sense, monetary policy and fiscalpolicy are intertwinedthroughthegovernment budget constraint.For goodreasons,though, societieshaveconvergedtowardarrangementsthat providea fair degree of separation betweenthe functionsof centralbanksand thoseof their fiscal authorities.For example, in a worldof fiat currency, central banksare generallyassignedthe responsibilityfor establishingand maintainingthe valueorpurchasing powerof thenation‘sunit of account.Yet, that task can be undermined, or completely subverted, if fiscalauthoritiesset their budgetsin amanner that ultimatelyrequires thecentral bank tofinancegovernment expenditureswithsignificantamountsof seignioragein lieu of current or future tax revenue.Theabilityof a central bank tomaintainprice stability can alsobeunderminedwhen the central bank itself venturesintothe realm of fiscalpolicy.Historyteachesusthat unlessgovernmentsare constrained institutionallyorconstitutionally, theyoftenresort totheprintingpresstotry toescapewhat appear tobe intractablebudget problems.And the budget problemsfacedby many governmentstodayare, indeed, challenging.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 119But history also teaches us that resorting to the printing press in lieu ofmaking tough fiscal choices is a recipe for creating substantial inflationand, in some cases,hyperinflation.Awarenessof theselong-term consequencesof excessivemoney creationis thereason that over the past 60years, country after countryhasmovedtoestablishand maintain independent central banks– that is, centralbanksthat have theabilityto make monetary policy decisionsfree fromshort-runpolitical interference.Without theprotectionsaffordedby independence, thetemptation ofgovernmentstoexploit theprintingpresstoavoidfiscaldisciplineisoftenjust toogreat.Thus,it issimplygoodgovernanceandwiseeconomic policytomaintaina healthy separation betweenthoseresponsiblefor tax and spendingpolicy and thoseresponsible for moneycreation.It is equallyimportant for central banksthat have been grantedindependencetobeconstrained from usingtheir ownauthoritytoengagein activitiesthat more appropriately belongto the fiscal authoritiesor theprivate sector.In other words,withindependencecomesresponsibilityandaccountability.Central banksthat breach their boundariesrisk their legitimacy,credibility, and ultimately, their independence.Given the benefitsof central bank independence, that could prove costlytosocietyin the longrun.There area number of approachestoplacinglimitson independentcentral bankssothat theboundariesbetweenmonetary policyand fiscalpolicy remain clear.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 120First, the central bank can be given a narrowmandate, suchaspricestability. In fact, this hasbeen a prominent trend during the last 25years.Manymajor centralbanksnowhavepricestabilityastheir soleorprimarymandate.Second, the central bank canbe restrictedastothe type of assetsit canhold on itsbalancesheet.This limitsitsability to engagein credit policiesor resourceallocationsthat rightfullybelongunder the purview of the fiscal authoritiesor theprivate marketplace.And third, thecentral bank can conduct monetary policy in a systematicor rule-like manner, whichlimitsthescope of discretionaryactionsthatmight crossthe boundariesbetweenmonetary and fiscal policies.MiltonFriedman‘sfamousk-percent money growthruleis oneexample, asare Taylor-type rulesfor thesettingof the interest rateinstrument.Unfortunately, over thepast few years, thecombination of a financialcrisisand sustainedfiscalimbalanceshasledto a breakdownin theinstitutional framework and thepreviouslyacceptedbarriersbetweenmonetary and fiscalpolicies.Thepressurehascomefrombothsides.Governmentsarepushingcentralbanksto exceed their monetary boundaries,and central banksaresteppingintoareasnot previouslyviewedasappropriate for anindependent central bank.Let me offer a coupleof examplestoillustratethesepressures.First, despite the well-known benefits of price stability, there are calls inmany countries to abandon this commitment and create higher inflationtodevalueoutstanding nominal government and privatedebt.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 121That is, some suggest that weshould attempt to useinflationtosolvethedebt overhang problem.Suchpoliciesareintendedtoredistributelossesonnominaldebt fromtheborrowersto the lenders.Using inflation asabackdoor tosuch fiscal choicesis bad policy, in myview.Pressure on central banksis alsoshowing up through other channels. Insome circles,it hasbecome fashionableto invoke lender-of-last-resortargumentsasa rationalefor central bankstolend to ―insolvent‖organizations,either failing businessesor, in some cases, failinggovernments.Such argumentsgobeyond the well-acceptedprinciplesestablishedbyWalterBagehot, whowrotein his1873classicLombard Street that centralbankerscould limit systemic risk in a banking crisisby ―lendingfreelyata penaltyrateagainst good collateral‖.Central bankershave abandoned this basic Bagehot principlein the lastfew years but have not replacedit witha clear alternative.Indeed, actionswereoften confusingand unpredictableand lackedacoherent framework.I believe that central banksneed tothink hard about how and whentheyexercisethisimportant role.We needto have a well-articulatedand systematic approachtosuchactions.Otherwise,our actionswill exacerbate moral hazard and encourageexcessiverisk-taking, thussowingtheseedsfor thenext crisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 122Unfortunately, neitherfinancial reform norcentralbankshaveadequatelyaddressedthisdilemma.Breachingthe boundariesisnot confined to thefiscal authoritiesaskingcentral banksto do their heavylifting.The Fed and other central banks have undertaken other actions that haveblurred the distinction between monetary policy and fiscal policy, such asadopting credit policies that favor some industries or asset classes relativetoothers.Such stepsweretakenwiththe sincerebelief that theywereabsolutelynecessarytoaddressthe challengesposed by the financial crisis.Theclearest examplescan be seen whentheFederal Reserveestablishedcredit facilitiestosupport marketsfor commercial paper andasset-backedsecurities.Most notablehasbeen the effort by theFed tosupport thehousingmarket through itspurchasesof mortgage backed securities.Thesecredit allocationshave not only breachedthetraditionalboundariesbetweenfiscal and monetary policy, theyhave generatedpointed public criticismsof theFed.Oncea central bank venturesinto fiscalpolicy, it is likelytofind itselfunder increasingpressure from the privatesector,financial markets, orthegovernment touseitsbalancesheet tosubstitutefor other fiscaldecisions.Such actions by a central bank can create their own form of moralhazard, as markets and governments come to see central banks asinstruments of fiscal policy, thus undermining incentives for fiscaldiscipline.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 123This pressure can threaten the central bank‘sindependenceinconductingmonetary policy and therebyunderminemonetary policy‘seffectivenessin achievingits mandate.In my view, this blurring of the boundariesbetweenmonetary and fiscalpoliciesis fraught withrisks.As I said, theseboundariesarosefor good reason, and weignore theirbreachat our peril. I believewemustseek waystorestoretheboundaries.The central bank‘sbalance-sheet policyAnother relatedissuefacingcentral banksarisesfromthedegreetowhichcentral bankshave expandedtheir balancesheets.There aretwodimensionstothis issue.One is thecomposition of the balancesheet.In the U.S., for example, thebalancesheet of theFederal Reservehaschangedfrom onemadeup almost entirelyof short-term U.S. Treasurysecuritiestoonethat is mostly long-term Treasuries,plussignificantquantitiesof long-term mortgage-backed securities.This concentration of housing-related securities is problematic because itis a form of credit allocation and thus violates the monetary/ fiscal policyboundariesI just mentioned.Thesecond aspect isthe overall size of thebalancesheet.Many central banksexpanded their balancesheetsin an effort to easemonetarypolicyaftertheir usual policyinstrument – aninterestrate– hadreached thezerolowerbound.Docentral bankersanticipatethat theirbalancesheetswill shrink tomorenormal levelsastheymove awayfrom thezero lowerbound?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 124Is it desirabletodoso?Or should monetarypolicy now beseenashavinganother tool, even in normal times?Somehave suggested that central banksadopt a regime in whichthemonetarypolicy rateis the interest rate on reservesrather than a marketinterest rate, such asthe federal fundsrate.This would then permit the central bank to manage itsbalancesheetseparatelyfrom itsmonetary instrument, freeingit torespond toliquiditydemandsof the financial system without alteringthe stanceof monetarypolicy.In principle, thiswouldtakepressureoff central banksto shrink theirbalancesheetsfrom the current high levelsand simplyrely on raising theinterest rate on reservestotighten monetarypolicy.Thealternativeis toreturn to a more traditional operatingregime inwhichthe central bank setsa target for a market interest rate, such asthefederal fundsratein theU.S., above the interest rateon reserves.Implementingthisregimewould requirea smaller balancesheet.I am very skeptical of an operatingregimethat givescentral banksa newtool without boundaries or constraints.Without an understanding, or even a theory, asto how the balancesheetshould or can be manipulated, weopen thedoor togiving vast newdiscretionaryabilitiesto our central banks.Thisviolatestheprincipleof drawingclearboundariesbetweenmonetarypolicy and fiscalpolicy.When markets or governments come to believe that a central bank canfreely expand its balance sheet without directly impacting the stance ofmonetarypolicy, I believethat variouspolitical and privateinterestswillBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 125comeforwardwitha long list of good causes, or rescues,for which suchfundscould or should be used.Economictheoryand practiceteachusthat monetary policy worksbestwhenit isclear about its objectivesand systematic in itsapproach toachievingthoseobjectives.Grantingvast amountsof discretiontoour central banks in theexpectationthat theycan cure our economicillsor substitutefor our lackof fiscal disciplineis a dangerousroad to follow.In June, the Fed eral Re serv e‘s Open Market Commit t eeoutlinedsomeprinciplesthat wouldguide itsexit from this period ofextraordinarymonetary accommodation.In my view, thoseprinciplesrepresentedan important first step in theFOMC‘sattempt to restorethe boundariesbetweenmonetary and fiscalpolicies.In particular, the FOMC clearly stated its desire to return to an operatingenvironment in which the federal funds rate is the primary instrument ofmonetarypolicy.Toachievethat objective,theFedwillhavetoshrink itsbalancesheettoamore normal level.I interpret thisassaying that our balancesheet should not be viewedasanew independent instrument of monetary policy in normal times.Theexit principlesalsoindicatedthe Committee‘sdesire toreturn theFed‘sbalancesheet to an all-Treasuriesportfolio.This re-establishesthe ideathat theFed should not useitsbalancesheettoactively engagein credit allocations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 126In other speeches,I haveoutlinedaframeworkthat I havetermeda―newaccord‖ betweentheFederal Reserve and the Treasury.It wouldenablethecentral bank toact inemergencieswhenrequestedbytheTreasuryor the fiscal authorities,but it wouldbe clear up front thatanynon-Treasuryassetsthat accrued on the central bank‘sbalancesheetwouldbe swappedfor government securitieswithina specifiedperiod oftime.This would ensure that fiscalpolicy decisionsremain under thepurviewof the fiscal authorities,not the central bank.SummaryTosummarize, it is important for governmentstomaintain independentcentral bankssothat theyare better abletoachievetheir mandates.It is alsosound policytolimit the discretionaryability of central banks toengagein policiesthat fundamentallybelongto fiscal authoritiesorprivate markets.Establishingand maintainingclear boundariesbetweenmonetary andfiscalpoliciesprotectstheindependenceof thecentralbank anditsabilitytocarry out itscore mandate – maintainingprice stability.Clearboundaries and resistingthe useof thebalancesheet asa newpolicy tool wouldalsoimprovefiscal disciplineby making it moredifficult for the fiscalauthoritiestoresort to theprintingpressasasolution to unsustainablebudget policies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 127Christian Noyer: Re-examiningcentral bank orthodoxy forun-orthodox timesSpeechby Mr Christian Noyer, Governorof the Bank of Franceand Chairman oftheBoard of Directorsof the Bank for International Settlements,at theconferenceof the Global InterdependenceCenter/Bank of France,Paris,26March2012.Theunconventional policiesimplemented during thecrisishavetransformedthe faceof central banking.But will thesechangesprove permanent and will ―theunconventionalbecome thenew normal?‖There is not yet definitiveanswerto thisquestion.We may not, aseasilyaswewould like, be able to revert exactlyto thestatusquoante.However,I stronglybelievewemust make sure that the gainsfrom thepre-crisisperiod, in terms of monetary and price stability, are notcompromised in theprocess.Prior tothe crisis, a description of central banks wouldhavecentred onfour characteristics:- They were focused with price stability being their primary or keyobjective, and no responsibility was sought or given for financialstability;- Theywereof limitedsize withvery small balance sheetsand interestratesastheir only policy instrument;Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 128- Theywereindependent, a conditionrecognised asnecessarytoanchor inflation expectations,and embodied in very stronginstitutional frameworks;- And theyweresuccessful: the ―Great moderation‖, a period ofexceptionallowvolatility in output and inflation, waswidelyseen asaproduct of efficient and wisemonetary policies.There wasa happy feelingthat, at last, a perennial monetary regimehadbeen found, well-tailoredto the characteristicsof a modern marketeconomy.Financial marketswereefficient and thezero lowerbound and liquiditytrap appearedtobe no more than historical curiosities.With hindsight, of course,wecan seenow that this ―ideal‖ economy maynever have existed.TheGreat Moderationwasasmuchaproduct of ―goodluck‖ (brought bydisinflationaryeffectsof globalisation) than good policy.Monetarystability isanecessarybut not asufficientconditionof financialstability, becausecapital marketsare not alwaysand necessarily efficient.And downward financial spiralsmay quicklybring our economiestothepoint whereinterest ratescan nolonger be used aseffectivetools.Therefore, as the crisis unfolded, central banks responded by takingunprecedented measures and, in the process, underwent three majorchangesAdiversification of their interventions.In order toboth:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 129- Unclog financial markets(both private and public). This involvedexceptional liquidityprovision to banksaswellastemporarypurchasesof assets,both privateand public.- Circumvent the zero lowerbound and bringdown real long-terminterest ratesthrough purchasesof government bonds, and/ orinterest rate guidance.Asaconsequence, central banks‘balance sheetsexpanded byafactor ofthree, dramaticallyincreasingtheir role in financial intermediation andsometimesraisingconcerns, at least in some quarters,about thepossibleinflationaryimpactTogether, this diversificationand the increasein size have created morecomplex interactionswithfiscal policies.Specifically, asset purchasesaresometimesseenas―quasifiscalpolicies‖bothontheassetside(duetothepotentialrisksattached) andtheliabilityside(when theycontribute significantlytomeeting thefunding needsofthesovereigns).At the timetheyweredecided, thoseexceptional interventionswereabsolutelynecessary.Although it had been forgotten, central bankswereinitiallycreated toprotect the economyfrom excessivefinancial disturbances.This was,historically, their ―raison d‘être‖.As ultimateand unique providersof liquidity, theycannot escapethisresponsibilityand let the financial system and theeconomy collapse.At the same time, by doing so, central banks haveexposed themselvestoa number of risksBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 130First, there areriskslinked tobalancesheet expansion. Theycannot beignored, althoughall centralbankshavebeenextremelycareful in valuingtheassetspurchasedor taken ascollateral.Second, theyruntherisk of blurringthelinesbetweenfiscal andmonetaryresponsibilities. Adynamic useof their balancesheetsbycentralbankshaseffectsontheallocationanddistributionof resourcesintheeconomy.Theymayfavourorpenalisesometypesofcollateralorcertainborrowers.If central bankstake on additional responsibilitiesin the area of financialstability, they will have to dosoin closecooperation withfiscalauthorities, thusexposingthemselvestopossibleinterferenceswithmonetarypolicy.Themajor risk, however, is therisk of confusion. Amultiplicityofinterventionscould beinterpreted asarelative dilutionof objectives.There is a tendencyby market participantsand some policymakerstoconsider central banks to be―universal problem solvers‖ whosebalancesheetscan be used, without cost, for all purposes.There is alsoa doubt, at least an ambiguity, in the mindsof someanalysts, about the true purposeof government bond purchases.Central banks‘activismmay createdoubtsastotheir ability tostick totheir core mandate – price stability – in the faceof increasingpressuresand constraints.Overall, the euro area is well protectedagainst all of theserisksthankstotherobustnessof itsinstitutional frameworkPrice stabilityisunambiguouslythe priority objectiveof monetary policyMonetaryfinancingof governmentsisstrictlyprohibitedBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 131TheEurosystem (theECB and National Central Banks) is extremelywellcapitalised, whichprotectsitsindependence.ThishasallowedtheEurosystem toimplement nonstandardmeasuresona largescalewithout endangeringits credibility.Of course,wedonot control fiscalpolicy. We will never acceptasituationwherefiscalimbalancescould constrain monetary policy.It is very important, therefore, that crediblefiscal consolidationtakesplaceacrossthe euroarea.This will make it easier for the Eurosystem tobe activein protectingfinancial stability.On the contrary, doubtsover governments‘resolvetoensure thesustainability of public financeswouldmake uspowerlesstofightinstabilityand expose theeuro area togreat dangers.Now for themore normative aspects.We may havetolivewithnonstandard measuresfor a long time.Indeed, some central bankshave adopted interest rateguidanceannouncementscoveringthenext twoyears.It islikelythatmonetarypolicywill,forsometime,makeuseofadiversityof instruments.Macro-prudential measureswill interact with monetary policiesin acomplex way.In that context, it is therefore all the more important to keep clarity ofpurpose and stick to two crucial features inherited from the pre-crisisconsensus: the focus on price stability and, its corollary, central bankindependence.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 132There should be noambiguityabout what central banks aretrying toachieve.Themore non-conventional their actions,the lessobscurity thereshouldbeastotheir ultimatepurpose.Non-conventional measures,like any others,can onlyachievetheirobjectivesif inflationexpectationsare solidlyand clearlyanchored.From that point of view,callsby some economistsand marketparticipantsfor a temporary relaxation of price stabilityobjectivesare, inmy view,totallymisguided.I find it significant, on the contrary, that two major central bankshaverecentlydecidedtoquantify their price stabilityobjectivesand enhancetheir communication accordingly.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 133FSAreview into anti-bribery and corruption systems andcontrols in investment banks and proposed new guidance for allfirms29Mar 2012The Financial Services Authority (FSA) published the findings of itsthematic review into anti-bribery and corruption (ABC) systems andcontrolsin investment banks.In responseto thosefindings,theFSAwill consult on proposedamendmentstotheFSA‘s regulatory guidance, ‗Financial crime:a guidefor firms‘.This proposednew guidanceapplies toall firms within scope of ourfinancial crime rules, not just investment banks.FromAugust 2011, theFSAvisited 15 firms, includingeight major globalinvestment banks and a number of smaller operations,toexaminehowfirmsmitigatebriberyand corruption risk.Briberyand corruptionrisk istherisk of the firm, or anyone actingon thefirm‘s b eh alf, engagin g in b rib ery and corru p tion .TheFSAfound that, despitea long-standingregulatoryrequirement tomitigatefinancialcrimerisk,themajorityoffirmsinour samplehadmoreworktodo toimplement effectiveanti-briberyand corruption systemsand controls.In particular, wefound the followingcommon weaknesses:- Most firmshad not properlytaken account of our rulescoveringbribery and corruption, either beforetheimplementation of theBriberyAct 2010or after;Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 134- Nearlyhalf thefirmsin oursampledid not haveanadequateABC riskassessment;- Management informationonABC waspoor, making it difficult for ustoseehow firms‘senior management could provide effectiveoversight;- Onlytwofirmshad either started or carried out specificABC internalaudits;- Thereweresignificant issuesinfirms‘dealingswiththirdparties usedtowin or retain business;- Though many firms had recently tightenedup their gifts, hospitalityandexpensespolicies,few had processestoensure gifts and expensesin relationtoparticular clients/ projectswerereasonableon acumulativebasis.Although firmsin our samplehad been slow and reactivein managingbribery and corruption risk, our visitsand the introduction of theBriberyAct had acted asa trigger for firms tofocusonABC issues.TheFSAis consideringwhetherfurtherregulatory action is required inrelationtocertain firms in its review.TraceyMcDermott, acting director of enforcement and financial crime,said:―It is imperativethat firms haveadequatearrangementsto control therisksof financial crime.We have seen examplesof good practiceand some examplesof poorpractice.Overall, despite thehigh profile of the issue, the investment bankingsectorhasbeen tooslowand too reactivein managing bribery andcorruption risks.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 135―Firmsacrossall sectorsmust have appropriate controlstomanagetheirfinancial crime risks, whetherrelatedtobribery and corruption orotherwise.TheFSAand, from next year, theFinancial Conduct Authority willcontinueto focuson financial crime risksin this sector and beyond toensure firmsare meetingtheir legal and regulatory obligations.‖Notesfor editorsTheFSArequiresfirms toestablishand maintaineffectivesystems andcontrolsto mitigatefinancial crime risk.Financial crime risk includesthe risk of bribery and corruption.In additiontotheseregulatoryrequirements,bribery, whethercommittedin theUK or abroad, is a criminal offenceunder the BriberyAct2010,whichhasconsolidatedandreplacedpreviousanti-briberyandcorruption legislationin theUK.TheFSAdoesnot enforce, or give guidanceon, the BriberyAct.FSAPrinciplesrequire FSMA authorisedfirmsto conduct their businesswith integrityand withdue skill, careand diligence;and totakereasonablecaretoorganiseand control their affairs responsiblyandeffectivelywithadequate riskmanagement systems.TheFSAregulatesthe financial servicesindustry and hasfour objectivesunder the FinancialServices and MarketsAct 2000:1.Maintainingmarket confidence;2. Securingthe appropriate degreeof protection for consumers;3. Fightingfinancialcrime;and4.Contributingto theprotection and enhancement of thestability of theUK financial system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 136Addressby Mr Lee Boon Ngiap, Assistant ManagingDirector, Monetary Authority of Singapore,General InsuranceAssociation of Singapore Annual General MeetingLuncheon, 27March 2012,Intercontinental Hotel, SingaporeGIAPresident, Mr Derek Teo, DistinguishedGuests, LadiesandGentlemen,1 Thank you for invitingme toyour Annual General MeetingLuncheon. MayI congratulateMr Derek Teoon your re-election asPresident of GIA, aswell astheother newly-electedmanagementcommitteemembers.I wouldalsolike tothank them for agreeingto take up the challengeofleadingthe industryover thenext year.2 This afternoon, I will start off by recappingsome of the majorachievementsof GIA, beforeoutliningsome of the immediatechallengesfacingthe general insuranceindustry.GIA‘s ContributionsBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com3 Under the leadership of itsmanagement committee, GIA hasaccomplishedmuch in the past few years.
  • 1374 I wouldlike tocommend GIA for itspro-activeapproachinstrengtheningtheself-regulatoryframeworkforgeneralinsuranceagents.GIA‘sAgents‘Registration Board hasput in much effortsto improve thestandardsof general insurance agentsthroughinitiativessuch astheTradeSpecificAgent Schemes.An industry workinggroup formed by theGIA is now finalisingaTelemarketingCodeof Practice for general insurers.Theseinitiativeswill continuetoraisethecompetencyand professionalstandardsof the general insurance industry, and provide consumerswithbetterqualityadviceand higher servicestandards.Theseaugur well for the development of the industry.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com5 Overthepastyear, GIAhasbeen activein educatingconsumersongeneral insuranceproducts.Oneexampleisthe travel insuranceseminar jointlyorganizedby GIAwith the NationalAssociation of TravelAgentsSingaporeand theConsumersAssociation of Singapore.Theseminar provided a useful platform for the industry toshareinsightsand knowledgeon how consumerscan purchasetheright type of travelinsurancefor their needs.GIAwasalsoinvolvedin therevamp of theMoneysensewebsite,and hadmadecontributionstothepublicationson the website.I am gladto note that GIAwill continue such effortstoeducateconsumerson thespecific risksand considerationswhenbuying generalinsuranceproducts.6 GIA has also made active contributionsto an industry-led workinggroup that is looking to enhance reinsurance contract certainty practicesin Singapore.
  • 138Together withtheSingaporeReinsuranceAssociation, ReinsuranceBrokersAssociation, Lloyd‘s and InsuranceLawAssociation ofSingapore, theworkinggroup isfinalisingguidelinesand best practicestosecure contract certainty.Theguidelineswill highlight the need for reinsurersand brokers toprovidecedantswiththeir signedcopy of the contract.It will alsorequire both parties to ensure that there is no ambiguityin thetermsand conditionsof the contract prior torisk inception.This will minimisepotential disputesover claims and coverage.MAS viewsthis asa very important initiativeand will workwiththeindustryon a smooth implementationof thesenew guidelinesand bestpractices.7 On thetalent development front, GIA, withtheRegionalDevelopment Committee, have contributed significantlythrough itsGlobal Internship Program (GIP).According to Lloyd‘sRisk Index 2011, ―talent and skillsshortage‖ wasidentifiedasoneof thetopthreerisksfacingtheinsuranceindustryin theAsia Pacific region. GIA‘s effortsin helpingto build the talent pipeline iscrucial.I wouldlike toencourage GIA to continue to explore talent initiativestosupport theindustry‘s needsin more specialised risk areasaswell asactuarial and leadership development.MAS will continuetoworkwithGIA toexplore the possibilityofexpandingthedepthandbreadthoftheGIPtobettercatertothegrowingneedsof the industry.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 139ChallengesAhead8GIA shouldbeproud of theseachievements,whichhascontributedmuch tothe development of the general insurance industryin Singapore.There is much more workin the years ahead asthe industry facesimportant challengesin a riskierand more difficult market. Allow me tosharemy thoughtson twoof theseimmediatechallenges.9First, let me congratulate the industry for reportingunderwritingprofitsin all linesof domesticbusinesslast year.In particular, themotor businessregistereditsfirst underwritingprofit insix years.Thelast timethe industrymanaged toturn a profit in thehighlycompetitivemotor businesswasin 2004and 2005, after more than adecadeof losses.But stiff competition set in immediately and many insurers startedcompromising on underwriting and pricing discipline in pursuit ofmarket share.Problemswithfraudulent and inflatedclaims alsostartedtoplaguethemotor insurancebusiness.This resulted in the industry reportingrecord underwritinglossesof $168million in 2008, withlossesin each subsequent year until lastyear.10GIA, throughitsintroductionof the Motor ClaimsFramework in2008,and activeparticipationin the MotorInsuranceTaskForce, hascontributedtomeasurestominimisefraudulent and inflatedclaims.Theseeffortsare commendableand MASis committedtoworkingtogether withGIAand other relevant stakeholderstocombat thisproblem.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 140But such measuresalonewill not sustain theprofitabilityof themotorbusinessif insurersdonot exerciseunderwritingand pricingdiscipline.11Whilecompetitivepremium ratesmay benefit consumers, they are notsustainableif theyareachievedwithout regard tosoundunderwritingandpricing.Eventually, insurerswill suffer losseswhichbecome toogreat tobear andsomewill exit thebusiness, leavingconsumerswithfewerchoices.Thosethat remain will be forced toraisepremium ratessharply, andcomplaintsfrom unhappymotorists can be expected tofollow.Ultimately, this isdetrimental to consumersand the insuranceindustry.We have seen this episodeplayed out before in thedomesticmotorinsurancemarket.Thechallengefor the industry thereforeisto takeheed of thelessonslearnt and maintain your underwritingand pricing disciplinethis timeround.It is in the interest of both consumersand insurersthat all of you onlypursuebusinessstrategiesthat aresustainableandnot sacrificeprudencefor potential short-term gains.12Thesecond challengefor theindustrythat I wouldlike totouchon istheneed to keep pace withglobal regulatory reforms.Much hasbeen saidand writtenabout the weaknessesin regulationsandbusinesspracticesthat causedthe global financial crisis.Theinsurancebusinessmodel enabledthe majorityof insurerstowithstandthefinancial crisisbetter than other financial institutions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 141Nevertheless, there are corporate governance, capital adequacy and riskmanagement lessons from the crisis that are applicable to the insuranceindustry. Let me share the regulatory initiatives in these areas that MASis focusingon this year.13First, one lesson from thecrisisisthat good corporategovernancematters.Thefailure by Boardsto exerciseeffectiverisk management oversighthaddamagingconsequencesfor many institutions.Toraise the corporategovernancestandards of the insuranceindustry, MAS recentlyissued a consultation paper proposingtoextendtheInsuranceCorporateGovernanceRegulationsto all locally-incorporatedinsurers.We intend tomakeit mandatory for all locally-incorporatedgeneralinsurersto meet minimum corporategovernance requirements,whichwill be calibrated to take intoaccount thesignificanceof an insurer‘soperations.Insurers‘compliancewiththe Corporate Governance Regulationswill beassessed aspart of MAS‘ ongoing supervisoryprogramme.14Second, MASwill shortly issuea consultationpaper toproposeenhancementstoour capital framework for insurancecompanies.Singapore wasamong thefirst in Asia tointroducea risk-basedcapital(RBC) framework for insurancecompaniesback in 2005.Our proposed enhancement aimstoimprove thecomprehensivenessofrisk-coverageand therisk-sensitivityof the framework,whileensuringthat the proposalsarepractical and takesintoaccount market realities.Unlike in banking, there is nocommon global capital standard forinsurancecompanies.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 142Soa review of our RBC framework is a major undertaking requiringbotha fundamental analysis of the appropriatenessof our existingframeworkaswell asa comparative studyof the insurancecapital frameworksinother jurisdictions.I lookforwardtoreceivingfeedbackfrom GIAanditsmemberswhenourconsultation paper isissued.15 Third, MAS‘effortsto improve risk management standardsin theindustrywill continueapace.MAS issueda set of guidelineson risk management practicesforinsurancecompaniesin 2007.Theguidelinesspell out sound riskmanagement practicesfor each coreactivitysuch asproduct development, pricingand underwriting.MAS will add to these guidelineswithadditionalruleson enterpriseriskmanagement (ERM).TheERM standardswill go beyond addressing risks in each core activitytoalsocover MAS‘expectationson how insurersidentify and manageinterdependenciesbetweenkey risks, and how this is translatedintostrategic management actionsand capital planning.ConclusionBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com16 In conclusion, let me onceagain thank GIAfor itsgood workinraisingthestandardsof general insuranceagents,educatingandempoweringconsumers,assistingMASin our regulatorywork, anddeveloping talent for the industry.But there isno room for complacency. The insuranceenvironment hasbecome more volatilein recent years, and consumersare increasinglymore sophisticatedand demanding.
  • 143Sotheindustry must enhanceitsabilitytooperatein a riskierenvironment, and servicestandardsmust continuetoimprove.MAS will continuetoworkcloselywithGIA to promote a sound anddynamic general insuranceindustryin Singapore.We have enjoyed a very good workingrelationship over theyears and welookforwardto continuingthis partnership in the years ahead.17 Thank you.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 144Developing a Single Rulebook in bankingAndreaEnria, ChairpersonEuropean BankingAuthority, Central Bank ofIreland – Stakeholder Conference‗FINANCIAL REGULATION -TH INKING ABOUT THE FUTURE‘ 27April 2012Ladies and Gentlemen,My main topic todaywill be the SingleRulebook, themain path ahead ofusto achievethe objectivesof thenew European institutional frameworkestablished withtheendorsement of the recommendationsof thedeLarosièrereport.I will primarily focuson ownsfunds,asthis isa keyissueforre-establishingtheregulatoryframeworkonasoundfootingandtheEBAis currentlyrunning a public consultation on this.I will alsobrieflytouch on another important component of the SingleRulebook:theliquidityrequirements.However,before tacklingtheseissues,I wouldliketo give you anoverview of thefirst year of existenceof the EBAand especiallyof theworkdone tofacethechallengesposed by thecurrent crisis.1. The efforts of the EBAin tackling the financial crisisIn the first year of itslife, the prioritiesof the EBAhad to befocused onBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 145thechallengesraised by thedeteriorationof the financial marketenvironment.Thestresstest exercise weconductedin the first part of 2011focused oncredit and market risksbut also, in recognitionof the risksthatsubsequentlycrystallised, incorporated sensitivityto movementsinfundingcosts.Banks werealsorequired to assessthe credit risk in their sovereignportfolios.In many respects,I believethe exercisewassuccessful:in order toachievethe tougher capital threshold, anticipatingmany aspectsof thenew Basel standards, banksraised€ 50bn in fresh capital in the first fourmonthsof theyear; weset up a comprehensivepeer review exercise,whichensured consistencyof the exerciseacrosstheSingleMarket,notwithstandingthemany differencesin national regulatory frameworks;theexerciseincluded an unprecedenteddisclosureof data (more than3200data pointsfor each bank), includingamongst other thingsdetailedinformation on sovereign holdings.However,theprogressof the stresstest wastrackedby a significantfurther deteriorationin the external environment.Themain objectiveof restoring confidencein the European bankingsectorwasnot achieved, asthe sovereigndebt crisis extendedto morecountries,thusreinforcingtheperniciouslinkagebetweensovereignsandbanks.Most EU banks, especiallyin countriesunder stress, experiencedsignificant funding challenges.In this context, the IMF and the European Systemic Risk Board (ESRB)called for coordinated supervisory actions to strengthen the banks‘ capitalpositions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 146TheEBA assessment wasthat without policy responses, thefreezeinbank fundingwouldhave led to an abrupt deleveragingprocess, whichwouldhave hurt growthprospectsand fuelledfurther concernson thefiscalposition of some sovereigns,in a negative feedback loop.We then calledfor coordinated action on both the fundingand thecapitalisationside.While advising the establishment of an EU-widefundingguaranteescheme, the EBAfocuseditsown effortson thoseareaswhereit hadcontrol, primarily bank capitalisation.Tothis end, theBoard of Supervisors,comprisingtheheadsof all 27national supervisoryauthorities, discussed and agreedthat a furtherrecapitalisationeffort wasrequired aspart of a suiteof coordinated EUpolicy measures.Our Recommendationidentified a temporarybuffer toaddresspotentialconcernsover EU sovereigndebt holdingsand required banksto reach9% CT1.The t ot al sh ort fall iden tified was € 115 bn.Themeasure wasagreedin October and enacted in December 2012.Itwasswiftly followedbythe ECB‘slongterm refinancing operations(LTROs), arguablythe key ―game changer‖ in this context.But the recapitalisation wasa necessarycomplementary measure:whilebanksneededunlimitedliquiditysupport, to avoid a credit crunch, theyhadtobe asked to acceleratetheir action to repair balancesheetsandstrengthencapital positions.Thesemeasureshave bought time but should not bring complacency.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 147Therecapitalisationplan hasseen banksmake significant effortstostrengthentheir capital positionwithout disrupting lendingintothe realeconomy.TheEBA‘s intensivemonitoring of the processshowsthat 96% of theshortfall identified wasmet by direct capital actions.Moreover,therehasbeen a strong spirit of cooperation betweenhomeandhost supervisorsin discussingand taking forwardtheseplansthroughcollegesof supervisors,whichhasacted asameaningful counterweight tothetrend fornationalconcernstocometotheforeinthecurrentenvironment.Going forward, heightenedattention toaddressingresidual creditrisk,making effortsto meet thenew CRD IV requirements,settinginplaceplanstogradually restoreaccessto private funding and exit theextraordinarysupport of theECB will be key.2. The Single Rulebook in bankingAs the finalisation of thenew legislativeframework for capital andliquidityrequirementswascoming closer, thefocusof the EBA workhasbeen increasinglymoving to our tasksin the rule-makingprocess.Thekey task that the reform proposed bythede Larosière report assignstothe EBAis the establishment of a SingleRulebook, ensuringa morerobust and uniform regulatory framework in the SingleMarket andpreventinga downwardspiral of competitiverelaxation of prudentialrules.TheEBA isasked to draft technical standardsthat, once endorsedby theCommission, will be adopted asEU Regulations.Thestandards will thereforebe directlyapplicabletoall financialinstitutionsoperatingin theSingleMarket, without any needfor nationalimplementationor possibilityfor additional layers of localrules.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 148I seethat at the moment, while thenegotiationson the capitalrequirement directiveand regulation (CRD4-CRR) are enteringthe finalstages,there isa call for more national flexibility.It is often argued that minimum harmonisation isall that is needed, asthedecision of a national authority to apply stricter requirements would onlypenalisefinancial institutionscharteredin that jurisdiction.Thisargument neglectsthefact that wehavelivedinaworldof minimumharmonisationuntil now, and this hasdeliveredan extremelydiverseregulatoryenvironment, proneto regulatorycompetition.It is a fact that theflexibilityleft by EU Directiveshasbeen a keyingredient in the run-up tothecrisis.TheDirectivesleft significant flexibilitytonational authoritiesin thedefinitionof keyprudential elements(e.g., definitionof capital, prudentialfiltersfor unrealised gainsand losses), the determination of riskweights(e.g., for realestateexposures),theapproachestoensurethat all therisksarecaptured by the requirements(e.g., effectivenessof risk transfers).All theseelementsof flexibilityhavebeen used bybanks to put pressureon their supervisors, triggeringa processthat ledto excessiveleverageand fuelledcredit and real estatebubbles.Theheterogeneityof the regulatory environment alsocomplicatedsignificantlythe effectivesupervision of cross-border groups,whichwereat the epicentre of the crisis:supervisorshad seriousdifficultiesbothbuildingup a firm-wideview of risksand actingin a timelyandcoordinatedfashion.Furthermore, regulatoryarbitragedrove businessdecision. Thisproblemhasnot been fixed yet.In its first year of activity, theEBA identified a number of differencesinBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 149regulatorytreatment that lead toverymaterial discrepanciesin keyrequirements.For instance, the EBAstaff conducted a simpleexerciseon the datacollectedfor therecapitalisationexercise.Thecapital requirement for the same bank werecalculatedusing the lessstringent andthemost restrictiveapproachesin four areaswherenationalrules present important differences– thecalculationof theBasel I floors,theapplicationof theprudential filters,the treatment (deduction fromcapitalorinclusioninassetswitha1250% weight) of IRB shortfallsandofsecuritisations.As a result, the ratio was 300 bps lower when the stricter methodologieswere applied, showing that differences can be very material and difficulttospot.In integratedfinancialmarkets, thesedifferencescanhaveverydisruptiveeffects.Oncerisksgenerated under the curtain of minimum harmonisationmaterialise, the impact is surelynot containedwithin the jurisdictionsthat adopted lessconservativeapproaches.Without using exactlythesame definitionof regulatory aggregates andthesamemethodologies for thecalculationof keyrequirements, theproblem will not be fixed.At the same time, it is absolutelytrue that the new regulatoryframeworkhastobe shaped in such a wayto leavea certain degreeof nationalflexibilityin theactivationof macroprudential tools,ascredit andeconomiccyclesare not synchronised acrosstheEU.Also, there could be structural featuresof financial sectors, orcomponentsthereof, whichmight requiretweakingprudentialrequirementsto prevent systemic risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 150But the same sourceof systemic riskshould be treated in a broadlyconsistent manner in different jurisdictionsacrosstheSingleMarket, toavoid an unlevel playing field and lessstringent approachesthat mightsubsequentlygeneratespilloversin other countries.Theideal long-term solution for avoidingconflictsbetweenthe flexibilityneeded for macroprudential supervisionand thedegreeof regulatoryharmonisationcalledfor bytheSingleRulebook isconstructinga suiteofmacroprudential instrumentsalong the blueprint of the countercyclicalbuffer.This providesa significant leewayfor tighteningstandardswhile theEuropean Systemic Risk Board (ESRB) is entrusted withthetask ofdraftingguidanceon the activation of thetool and of conductingex postreviews.At the same time, reciprocityin theapplicationof the tool allowsforcross-border consistencyand reducestheroom for regulatory arbitrage.So, wemay wellhave a singlerule, adopted through anEU Regulation,while thisrule providesfor flexibilityin itsapplication, witha frameworkthat theBasel Committeehaslabelledas―constrained discretion‖.3. Giving life to the Single Rulebook: the new regulatoryframework of bank capital and liquidityIn giving life to theSingle Rulebook in banking, the EBA is facingamajor challenge.TheCRD4-CRR proposal envisagesaround 200tasks,more than 100technicalstandards- 40 of whichwill have to be finalisedby the end ofthisyear.We will have to ensure standards of high legal quality asthey will beimmediately binding in all 27 Member States when endorsed by theEuropean Commission.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 151We will have to respect due process, withwideand open consultationsand adequate impact assessments.As to the substance of the new regulatoryframework, I will focustodayonthe definition of capital and the quality of own funds, which I consider asoneof the cornerstonesof theSingle Rulebook in banking.3.1. Own fundsThedefinition of capital hasbeen a major loophole in therun-up to thecrisis.As financial innovation brought about increasinglycomplex hybridinstruments,national authoritieshavebeen played against eachother bytheindustry, withthe result that the standardsfor thequalityof capitalwerecontinuouslyrelaxed.As a consequence, oncethe crisishit, a significant amount of capitalinstrumentsproved tobe of inadequatequalitytoabsorblosses.In several cases,taxpayers‘money wasinjectedwhile theholders ofcapital instrumentscontinuetoreceiveregular payments.TheBasel Committeehasdone an outstandingjob in significantlystrengtheningthedefinitionof capital and wemust make surethat this isnot lost in the implementationof the standards.TheEBA alreadyachieved some progressin theuseof stringent uniformstandardswhenimposingtheuseof a common definitionof capital forthepurpose of the stresstest and the recapitalisationexercise.Thisprovesthat collectiveenhancementscanbereachedwhennecessary.But what can be done in periodsof stressmust be perpetuated in normaltimes.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 152For thispurpose, on 4April, the EBA published a consultation on a firstset of regulatory technical standards on ownfunds.Thesecover most areasof own funds, fleshingout the featuresofinstrumentsof different quality(from CET1toTier 2 instruments). Theconsultationwill provideappropriate input from interestedpartiesandregular contactswithbanks and market participantsare already underway.Thestandards elaborate on thecharacteristicsof the instrumentsthemselves, aswell ason deductionstobe operated from ownfunds.It is indeed crucial to ensure that there is a uniform approach regardingthe deduction from own funds of certain items like losses for the currentfinancial year, deferred tax assets that rely on future profitability, definedbenefit pension fund assets.It is alsonecessarytoensure that, whereexemptionsfrom andalternativestodeductionsareprovided, sufficientlyprudent requirementsare applied.Thestandardscoveralsoseveralareasaffectingmore directlycooperativebanksand mutuals, whoseparticular featureshave to betaken intoadequateaccount.At the same time, it is necessaryto defineappropriate limitationstotheredemption of the capital instrumentsbytheseinstitutions.Thestandards will alsocontributetoincreasethepermanenceof capitalinstrumentsmoregenerallybystrengtheningthefeaturesofthelatterandbyspecifyingtheneedfor supervisoryconsent whenreducingownfunds.Finally, the standards will also increase the loss absorbency features ofeligible hybrid instruments, in line with the objective to bring investorsclosertoshareholdersand share losseson a pari passu basis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 153In order tocompleteits current workon ownfunds, the EBA will soonpublish a technical standard on disclosureby institutions.Theworkof the EBAon own fundswill not be concluded with theendorsement of thenew technical standards.Indeed, although technical standards, likeEU Regulations,should notleaveroom for interpretation, it cannot be excluded that some provisionswill not work astheyare meant to.Thisisthereasonwhyaclosereviewof theapplicationof thestandardsisnecessarytodetect potential loopholesand proposechangeswhenneeded.Aframeworkshould be developed, probablyin the form of a Q&Aplatform, in order toaddresstechnicalissuesthat may well emerge in thepractical applicationof thestandards.Furthermore,animportant taskthat hasbeenattributedtotheEBA isthepublication of a list of instrumentsincludedin Common EquityTier 1(CET1) aswell asthe monitoring of thequalityof capital instruments.I believe the current text of theCRD4-CRR doesnot go far enough inensuring a strong control on the instrumentsthat will be includedin thecapital of higher quality.I understand the decisionof the EU institutionsto followan approachthat privilegessubstanceover form: thedefinitionof Common EquityTier 1will not be restrictedtoordinary shares, asthere is noharmonisedEU-widedefinition that could be reliedupon.Instead, the legislationwill require that onlyinstrumentsthat are in linewith all theprinciplesdefined by the Basel Committeewill qualify.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 154In order for this toensure a strict control on thequalityof theseinstruments,strongmechanismsshouldbeput inplacetomake surethatthereis noroom for wateringdown therequirements.The―substance‖ needstobe checked and hastobe thesame acrosstheSingleMarket.From my perspective, the list that theEBAwill keep should be legallybinding.There should be an in-depth scrutiny of the instrumentsconducted at theEU level bythe EBA, in cooperation with national supervisors, to confirmtheinclusion in the list.If an instrument is included in the list, it should be acceptedthroughouttheSingle Market.If it is not includedin the list, no authorityshould have thepossibilitytoconsider it eligible asCET1.Thepresent text limitsthe roleof the EBAtothepublication of anaggregated list onlybased on the assessment done at national level.This wouldnot bring any added valuecomparedtoa situationwhereMemberStateswouldbe required topublishby themselvesa list ofinstrumentsrecognisedin their jurisdictions.On the contrary, thiscould be misleading, asit could conveytheimpressionthat theinstrumentshave received an EU-wide recognition.In any case,even if the legislativeframeworkdoesnot provide theEBAwith the necessarylegal tools, weare committedtofullyexploitingthedraft Regulation‘sprovisionsthat require the EBAtomonitor thequalityof own fundsacrosstheSingleMarket and tonotify the Commission incaseof evidenceof material deteriorationin thequalityof thoseinstruments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 155If weconsiderthat some instrumentsthat are not of sufficient qualityhavebeen accepted, wealsohave thepossibility to open formalproceduresfor breach of European law.Having strongenforcement toolsisessential: supervisorshave lostcontrol of thedefinition of capital onceand weshould not allowthis tohappen again.We are acutely awarethat thenew ruleswill triggera new waveof financialinnovation, aimedat limitingtherestrictiveimpact of thereform.Indeed, this isalreadyunder way.We alreadyhear that new waysare beingdevised tosmooth theimpact ofpermanent write-downsor tocircumvent the prohibitionof dividendstoppersfor hybrid instruments.Our monitoring of capital issuancesisongoing.TheEBA recently decidedtodevelop a set of benchmarksfor hybridinstrumentstogivemore clarityonwhat arethetermsand conditions– intermsofpermanence,flexibilityofpayments,lossabsorbency–thatmakean instrument compliant withapplicablerules.Theworkin thisareawillbeginwhenthefinallegislationisinplaceandasufficient number of new issuancesare available, in order tohave ameaningful sampleof instrumentstoassess.In the future, hopefully, this work could move a step further, towardsprovidingcommon templates,whichcould lead to theharmonisation ofthemaincontractualprovisionsof hybrid capital instruments,in linewiththeobjectivesof a SingleRulebook.Aconcreteillustrationofthesecommon templateshasalreadybeengivenbythe EBAwhenpublishinga common term sheet for the convertibleinstrumentsacceptedfor the purposeof the recapitalisationexercise.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 1563.2. LiquidityThenewliquiditystandardsrepresent asecondimportant areaofworkfortheEBA.Thefirst deliverable is due at the end of 2012, whenwewill have toprovidefor uniform reporting formats.Theframeworkis currentlyunder development and is expectedto bereleasedfor public consultationover thesummer.However,wecan already foreseethat thereportingis likely tobe fairlysimilar to that used by theBasel Committeefor the quantitativeimpactstudy, whichmany European banks arealready familiar with.But themost important and delicateareaof workis the definitionofliquidassetsand, moregenerally, thecalibrationofthenewrequirements.Weareawarethatthebankingindustryhasraisedseriousconcernsonthetwoliquiditystandardsdefinedby theBasel Committee, the liquiditycoverageratio (LCR) and thenet stablefunding ratio(NSFR).TheBasel Committeeitself is reviewingthe calibration of theratios,recognisingthat some underlying assumptionsare excessivelyconservative, even if confronted withthe toughest momentsof thefinancial crisis.Thekey principlesunderlying theLCR and the NSFR are sound andcannot be given up by regulators:banks need tohave sufficient buffers ofliquidassetsto withstanda shock for some time without theneed forpublic support; maturity transformation needstobe constrainedtosomeextent, soastoprevent banks from adopting fragile businessmodelsrelying excessivelyon volatile, short term wholesalefundingtosupportlonger term lending.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 157But it is essential to get the calibrationright, asfunding is and willincreasinglybe themain driver of the deleveraging processat EU banks.Timeis needed to doa proper job: wehaveto ensure that data ofadequatequalityis available– hencethe need for a uniform reportingprovided at the end of 2012– and toallowfor in-depthanalyses.Thefirst impact assessmentson LCR and the NSFR are duein 2013and2015respectively.TheEU hastakenthedecisiontousethemonitoringperioduntil 2015fortheLCR and 2018for the NSFR, before proposinglegislationfor a finalcalibration of theliquidityratios.This monitoring phaseexactly mirrorstheBasel Committee‘stimeline.It is in my view the right choiceto allowfor this extensiveobservationperiod. I wouldstronglyargue that weshould avoid making any policychoicebeforeproper evidenceon the potential impact of the tworatios.ConclusionsLadies and gentlemen,TodayI tried to convey toyou a bird‘s eye picture on the difficultchallengesthe EBA is facing.In the first year of activitywehave alreadydone a huge effort tostrengthenthe capital position of EU banks and torestoreconfidenceintheir resilience.Theworkis not over in this area.Theliquiditysupport providedby theECB avoided an abruptdeleveragingprocess,but banks arestill in theprocessof repairing anddownsizingtheir balancesheetsand of refocusingtheir corebusiness.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 158We, as supervisors, need to accompany this process and do our utmost toensure that it occurs in an ordered fashion, without adverse consequenceson thefinancingof the real economy.Onewaytosupport the processisthe introductionof the reforms oncapital and liquiditystandardsendorsed by theG20.I strongly believe that weneed to exploit this opportunitytomove toatruly harmonised regulatory framework,a SingleRulebook that ensuresthat high qualitystandardsare enforced throughout the SingleMarket.We have tobe particularlyrigorouson thedefinitionof capital, asthis isthebasisfor most prudential requirements.We cannot affordanymore financial innovationthat allowsinstrumentstobeaccepted ascapital, whilenot respectingthe key principlesofpermanence, flexibilityof paymentsand lossabsorbency.The control on eligible capital instruments needs to be very strict andshould be performed at the EU level. Ideally, the co-legislators shouldgivethe EBAthe legal basistoperform this difficult task.But inanycasewewill conduct aclosemonitoringofcapitalissuances,asweconsider our dutyto ensurethat onlytheinstrumentsof the bestqualityare acceptedasregulatorycapital.As to liquiditystandards, I believethat while the principlesembodied intheBasel text are absolutelyshared, weneed to do more work on thecalibration of therequirements.We understand the concernsexpressed by the industry, but it is importantthat we collect solid empirical evidence before taking any decision in thisdelicate area, which will provide a major driver for the needed changesinbanks‘businessmodels.Thank you for your attention.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 159FSAJapan - PressConference by ShozaburoJimi, Minister forFinancial Services (Excerpt)[Opening Remarks by Minister Jimi]This morning, theMinister of Economic and Fiscal Policy, the MinisterofEconomy, Tradeand Industry and theMinisterfor Financial Servicesheldameeting, andI will make astatement regardingthepolicypackageformanagement support for small and medium-sizeenterprises(SMEs)based on the final extension of the SME FinancingFacilitationAct.Recently, the Diet passed and enactedan amendment bill toextend theperiodoftheSME FinancingFacilitationAct foroneyear forthelasttimeand an amendment bill to extend the deadlinefor thedetermination ofsupport by the Enterprise Turnaround InitiativeCorporation ofJapan, over whichMinisterof Economicand FiscalPolicy Furukawahasjurisdiction, for one year, and the new lawswerepromulgated and put intoforce.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 160I believe that this year will be very important for creating an environmentfor vigorously implementing support that truly improvesthe managementof SMEs, namelyan exit strategy.From this perspective, the ministerswhorepresent the Cabinet Office,theFinancial ServicesAgency (FSA) and the Small and MediumEnterpriseAgency held a meeting and adopted the policy formanagement support for SMEs.TheFSAwill seektofacilitatefinancingfor SMEs through measuresrelatedtothe final extension of theperiod of the SME FinancingFacilitationAct, includingthis policy package, and will alsocreateanenvironment favorablefor management support for SMEs whilemaintainingcooperation withrelevant ministries and agencies.Fordetails,theFSAstaff willlaterholdapressbriefing, sopleaseaskyourquestionsthen.[Questions & Answers]Q. The G-20meetingstarted onApril 19.I hear that the expansion of the International MonetaryFunds lendingfacility, whichhasbeen thefocusof attention, may be put off, and themarket could fall intoturmoil again, withthe yield on Spanishgovernment bondsrisingin Europe.Could you tell me how you view the recent financial marketdevelopments?A. As for the current situationsurrounding the European debt problemthat you mentionednow, individual countries financial and capitalmarketshave generallybeenrecoveringfor thepast several monthsasaresult of effortsmade by euro-zone countries and the European CentralBank, asyou know.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 161On the other hand, concern over theEuropean fiscal problem hasnotbeen dispelled, asindicated by unstablemarket movementscausedbyconcern over Spains fiscal condition.The euro zone has set forth the path to fiscal consolidation and PresidentDraghi of the European Central Bank (ECB) has taken bold measures, asyou know well.Such measuresastheECBs long-term refinancingoperationand thestrengtheningof thefirewall have been taken.Toensure that themarket will be stabilizedand the European debtproblem will come toan end, it isimportant not only that theseries ofmeasuresadopted by theeuro zone iscarried out but alsothat theIMFsfinancial baseis strengthened.From this perspective, Ministerof FinanceAzumi recentlyexpressed anintentionto announceJapanesefinancial support worth 60billion dollarsfor the IMF at the G-20meeting.I hopethat thisJapaneseaction, combinedwithEuropesownefforts,willhelp toresolvethe European debt problem.As you know, it is unusual for Japan toexerciseinitiativeand announcesupport for theIMF.Although Japan hasvariousdomesticproblems,it is theworldsthird-largestcountryin termsof GDP.In addition, asI have sometimesmentioned, Japan is theonlyAsiancountrythat hasmaintainedaliberaleconomyandafreemarket sincethelatterhalf of the 19thcentury.EventhoughJapanlost65% ofitswealthbecauseof WorldWar II, it wenton to recover from the loss.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 162In that sense,it isvery important for Japantoexerciseinitiative,onwhichtheUnited Stateseventuallyshowedanunderstanding from what I haveheardinformally.Q. It hasbeendecidedthat KazuhikoShimokobeof theNuclearDamageLiabilityFacilityFund will be appointedasTokyo Electric PowerCompanys new chairman.Tokyo ElectricPowers management problem hashad some effects on thecorporatebondmarket and alsohasaffectedsSMEs throughahikeinelectricityrates.What doyou think of this appointment?A. I am awarethat Mr. Shimokobe, whois chairman of theNuclearDamageLiability Facility Fundsmanagement committee, hasacceptedtherequest to serve asTokyo Electric Powers chairman, but the FSAwouldliketo refrain from commenting on personnelaffairs.Formerly, I, together withMr. Yosano, joinedthe cabinet taskforce,which wasresponsiblefor determiningtheschemeforrehabilitatingTokyoElectricPower,in responsetotheeconomicdamagecausedbythenuclear stationaccident, asadditionalmembers,and oureffortsledtotheenactment of theAct on theNuclear Damage LiabilityFacilityFund.I understand that Tokyo Electric Powerand theNuclear DamageLiabilityFacilityFund aredrawingup a comprehensive special businessplan.What kind of support Tokyo Electric Powerwill askstakeholderstoprovideand how stakeholdersincludingfinancial institutionswillrespond are mattersto be discussed at the private-sectorlevel, asI havebeen saying, sotheFSAwouldlike to refrain from making commentsforthemoment.In any case,regarding Tokyo Electric Powersdamage compensation,makingdamagecompensation paymentsquickly and appropriately andBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 163ensuring stableelectricitysupplyare important dutiesthat electric powercompanies must fulfill.Therefore, with the fulfillment of thosedutiesastheunderlyingpremise, it isimportant toprevent unnecessary, unpredictableadverseeffects- you mentioned the effectson thecorporatebond market earlier -soI will continuetocarefullymonitor market developments.Q. On April 19, theDemocratic Party of Japans working team on theexaminationof the future statusof pensionasset management and theAIJ problem adopted an interim report.Could you tell me about thestatusof theFSAsdeliberation on measurestoprevent the recurrenceof theproblem, includingwhenthemeasureswill be worked out?A. I readabout that in a newspaper article.Regardingproblemsidentified in this case,it is necessarytoensure theeffectivenessof countermeasureswhile takingaccount of practicalfinancial practices.That report is an interim one, soit stated that variousmeasureswill beworkedout in thefuture. I havemy ownthoughtsasthepersonin chargeof the FSA.However,I think that theFSAneedstoconduct astudyonmeasuressuchasstrengtheningpunishment against falsereportingand fraudulentsolicitation - asyou know, falsereportsweremade in this case-establishinga mechanism that ensureseffectivechecksby third-partieslike companies entrustedwith funds, auditingfirms and trust banks - thecheckingfunction did not workat all in this case- and includingininvestment reportsadditional informationuseful for pension fundassociationstojudgethereliabilityof companiesmanagingcustomersassetsunder discretionaryinvestment contractsand theinvestmentperformance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 164In anycase,regardingmeasurestoprevent therecurrenceof thiscase,wewill quicklyconduct deliberation while takingintoconsiderationtheresultsof theSecurities and ExchangeSurveillanceCommissionsadditional investigation and thesurveyon all companiesmanagingcustomers assetsunder discretionaryinvestment contracts- thesecond-round surveyis underway- aswell asthevariousopinionsexpressedintheDiet, includingtheargumentsmadein theinterimreport,whichwaswrittenunder Ms.Renhosleadership.We will implement measuresoneby oneafter each hasbeen finalized.Q. Regardingthepolicypackageannounced today, several peoplesaidintheDiet that more efforts should be devoted to measurestosupportSMEs in relationtothe extension of theperiod of support bytheEnterpriseTurnaround InitiativeCorporation of Japan.In relation to the policy package, do you see any problems with thecollaboration that has so far been made with regard to managementsupport for SMEs?A. Twenty-twoyearsago, in 1990,I became parliamentary secretaryforinternational tradeand industry, and served in theNo. 2 post of theformer Ministryof International Tradeand Industryfor oneyear andthreemonthsunder then Minister of International Tradeand IndustryEiichi Nakao.At that time, I wasin chargeof financing for SMEs, such asfinancingprovided by Shoko Chukin Bank, the Japan FinanceCorporation forSmall and Medium Enterprise,the National Life FinanceCorporationandtheSmall BusinessCorporation, for one year and three months.Many departmentsand divisionsare involved in the affairs of SMEs.While diversityand nimblenessare important for SMEs,I know from myexperiencesthat theylack human resourcesand that unlike largeBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 165companies, it isdifficult for them tochange businesspoliciesquickly inresponseto tax system changes.TheFSAwill continue to cooperatewithrelevant ministriesand agenciesand relevant organizations,such asthe Enterprise Turnaround InitiativeCorporation of Japan, liaisoncouncils on support for the rehabilitationofSMEs, financial institutionsand relatedorganizations,includingtheJapaneseBankersAssociation, andcommerceandindustrygroups- thereare four traditional associationsof SMEs - aswellasprefectural creditguaranteeassociations,whichplay an important role for thegovernmentspolicyfor SMEs.In addition, theFSAwill cooperatewithgovernment-affiliatedfinancialinstitutionsand takeconcreteactions,and I hope that recovery andrevitalizationof local economiesbased on the rehabilitationof regionalSMEs will lead to thedevelopment of theJapaneseeconomy.However,betweenthe three ministerswhoheld a meeting today, thepolicy towardSMEstendstolack coordination.In Tokyo, Ministerof Economy, Tradeand Industry Edanoand Ministerof Economicand Fiscal Policy Furukawaand I workedtogether toadoptthepolicypackage.In Japans47prefectures,thereareliaisoncouncilsonsupport for rehabilitationof SMEsand there are commerceand industrydepartmentsin prefectural and municipal governments, and theseorganizationswill alsobe involved, sothepolicy for SMEs iswide-rangingand involvesvariousorganizations.Therefore, while weprovidemanagement support, thesevariousorganizationstend toact without coordination.Today, the three of usheld a meeting to exercisecentral governmentcontrol, and wewill keep closewatchon minutedetails soastoensurecoordination.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 166As I haveoften mentioned, thereare 4.3 million SMEs, whichaccount for99.7%of all Japanesecorporationsin Japan, and 28million people, whichtranslatesintoone in four Japanesepeople, are employed by SMEs, soSMEs have largeinfluenceon employment.We will maintain closecooperationwithrelevant organizations.Q. In relationto thepreviousquestion, I understand that theEnterpriseTurnaround InitiativeCorporation of Japan hasmostly handledcasesinvolvingSMEs.At a board meetingyesterday, it wasdecided that a former official of aregionalbank will beappointedtoheadthecorporation. How doyou feelabout that?A. I reada newspaperarticle about the decisiontoappoint a formerpresident of TohoBank.TohoBank isthe largest regional bank in Fukushima Prefecture, andpersonally, I am pleasedthat a very suitablepersonwill beappointedasanew president.Fukushima Prefecture has been stressing that the revival of Japan wouldbe impossible without the revival of Fukushima in relation to the nuclearstation accident.In that sense, theselectionof theformer president of TohoBank, a fairlylargeregional bank, whoalsoserved aschairman of theRegional BanksAssociation of Japan, is appropriate.This morning, Ministerof Economic and Fiscal Policy Furukawareported on the selection.I think that a very suitableperson hasbeenselected.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 167Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 168Thereare many risk management experts thatdiscussthisinteresting speechShareholder value and stability in banking: Isthere a conflict?SpeechbyJaimeCaruana,GeneralManager,Bank forInternational SettlementsUnderstandably, theglobal regulatoryresponsetotheglobal financial crisishasstirred controversy.That response,withBaselIII at itscore,seekstostrengthentheresilienceof the bankingsystem.In doing so, it asksshareholderstogive up high leverageasa sourceofhigh returnson equity.And it asksbondholders,especiallythoseof systemically importantinstitutions,totakemore of a hit in the event of failure.In this light, it is easyenough toimaginethat investorswouldhave littlereason tohail thenew framework.This view,however,tellsonly part of thestory.It assumesthat, on balance, bank investorswerewell served by thepre-crisissystem.It alsopositsa conflict betweenvaluefor shareholderson theone handandthepublic interestin saferbanking on the other.In my remarkstodayI wouldlike tosuggestthat thissupposedconflict ofinterestsis overstated.Yes,tensionsmay arise over ashort investment horizon.But overlonghorizons,theytend todisappear– because,inthelongterm,thefocusnecessarily shiftsto sustainableprofitsand returns.This is not justtheorising:we‘ll take a look at the statisticalevidencein amoment.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 169And unlessonebelievesthat marketscan be consistentlytimed – a raregift at best – it islong horizonsthat should matter for investors.Let me first outlinewhat wein Baselmean by saferbanking and takestockof wherewestand in thedevelopment and implementationof newstandards.This is an issuein which, I am sure, you will have a keen interest.I shall then arguethat the concernsof investorsand bank supervisorsareremarkablywellaligned in the long term.Basel‘svision of safe bankingIn the past few years, theBasel Committeeon Banking Supervisionhasconducted a sweepingreview of regulatorystandardsand it hasput inplacea strengthened frameworkthat incorporatesnew macroprudentialelements.Thisframeworkisinseveralwaysagreat improvement over thepre-crisisregulatoryapproach.First of all, it setsa much more conservativeminimum ratio for capitalthat is of far better quality.When thewholeBasel III package is implemented, banks‘commonequitywill need to be at least7% of risk-weightedassets.ThiscomparestoaBaselII levelof2%–andthat isbeforetakingaccountof the changestodefinitionsand risk weightsthat make theeffectiveincreasein capital all thegreater.Among the improvementsin capturing risk on the assetsside, I wouldespeciallypoint to the improved treatment of risksarisingfromsecuritisationand contingent credit lines.Moreover,theserisk-based capital requirement measureswill besupplementedby a non-risk-basedleverageratio, which will serveasabackstop and limit model risk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 170This new frameworkrespondsto the main lessonsfrom thecrisis:bankshad leveraged excessively, had understatedthe riskinessof certain assets(particularlythose considered practicallyrisk-free), and had madeinnovationsthat reduced the loss-absorbingcapacityof headlinecapitalratios.Second, Basel III takesthenotion of a ―buffer‖ much more seriously.The7% figure includesa 2.5% capital conservationbuffer, whichbankscan draw upon in difficult times.Dividendsand remuneration will be restricted at timeswhenbanksareattemptingto conserve capital.Supervisorswillhavethediscretiontoapplyanadditional, countercyclicalbuffer when risks show signsof building up in good times, most notablyin theform of unusuallystrong credit growth.Thegoalistobuild upbuffersin goodtimesthat bankscandraw downinbadtimes.Third, the packagecontainselementsto addresssystemic risk head-on, bothbymitigatingprocyclicalityandbycushioningtheimpact offailureson the entire system.I have alreadymentioned the countercyclical buffer, whichaimstoaddresstheprocyclical build-up of risk, and the leverageratio, whichwillhelp contain thebuild-up of excessiveleveragein good times.Theframeworknow alsorecognisesexplicitlythat stressesat thelargest, most complex financial institutionscan threaten therest of thesystem.TheFinancial StabilityBoard (FSB) and the Basel Committee envisagethat thesesystemicallyimportant financial institutions,or SIFIs,willhavegreater lossabsorbency, more intensesupervision, stronger resolution andmore robust infrastructure.Theseaimscomplement each other, and share a common rationale.Greater lossabsorbency – includingcapital surchargesthat rangefrom 1to2.5% for thoseinstitutionsdesignatedasSIFIs – andbettersupervisionshould reduce the probability that problemsat thesebig market playersdisrupt activitythroughout thewider financial system.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 171Stronger resolution and better infrastructure should reducethesystemicimpact of a SIFI‘sclosureor restructuringandtherebystrengthenmarketdiscipline.In addition, methodsto identify globallysystemically important insurersare beingdevelopedand should be readyfor publicconsultationby theG20Leaders‘Summit in June 2012.And, workisunder waytoaddresstheissueof banksthat aresystemic ona national rather than a global level, aswell asto identify other globallysystemic non-bank financial institutions.Fourth, liquiditystandardshave been introduced.Thesecomprise a liquiditycoverageratio, or LCR, and a net stablefundingratio, or NSFR.Thestandards will ensure that bankshave a stablefunding structure anda stock of high-qualityliquid assetstomeet liquidityneedsin timesofstress.Importantly, the group of governorsand headsof supervision thatoverseestheBasel Committeehasconfirmedthat this liquiditybuffer isthereto beused.Specifically, bankswill be required to meet the 100% LCR threshold innormal times.But, during a period of stress,supervisorswouldallowbankstodrawdowntheir poolsof liquid assetsand temporarily tofall belowtheminimum, subject tospecific guidance.TheCommitteewill clarifyitsrulesto statethis explicitly, and will definethecircumstancesthat wouldjustify use of the pool.Sincethis isthe first timethat detailed global liquidityruleshavebeenformulated, wedonot have the same experienceand high-qualitydata aswedofor capital.Anumber of areaswill require careful potential impact assessment asweimplement theserules.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 172TheBaselCommitteehasthereforetakenagradual approachin adoptingthestandardsbetween2015and 2018,and will meanwhile assesstheimpact during an observation period.At the same time, in order to reduceuncertaintyand toallowbankstoplan, keyaspectsof liquidityregulation, such asthepool of high-qualityliquidassets, arebeing reviewedon an acceleratedbasis.But any changeswill not materiallyaffect the framework‘sunderlyingapproach, whichis toinducebanks tolengthentheterm of their fundingand toimprove their risk profiles, instead of simplyholding more liquidassets.Finally, it is time for thesenew rulesand frameworksto be implemented.TheBaselCommitteeisalreadyengagedin thefull, consistent andtimelyimplementationof theframeworkbynational jurisdictions.Tothis end, the Committeehasstarted toconduct both peer andthematic reviewsthrough itsStandardsImplementation Group.Last October, the Committeepublishedthe first regular progressreportson members‘implementationof what theyhave agreed.Eachmember willalsoundergoamoredetailedpeerreview,startingwiththeEU, Japan and the UnitedStates.And the Committeeis currentlyreviewingthemeasurement ofrisk-weightedassetsin banking and tradingbooks, withan eye toconsistencyacrossjurisdictions.Thegoal of thesemeasuresis clear:to havea stronger and safer financialsystem.This should benefit everyone – the bankingindustry, usersof financialservicesand taxpayers.But some may question whether shareholderswill benefit aswell. Hastheleveraged businessmodel of thepast reallyserved them well?Therecord, to whichI turn next, suggeststhat it hasnot.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 173Shareholder returnsand the leveraged businessmodelOverthelongterm, bankshaveturned inasub-par performance,whetherassessed on accountingmeasuresor by return on equity.Historically, the averagereturn on equityin banking hasmatchedthat ofother sectors(seeTable).But unlike in other sectors,thesereturnshave involved thegeneroususeof leverage, either on the balancesheet or, frequently, off it.Weknowthat bankinginvolvesleverageandmaturitytransformation, butthequestion is howmuch is appropriate?There may beno clear answer,but let‘slook at thedata. Bank equitywason averageleveraged more than 18 timesin 1995–2010.Equityinnon-financial firmswasleveraged onlythree times(seeTable).This impliesthat, compared withother firms, banks have succeededindeliveringonlyaveragereturn on equityover thelongterm but at thecostof higher volatilityand lossesin bad times(Graph 1).Turn now to stock returnsand themessagedoesnot changemuch.Anyone whoat the start of 1990had invested in a portfolio that waslongglobalbankingequitiesand equallyshortthebroadmarket indiceswouldtodaybe sittingon a loss(Graph 2, right-hand panel).And, over the longterm, risk-adjustedreturnshavebeen sub-par.Themain exception is Canada, wherebanks havebarelysuffered in therecent crisis (Graph 2, left-hand panel).It is high leveragethat hascontributed to thevolatilityof bank profits.And it is high leveragethat makes banksperform sobadlyona rainy day.During periodsthat comprise theworst20%of stock marketperformance, banksdoworsethan most other sectors(Graph 3, left-handpanel).Clearly, the flip sideis that theydo very nicelyon sunnydays(Graph3, right-hand panel).For investors, this isnot a compellingvalue proposition.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 174Tobe sure, somemay be agile enough toprofit from the downsideinbank stocks.But mostinvestorsinevitablyentered theglobal financial crisisfullyinvestedor overweight in bank stocks.And, historically, market timinghasproved anelusivestrategy.Not onlyis theperformance of banks over time inconsistent with thenotionthatshareholderscanbenefit fromhighleverageandstatesupport;theevidenceacrossbanksactuallysuggeststhatthebanksthat weremorestronglycapitalisedat the outset weatheredthe crisis better.Theleft-handpanel of Graph 4 suggeststhat no particular relationshipexistedbetweenTier 1capital and thepre-crisisreturn on equity.Indeed, bankswithstrongerTier1equitycouldanddid matchthereturnsof lesswell capitalisedpeers.When thecrisishit, however, the lesswell capitalised banksscrambled toraisefundsin difficult market conditions,whiletheir stronger competitorscould avoid fire salesand distressed fund-raising(centre panel).And it wasthe banksthat had reported high-flying returnsbeforethecrisisthat werethemost likely to resort tofire salesand distressedfund-raising(right-handpanel).Theconclusion isthat stronger capital makes a difference.Afurther considerationis that it iseasierand probablycheaper toraisecapital in good times.Together, these observations suggest that leverage is not the only way togenerate returns – and that, when returns don‘t depend on leverage, theyare more sustainable.What investors can expect from banksAll this indicatesthat investorscould reach a better understandingwithbank managements.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 175Thekey is sustainedprofitabilitythrough both good and bad times.Recent workat theBISsuggeststhat, wheneconomic activitymovesfrom peak totrough, thebetason bank stocks, relatingpercentagechangesin their valueto that of broad market indices, increasebywellover 150basispoints.In effect, banksaregeneratinggood returns in good timesby writingout-of-the-moneyputsthat come back tohaunt them when themarketfalls.How did weget here?Thestoryof a major UK bank issymptomatic.Twentyyears ago, the head of thebank promised investorsthat theinstitution wouldbeat itscost of equity, whichhe took to be19%.For a while,thebank wasableto achievethisreturn by closingbranches.But ultimately such promises led bank managers to invest their liquidityreserve in asset-backed securities, boosting earnings in effect by writingputson both credit and liquidity.When it came to the crunch, the bank could not keep its return on equityabove 20% during the global financial crisis and had to seek help from thestate.Given the trend declinein inflation and government bond yields, 20% intheearly 1990stranslatestosomethingmore like 15% today.Still, bank managementsthat continue to promise such returns may findthemselves again writing puts, effectively making themselves hostage tobadtimesin order topump up returnsin good times.Accounting norms that treat riskpremia in good timesasdistributableprofitsdonot help.In any case,managementswhopromise sustained 15% returnsin alow-inflation, deleveragingeconomymay be leadinginvestorsastray.Over time, sustainedprofitabilityat more reasonablelevelsshould bringbank sharepricesback to a premium over book values.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 176Past behaviour supports this conclusion. In particular,my colleaguesestimatethat if leveragedecreasesfrom 40to20, the required return – thereturn investorsdemand – dropsby 80basispoints.The intuition is that, when banks increase their equity base (or reduceleverage), they work each unit of equity less – that is, the risk borne byeach unit of equity falls—andsodoesthereturn investorsrequire.This prospect would characterise a new long-run understanding betweenshareholders and bank managements that produce sustained profits. Buthow should banksget there?Here I donot refer totheimmediateproblembanksfacein bringingtheirassetsintolinewiththeir capital, leadingto considerable deleveraging.Instead, I refer tothelonger-term problem.How should banks generatereturnsin order tobe sustainable?I wouldarguethat suchreturnscanarisefrom areconsiderationofbanks‘businessmodels.In linewiththe lessonsdrawnfrom thecrisisby banks, investorsandprudential authorities,thesemodelswouldrecognise that our knowledgeof systemic risk is incomplete.As a result, bank managers wouldseek sustainableprofit lessinrisk-takingand maturity transformationandmore in operational and costefficiency.Cost efficiencycan powerfullycontributeto bank earnings.As a rule of thumb, on averageacrosscountries, a 4% reduction inoperatingexpensestranslatesintoroughly a 2 percentagepoint increasein return on equity.Moreover,experiencestronglysuggeststhat determined attempts tocleanup balancesheetsand cut costscan gohand in hand withasustainedrecovery in profitson the back of a stronger capital base.This is preciselytheexperienceof Nordiccountries,whichsufferedseriousbanking crisesin the early1990s(Graph 5).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 177With costsunder control, banks can achievehigher profitabilitywithstronger capital.ConclusionsLet me pull together the threadsof the argument.Thebanks that fared better in the crisiswerethose that weremoreprudentlycapitalised.Investorsaswellasregulatorswant to ensure that this wisdom is writtenintothe rulesof thegame.The financial reforms that have been agreed will increase the quality andamount of bank capital in the system; they will also promote increases ofcapital buffersin good timesthat can be drawndown in bad times.Big, interconnectedand hard-to-replacebankswill carry extra capital.Theauthoritiesare workingtoensurethat nobank istoocomplex to bewounddown. Theyare refiningnew liquiditystandards.And theyare takingunprecedented stepsto make sure that thenewregulationsare implemented effectivelyacrosscountries.The outcome should be a stronger financial system. But regulation is onlypart of the answer and stronger market discipline will alsobe necessary toensure resilience.I havepresentedthecasethat, over the longterm, there is noconflictbetweenshareholder value and the publicinterest in safer banking.This propositionissupportedby therecord of return on equityand bankshareprice performance– a record that refutestheargument that bankshaveused leveragetoproducesustainedshareholder value – and the keywordhere is ―sustained‖.Bank returnsmay havebeen comparatively high in good times.But thosereturnshave melted awayin bad times.And theyhave come at thecost of greater risk.In the long run, bank businessmodelshaveproduced middlingreturnswith substantial downsiderisk.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 178This meansthat in good timesbankshave overpromised andoverestimatedtheir underlying profitability.Theyhave writtenput optionson their liquidityand credit and reportedthepremia ascurrent income.In effect, theyhave made distributionsout of what should have beentreatedasexpected losses.How can investorshelp banks move in the right direction?Theycould encouragesustainablebusinessmodelsbased lessonrisk-takingand more on a careful analysis of competitiveadvantageandoperational efficiencies.And theyshould bewaryof entertainingunrealisticexpectationsaboutsustainableratesof return.Onlywhen solid businessmodels and realistic commitmentstosustainablereturnsarerewardedcanshareholdervaluebereconciledwithsafebanking.Indeed, there isnoother way.*****As a postscript, and for the sakeof completeness, let me outline threeother regulatory initiatives.First, the FSB, with the involvement of the IMF, the World Bank andstandard-settingbodies, will draft an assessment methodologythatprovidesgreater technicaldetail on theKeyAttributesof EffectiveResolutionRegimesfor Financial Institutions.TheFSB will use thedraft methodologyto begin, in the second half of2012,a peer review evaluatingmember jurisdictions‘legal andinstitutional frameworksfor resolution regimes (and of anyplannedchanges).And supervisorsplan to put in placeresolution plansandinstitution-specificcooperation agreementsfor all 29G-SIFIsbyend-2012.Second, work continuestowardsstrengtheningOTC derivativesmarkets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 179Thisincludesmeetingthe commitmentsbyG20Leaderstomovetradingin standardised contractstoexchangesand central counterpartiesbyend-2012.Market supervisorsand settlement system expertsare close tofinalisingstandardsfor strengtheningCCPsand other financial marketinfrastructures.Meanwhile, bankingsupervisorsarereviewingtheincentivesfor bankstotradeand clear derivativescentrally.Another important initiativehereistheestablishment ofaglobal, uniformlegal entityidentifier, for which theFSB, with thesupport of an industryadvisorypanel, is developing recommendationsto be presentedtothenext G20Summit in Mexicoin June.Third, potential risksrelatedtothe shadow banking system are beingaddressed.Bankingsupervisorsare examiningbanks‘interactionswithshadowbanking, includingissuesrelated toconsolidation, largeexposure limits,risk weightsand implicit support, and will proposeanyneededchangesbyJuly 2012.Market supervisorsare lookingat the regulation of moneymarket fundsand at issuesrelatingto securitisation on the same schedule.MultidisciplinaryFSB task forcesare examiningother shadow bankingentitiesand, separately, securitieslendingand repomarkets,with a viewtomaking policyrecommendationslater thisyearBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 180Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 181Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 182Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 183JensWeidmann: Global economicoutlook – what is the best policy mix?Speechby Dr JensWeidmann, President of the Deutsche Bundesbank, at theEconomic Club of New York, NewYork, 23April 2012.1. IntroductionLadies and GentlemenGeorgeBernard Shaw is said to have made an interestingremark aboutapples– ―If you haveanappleandI haveanappleandweexchangetheseapplesthen you and I will still each haveone apple.But if you have an ideaand I have an idea and weexchangetheseideas,then each of uswill have twoideas.‖I think thosewordsperfectlyencapsulatetheintention of theEconomicClub of NewYork and of today‘s event.Ideas multiplywhenyou share them and theybecomebetter whenyoudiscussthem.I am thereforepleasedand honoured to be able toshare someideaswithsuch a distinguishedaudiencetoday.And I look forwardtodiscussing them withyou.In alonglistofspeakers,I amthethirdBundesbank President tospeakattheEconomic Club. The first wasKarl OttoPöhl in 1991,followedbyHans Tietmeyer in 1996.Although onlya few years have passedsincethen, the global economiclandscapehascompletelytransformed inthemeantime – justthink of thespread of globalisation, think of the introduction of the euro, think of theAsian crisisor the dotcom bubble.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 184All theseeventsand othershave constantlyshapedand reshapedourworld.Most recently, wehave experienced a crisisthat, once again, will changetheworldasweknow it – economically, politicallyand intellectually.It is this new unfolding landscapethat providesthebackdrop to myspeech.I shall addresstwoquestions:―Where dowestand?‖and ―Where dowegofrom here?‖Of course, it is thesecondquestion that is thetrickyone.In answeringit, weshouldbeawarethat everysmallstepwetakenowwilldeterminewherewestand in the future.Specifically, I shall argue that measuresto ward off immediate risks to therecovery are closely interconnected with efforts to overcome the causesofthecrisis.Theyare interconnected much more closelyand vitallythan proponentsof more forceful stabilization effortsusuallyassume.But, first, let usseewherewestand at the present juncture.2. Where do we stand?When welookback from wherewearestandingright now,weseea crisisthat hasleft deep scars.TheInternational Labour Organisation estimatesthat up to 56 millionpeoplelosttheir jobsin the wakeof thecrisis.This number equalsthecombined populationsof California and thestateof New York.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 185Or look at government debt: Between 2007 and 2011, gross governmentdebt as a share of GDP increased by more than 20 percentage pointsintheeuro area and by about 35percentagepoints in theUnited States.I think weall agree that the crisiswasunprecedentedin scaleand scope.And the first thing todo wasto prevent the recessionturningintoadepression.Thankstotheeffortsof policymakers and central banks acrosstheglobe, thishasbeen achieved.Followinga slight setback in 2011, the worldeconomy nowseemstoberecovering.In its latestWorld EconomicOutlook, theIMF confirmsthat globalprospectsare graduallystrengtheningand that thethreat of sharpslowdownhasreceded.Lookingahead, theIM F projectsglobal growthtoreach 3.5% in 2012and4.1% in 2013.For thesame years, inflation in advancedeconomiesis expectedto reach1.9% and 1.7%.Basically, I sharetheIMF‘sview. However, weall are awarethat theseestimateshavetobetaken with a grain of salt – probablya largeone.Beinga central banker, I am not quite ascalm about inflation.Takingintoaccount risingenergy pricesand robust coreinflation, pricescould risefaster than the IMF expects.We have tobe careful that inflation expectationsremain well anchoredand consistent withprice stability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 186Expectationsgettingout of linemight very well turn out to beanon-linearprocess.If this wereto happen, it wouldbe difficult and expensive to rein inexpectationsagain.Even though the outlookfor growth hasimproved over the pastmonths,somerisksremain –theEuropeansovereigndebt crisisbeingoneofthem. And this seemsto be theone riskthat isweighingmost heavily onpeoples‘minds– not just in Europe but here in the United States,too.Theeuro-areamember stateshave respondedby committingtoundertake ambitiousreformsand by substantiallyenlargingtheirfirewalls.Thisnotwithstanding, thesovereigndebt crisishasnot yet been resolved.Therenewedtensionsover the past twoweeksare a casein point.Thus, wehave to keep moving, but each step wetake hasto beconsideredvery carefully.As I have alreadysaid:each small step wetake now will determinewherewestand in the future.3. Where do we go from here?Eventually, three thingswill have to happenin the euro area.First, structural reformshavetobeimplementedsothat countriessuchasGreece, Portugal and Spain becomemore competitive.Second, publicdebt hastobereduced–achallengethat isnotconfinedtotheeuro area.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 187Third, the institutional framework of monetary union hasto bestrengthenedor overhauled, and weneed more clarity about whichdirectionmonetary union isgoing totake.I think weall agree on this – includingtheIMF in itslatestWorldEconomicOutlook.However,there is much lessagreement on the correct timing.Sincethecrisisbegan, theimperativesI havejust mentionedhavetendedtobe obscured by short-term considerations.And surprisingly, thistendencyseemstobe becomingstronger now thattheworldeconomy isgettingback on track.This view isreflectedby somethingLawrenceSummers wrotein theFinancial Timesabout four weeksago.ReferringtotheUS,hesaidthat ―… themost seriousrisktorecoveryoverthenext few years […] is that policywill shift tooquickly awayfrom itsemphasison maintainingadequate demand, towardsa concern withtraditional fiscal and monetary prudence.‖It is in thisspirit that some observers arepushing for policiesthateventuallyboil downto ―more of the same‖: firewallsand ex ante risksharingin the euro area should be extended, consolidationof public debtshouldbepostponedor,at least, stretchedovertime,andmonetarypolicyshould playan even bigger rolein crisismanagement.I explicitlydonot wishto deny thenecessityof containingthecrisis.But all that can be gainedis thetime to addressthe root problems.Theproposed measureswouldbuy ustime, but theywouldnot buy usalastingsolution.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 188And five years after the burstingof the subprime bubble and three yearsafter the turmoil in the wakeof the Lehman insolvency, wehave to askourselves:Where will it take usif weapplythesemeasuresover and overagain – measureswhichare obviously geared towardsalleviatingthesymptoms of the crisisbut whichfail toaddressitsunderlying causes?In my view, this wouldtakeusnowhere.There aretworeasonsfor this.First, the longer such a strategy is applied, theharder it becomestochangetrack.Moreand more peoplewill realisethis and they will start to loseconfidence.Theywill loseconfidencein policymakers‘ability tobringabout a lastingsolution to our problems.And weshould bearin mind that the crisisis primarily a crisisofconfidence:of confidencein thesustainabilityof public finances,incompetitivenessand, to some extent, in theworkingsof EMU.But there isa second reason whythe―more of thesame‖ will not take usanywhere.Theanalgesic weadministercomeswithsideeffects.And the longer weapplyit, the greater these sideeffectswill be, and theywill come back to haunt usin the future.In the end, it is just not possibletoseparate theshort and thelong term.You will be tomorrow what you do today.With these twocaveatsin mind, let ustake a closerlook at thesuggestedpolicymix.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 189For thesake of brevity, I shall focuson monetary and fiscalpolicies.3.1An even bigger role for monetary policy?Tocontain thecrisis, the EMU member stateshavebuilt a wall of moneythat recentlyreached the staggeringheight of 700billion euros.As I have alreadysaid, ring-fencingiscertainlynecessary, but again:it isnot a lastingsolution.And it isnot theskythat‘sthelimit – thelimitsare financial andpolitical.In the faceof such limits,theEurosystem is now seen asthe ―last manstanding‖.Consequently, some observersaredemanding that it play an even biggerrolein crisismanagement.Morespecifically, such demandsincludelowerinterest rates,moreliquidityand larger purchasesof assets.But doesthe assumption on which these demandsare based hold truewhenwetake a closer look at it?In theend, monetarypolicyisnotapanaceaandcentralbank ―firepower‖is not unlimited, especiallynot in monetaryunion.True,thiscrisisisexceptional in scaleandscope, andextraordinarytimesdocall for extraordinarymeasures.But the central banksof theEurosystem have alreadydone a lot tocontain crisis.Now wehavetomakesurethat bysolvingonecrisis,wearenot preparingtheground for thenext one.Take, for example, the side effectsof low interest rates.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 190Researchhasfound that risk-takingbecomesmore aggressivewhencentral banksapplyunconditional monetary accommodationin order tocounter a correction of financial exaggeration, especiallyif monetarypolicy doesnot react symmetrically to thebuild-up of financialimbalances.In the end, putting too much weight on countering immediate risks tofinancial stability will create even greater risks to financial stability andprice stability in thefuture.TheEurosystem hasapplied a number of unconventional measurestomaintainfinancial stability.Thesemeasureshelpedtoprevent an escalation of the financial turmoiland constitutea virtuallyunlimitedsupplyof liquidityto banks.But monetary policy cannot substitutefor other policiesand must notcompensatefor policyinactionin other areas.If theEurosystem fundsbanksthat arenot financiallysound, anddoessoagainst inadequate collateral, it redistributesrisksamong nationaltaxpayers.Such implicit transfersare beyond themandateof theeuro area‘scentralbanks.Rescuingbanksusingtaxpayers‘moneyissomethingthat shouldonlybedecided by national parliaments.Otherwise,monetarypolicywouldnurture thedeficit biasthat isinherenttoa monetary union of sovereign states.In this regard, thesituation of the Eurosystem is fundamentallydifferentfrom that of the Federal Reserve or that of the Bank of England.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 191Moreover,extensiveand protractedfundingof banksbythe Eurosystemreplacesor displacesprivateinvestors.This breedsthe risk that some bankswill not reform unviablebusinessmodels.Sofar, progressin this regard hasbeenvery limitedin a number ofeuroareacountries.And the Eurosystem hasalsorelieved stressin the sovereignbondmarket.However, we should not forget that market interest rates are an importantsignal for governments regarding the state of their finances and that theyare an important incentivefor reforms.Of course,marketsdonot alwaysget it right.Theymay have underestimatedsovereign risks for a long timeand nowtheyare overestimatingit.But past experiencetaught usthat their signal is still themost powerfulincentivewehave.At any rate, I wouldnot rely on political insight or political rulesalone.After all, monetary policy must not losesight of itsprimary objective:tomaintainpricestability in theeuro area asa whole.What doesthis mean?Let ussaythat monetary policy becomestooexpansionary forGermany, for instance.If this happens, Germanyhastodeal with this using other, nationalinstruments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 192But by the same token, wecould say this: even if weare concerned abouttheimpact on theperipheral countries,monetary policymakers must dowhat is necessaryonceupsiderisksfor euro-area inflation increase.Deliveringon itsprimary goal of maintainingprice stability isessentialfor safeguarding themost preciousresourcea central bank cancommand: credibility.Tosum up: what wedo in the short-termhas tobe consistent withwhatweare trying to achievein thelong-term – price stability, financialstability and sound public finances.Thisimpliesadelicatebalancingact – abalancingact weshall upset if weoverburdenmonetary policy with crisis management.3.2 Rethinking consolidation and structural reforms?Now, what about consolidationand structural reforms?Here, too, wehavetostrike the right balancebetweenthe short and thelongrun.Thosewhoproposeputting off consolidation and reformsargue thatembarkingon ambitiousconsolidationeffortsor far-reachingstructuralreforms at thepresent moment wouldplace toogreat a burden onrecovery.Theydonot denythe necessityof such stepsover themedium term, butin theshort-run theyconsiderit more important tomaintain adequatedemand, avoid unsettlingpeopleand nurture therecovery.But in theend, the current crisisis, toa largedegree, a crisisofconfidence.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 193And if already announced consolidationand reformsweretobedelayed, wouldpeoplenot loseeven more confidencein policymakers‘ability toget to the root of thecrisis?We can only win back confidenceif webring down excessivedeficitsandboost competitiveness.And it ispreciselybecausethesethingsare unpopular that makes it sotemptingfor politicianstorely instead on monetary accommodation.It is true that consolidation, in particular, might, under normalcircumstances, dampen aggregatedemand and economic growth.But thequestionis:are thesenormal circumstances?It is quiteobviousthat everybody seespublicdebt asa major threat.Themarketsdo, politiciansdo, and peopleon MainStreet do.Awidespreadlack of trust in public financesweighsheavily on growth:thereis uncertaintyregardingpotential future tax increases,whilefundingcostsare risingfor privateand public creditorsalike.In such a situation, consolidation might inspire confidenceand actuallyhelp theeconomy to grow.In myview,therisksof frontloadingconsolidationarebeingexaggerated.In any case,there is littlealternative.In the end, you cannot borrow your wayout of debt; cut your wayout istheonly promisingapproach.4. ConclusionAllowmetoconcludebygoingbacktothebeginningof myspeechwhereI mentionedthebenefits of sharing and discussingideas.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 194I havestressed that wehave toembark on reformsthat makethecrisiscountriesmore competitive;that wehave to reduce public debt and thatwehave tofurther improve the institutional framework of monetaryunion.But thespirit ofmyargument wasexpressedsuccinctlysome20yearsagobyKarl OttoPöhl.In hisspeech at theEconomicClub he said:―The truefunction of acentral bank must be, however, to take a longer-term view.‖And after fiveyears of crisis, the long term might catch up withusfasterthan weexpect.We thereforehave to think about the future now – and wehave to actaccordinglyaswell. Thank you for your attention.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 195AndreasDombret: Towardsa more sustainable EuropeSpeech by Dr Andreas Dombret, Member of the Executive Board of theDeutsche Bundesbank, at the Euromoney GermanyConference, Berlin, 25April 2012.* * *1IntroductionLadies and GentlemenI am delightedto have the opportunitytospeak toyou todayat theEuromoneyGermany conference.Now in its8th year, the conferencehasestablisheditselfasafirst-classopportunityfor policymakers and financial practitionerstoexchangeviews.I firmly believe that thisfree flow of ideasis of benefit to usall, and I amlookingforwardtosharing my viewswith you in thenext 20 minutes.We are facinga crisisthat is nolonger confinedtoindividual countries.Throughout and beyond Europe, it weighsheavily on people‘sminds.Somebelieve, it even challengestheviability of monetary union in itscurrent form.Given the exceptional scaleand scope of the crisis, it is hardly surprisingthat viewsdivergeon how to overcome it.But it is worthrecallingthat despiteintensedebateson thebest wayforward,weshare a common vision for thefuture of our monetary union:a sound currency, sound publicfinances,competitiveeconomies,and astablefinancial system.Thesearethe principlesenshrined in theMaastricht Treaty.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 196With theadoptionofthetreaty, all euro-areamember statescommittedtoa European stabilityculture.Among thosemost eager tojoin werethecountrieswith first-handexperienceofthepainful consequencesof deficitsspirallingout ofcontroland of a monetarypolicy not alwaysfullycommittedtomaintainingpricestability.Theunholy―marriage‖ between Bancad‘Italia andtheItaliantreasuryin1975is aperfect example.Banca d‘Italia vowedto act asbuyer of last resort for government bonds.Up to the ―divorce‖ in 1981,Italian government debt more thantripledwhileaverageinflationstood at 17%.After Banca d‘Italia wasgranted greater independence, inflation ratesbegantofall significantly.Theprinciplesof a sound currency, sound public financesand acompetitiveeconomy thus remain the cornerstonesof a strongandsustainablemonetary union.Far from beinga specificallyGerman conviction, theyserve thewell-beingof citizensthroughout the euroarea.And theongoingvalidityoftheseprinciplesisaprerequisiteforthepublicacceptanceof monetary union.Thus, any approach that doesnot respect and comply withtheseprincipleswill not bringabout a lastingsolution tothe crisis.Thecurrent crisisis not a crisisof the euro asour common currency.Sincethe start of theeuro, inflationhasbeen in linewith theEurosystem‘sdefinition of pricestability, and theeuro continuestobe astrongcurrency – tosome, it actuallyappearsto be toostrong.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 197But it is generallyaccepted that thetwocentral elementsof the crisis arelargemacroeconomicimbalancesstemmingfrom divergingcompetitivenesslevels,and unsustainablelevelsof publicdebt.2 The root causesof the crisis: macroeconomic imbalancesandover-indebtednessNo lastingsolution tothecrisiswill be achieved unlesstheseroot causesare tackled.Firewallscan help some countriesto cope better withtheeffectsofsudden shiftsin investor sentiment, but, ultimately, all it can do is buytime.AstheIM F pointsout initsrecent WorldEconomicOutlook, firewallsbythemselvescannot solve the difficult fiscal, competitivenessand growthissuesthat some countriesare now facing.2.1Macroeconomic imbalancesThere is broad consensusthat macroeconomic imbalances, whichhavebuilt up in recent years, lie at theheart of the crisis.But thebest waytocorrect theseimbalanceshasbeen thesubject ofintensedebate.Exchangerate movementsare usuallyan important channel throughwhichunsustainablecurrent account positionsare corrected– deficitcountrieseventuallyseea devaluation, while surplustend torevaluetheircurrencies.Thereactionsthat this triggersin imports,exportsand correspondingcapital flowsthenhelp to bringthe current account back closer tobalance.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 198In a monetary union, however, thisis obviouslynolonger anoption.Spain nolonger hasa peseta todevalue; Germanyno longer hasadeutschemark torevalue.Other thingsmust thereforegiveinstead:prices, wages,employment andoutput.Thequestion now is whichcountrieshave to shoulder the adjustmentburden.Naturally, this iswhereopinionsstart todiffer.TheGerman positioncould be described asfollows:the deficit countriesmust adjust.Theymust addresstheir structural problems, reducedomesticdemand, become more competitiveand increasetheir exports.But thispositionhasnot gone uncontested.Indeed, well-knowncommentatorssuggest that surpluscountriesshouldbearpart of the adjustment burden in order toavoid deflation in deficitcountries.Theyalsopoint out that not all countriescan act like Germany, in otherwords,not all countries can run a current account surplus.Hence, they suggest that surpluscountriesshouldshoulderat leastpartof the burden.But thiscriticism missesthe point of what the correction of domesticimbalancesactuallymeans:Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 199As regardsthe lingeringthreat of a protracted deflation, it is rather aone-off reduction of pricesand wagesthat is required, not a lastingdeflationaryprocess.In fact, frontloading reforms and necessary adjustment has proven to bemore successful than protracted adjustment, as experience in the Balticstatesand Ireland shows.And while not all countries can run a current account surplus, all canbecome more competitive– higher competitivenessdue toproductivityincreasesor lowermonopoly rentsin, up to now, overregulatedsectorsisnot a zero sum game.Structural reformscan unlock thepotential toincreaseproductivityandthusimprove competitivenesswithout inducingdeflation.There is no wayaround thefact that Europe is part of a globalisedworld.And, at theglobal level, weare competingwitheconomiessuchastheUnitedStatesor China.Tosucceed, Europeasa wholehastobecomemore dynamic, moreinventiveand more productive.Oncethe deficit countriesstart to becomemore competitive, surpluscountrieswill adjustautomatically.Theywill become lesscompetitivein relativeterms, exporting lessandimportingmore.And weshould acknowledgethat this processhasalreadybeen set inmotion.Exportsof a number of peripheral countries have startedtogrow, bringing down current account deficitsin the process.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 200Correspondingly, German importsfrom theeuro area have grownstronglyover the last two years, almost halvingthe current accountsurplusbetween2007and 2011.Tofacilitatetheadjustment process, euroarea membershave committedsignificant fundswithin theframeworkof the EFSF and the ESM.Germanyis contributingthebiggest share.This support isbased on thehigh reputation Germany enjoys amonginvestors.We wouldput this trust in jeopardyif wewereto give in to callsfor fiscalstimulusin Germany in order toraisedemand for importsfrom theperipheral euro area.But weakeningGermany‘s fiscal positionwouldlead to higher refinancingcostsand, therefore,eitherreducethecapacityofthefirewallsor raisetheborrowingcostsfor programme countries.Moreover,studiesbythe IM F suggestthat positivespill-over effectsfroman increasein German demand to partner countriesin the euro areawouldbe minimal.So, instead of stimulatingexports in peripheral euro-areacountries,additional fiscal stimulusat a timewhenGermany‘s economyis alreadyrunning at normal capacitywouldbe of detriment toallparties.2.2 Fiscal consolidationTurning to fiscal consolidation, it isoften stressedthat suchmeasures,together withstructural reforms, wouldbe too much of aburden.Theywould create a viciouscircleof decreasingdemand and furtherbudget pressure that wouldeventuallybringthe economy down.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 201But tothe extent that the current output level wasfuelledby anunsustainableballooningof private and public debt, correction assuch isunavoidable,andtheonlyquestionthat remainsisthat ofthebest timing.However,thiscrisis is a crisisof confidence.While, under normal circumstances,consolidationmight dampen theeconomy, the lack of trust in public financesand in policymakers‖willingnesstoact isa hugeburden for growth.Thus, frontloaded, and thereforecredible,consolidation wouldinsteadstrengthenconfidence,actuallyhelp theeconomytogrow and reducethedanger of the crisisspreadingtothe financial system.In addition, urgentlyneeded structural reformsand consolidation areoftenhard todisentangle.For example, a bloatedpublic sectoror very generouspension system areboth a drag on growth and a burden on the budget.Thesameappliestoinefficient companiesthat arestate-ownedoroperatein highlyregulatedsectors.Therisksto growthemanatingfrom immediatefiscalconsolidationthereforehave tobe put intoperspective.Negativeshort-term effects cannot be ruledout.But tothe extent that consolidation constitutesnecessarycorrectionsofan unsustainabledevelopment and bringsabout greater efficiency, thelong-term gainsdonot onlyvastlyexceed potential short-term pain, theyalsohelptoalleviateit nowbyrestoringthelost credibility in theabilitytotacklethe root causesof the crisis.3 The role of monetary policyUp to now, thepicture hasbeen mixed in this regard.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 202We have seen substantial progress,often initiatedby new, morereform-mindedgovernments,but alsosome setbacks.Amuch clearerpattern hasemerged withrespect to theexpectationsplaced on monetary policy.Whenever a new intensification of the crisislooms, the first questionseemsto be ―What can the central banksdo about this?‖Tome, thisis a worrisomedevelopment. Monetarypolicyhasalreadygonea very long waytowardscontainingthecrisis.But wehave tobe awarethat themedicineof a very low interest ratepolicy, ampleprovision of liquidityat very favourableconditionsandlarge-scalefinancialmarket intervention doesnot come without sideeffects– whichare all the more severe, the longer thedrug isadministered.In the courseof thiscrisis, the role of central bankshaschangedfundamentally.Beforethecrisis,theyprovidedscarceliquidity;nowtheyincreasingserveasa regular sourceof funding for banks, and thisthreatensto replaceordisplaceprivate investors.This may give risetonew financial instability if, asa result of themeasures,banksand investorsbehavecarelesslyor embark onunsustainablebusinessmodels, for instance, due tosubstantialcarrytrades.But emergencymeasureswill not becomethe―new normal‖.Banks, investorsand governmentshave tobe fullyawareof this, andcentral bankscannot toleratethat their well-intentioned emergencyBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 203measuresresult inadelayinnecessaryadjustmentsinthefinancialsectoror protracted consolidationand reform effortsamong governments.4 ConclusionLadies and Gentlemen, In my remarks, I have focused on necessaryreforms in the euroarea member states.This is not tosay that changesto the institutional set-up of monetaryunion arenot important.If member stateswant toretain autonomy withregard tofiscal policy, weneed stricterrules toaccount for theincentivestoaccumulatedebt thatexistin a monetary union.Thefiscal compact isa promising step forward.Now, it is essentialthattherulesare applied rigorously.Referring to the mottoof this conference―AGerman Europeor aEuropean Germany‖, how should one label therecipetoovercome thecrisisthat I have just presented?Well, it is, quiteobviously, a European solution.And that isbecauseit fullyreflectsand respectsthe letter aswell asthespirit of the European Treaty and therefore of the principlesthat Istressed at thebeginning.Thecurrent crisisis most certainlya definingmoment for monetaryunion.But the crisisand the measurestaken to overcome it should not beallowedto redefineimplicitlywhat monetary union actuallyis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 204This time wereallycannot ―let thiscrisisgoto waste‖, astheformerWhiteHousechiefofstaff, Rahm Emanuel,put it. Thecrisishaslaidbarestructural flawsat many levels.It hasquestionedthe wayweadhered to theprinciplesof EMU, but didnot invalidatetheprinciplesthemselves,quite thecontrary.I am confident that having stared intotheabyss, Europe will make theright choicesand pave the wayfor a more prosperousand sustainablefuture– tothe benefit of Germany aswell asof the euro area asa whole.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 205Speech, Chairman Ben S.BernankeAt theRussell SageFoundation and TheCenturyFoundation Conferenceon "Rethinking Finance"New YorkSomeReflections on the Crisisand the PolicyResponseI wouldlike to thank the conferenceorganizersfor the opportunitytooffer a few remarks on the causesof the2007-09financial crisisaswell ason theFederal Reserves policy response.Thetopic isalargeone,andtodayI will beableonlytolayout somebasicthemes.In doing so, I will draw from talksand testimonies that I gave during thecrisis and its aftermath, particularly my testimony to the Financial CrisisInquiry Commissionin September 2010.Given the time available,I will focusnarrowlyon thefinancial crisisandtheFederal Reservesresponse in itscapacityasliquidityprovider of lastresort, leavingdiscussionsof monetary policy and theaftermath of thecrisistoanother occasion.Triggersand VulnerabilitiesIn its analysisof thecrisis, my testimonybeforetheFinancial CrisisInquiry Commissiondrew thedistinctionbetweentriggersandvulnerabilities.Thetriggersof thecrisisweretheparticulareventsorfactorsthat touchedoff the eventsof 2007-09--theproximatecauses, if you will.Developmentsin themarket for subprimemortgageswerea prominentexampleof a trigger of the crisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 206In contrast, the vulnerabilities were the structural, and morefundamental, weaknesses in the financial system and in regulation andsupervisionthat served to propagate and amplify the initial shocks.In the privatesector, some keyvulnerabilitiesincludedhigh levelsofleverage;excessivedependenceon unstableshort-term funding;deficienciesin risk management in major financial firms; and the useofexotic and nontransparent financial instrumentsthat obscuredconcentrationsof risk.In the public sector, my list of vulnerabilitieswouldincludegapsin theregulatorystructure that allowedsystemically important firmsandmarketsto escapecomprehensivesupervision;failuresof supervisorstoeffectivelyapplysome existingauthorities;and insufficient attentiontothreatstothestabilityof thesystem asa whole(that is,the lack of amacroprudential focusin regulationand supervision).Thedistinction betweentriggersand vulnerabilitiesishelpful in that itallowsustobetter understand whythe factorsthat are often cited astouchingoff the crisis seem disproportionate tothemagnitudeof thefinancial and economicreaction.Considersubprime mortgages,on whichmany popular accountsof thecrisis focus.Contemporaneousdata indicated that the total quantityof subprimemortgagesoutstandingin 2007waswelllessthan $1trillion;somemore-recent accountsplacethefiguresomewhat higher.In absoluteterms, of course,thepotential for losseson theseloanswaslarge--onthe order of hundredsof billionsof dollars.However,judged in relationtothe size of global financialmarkets,aggregate exposuresto subprimemortgageswerequitemodest.By wayof comparison, it is not especiallyuncommon for one dayspaperBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 207lossesin global stock marketsto exceedthe losseson subprimemortgagessufferedduring theentire crisis, without obviousill effect onmarket functioningor on the economy.Thus, losseson subprimemortgagescan plausiblyaccount for themassivereactionseen during thecrisisonlyinsofarasthey interactedwith other factors--morefundamental vulnerabilities--that served toamplify their effects.On thesurface,thepuzzle of disproportionatecauseand effect seemssomewhat lessstark if one takestheboom and bust in theU.S. housingmarketasthetriggerofthecrisis,asthepapergainsand lossesassociatedwith the swingin housepricesweremanytimesthe lossesassociateddirectlywithsubprime loans.Indeed, the 30percent or soaggregatedeclinein housepricessincetheirpeak hasbynow eliminated nearly$7trillion in paperwealth.However,on closer examination, it isnot clearthat even thelargemovementsin houseprices, in the absenceof theunderlying weaknessesin our financial system, can account for the magnitudeof thecrisis.First, much of the declinein housepriceshasoccurred sincethemostintensephaseof the crisis;thedeclinein pricessinceSeptember 2008isprobablybetter viewedaslargely theresult of, rather than acause of, thecrisis and ensuingrecession.Morefundamentally, however,any theory of the crisisthat tiesitsmagnitudetothesizeofthehousingbust mustalsoexplainwhythefall ofdot-comstock pricesjust a few years earlier, whichdestroyed asmuch ormorepaperwealth--morethan$8trillion--resultedin arelativelyshortandmild recessionand nomajor financial instability.Onceagain, the explanation of thedifferencesbetweenthe twoepisodesmust be that theproblemsin housing and mortgage marketsinteractedwith deeper vulnerabilitiesin thefinancial system in waysthat theBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 208dot-combust did not.Solet me turn, then, to a discussionof thosevulnerabilitiesand how theyamplifiedthe effectsof triggerslike thecollapseof thesubprimemortgagemarket.Anumber of the vulnerabilitiesI listeda few momentsagowereassociated withthe increasedimportanceof theso-calledshadowbankingsystem.Shadowbanking, asusuallydefined, comprisesa diverse set ofinstitutionsand marketsthat, collectively, carryout traditional bankingfunctions--but dosooutside, or in waysonlylooselylinkedto, thetraditional system of regulateddepositoryinstitutions.Examplesof important componentsof the shadow bankingsystemincludesecuritizationvehicles,asset-backed commercial paper (ABCP)conduits, moneymarket mutual funds, marketsfor repurchaseagreements(repos), investment banks, and mortgage companies.Before the crisis,theshadowbankingsystem had come to playa majorrolein global finance.Economicallyspeaking, asI noted, shadow banking bearsstrongfunctional similaritiestothetraditional bankingsector.Like traditional banking, theshadow banking sectorfacilitatesmaturitytransformation (that is, it is used to fund longer-term, less-liquid assetswith short-term, more-liquid liabilities),and it channels savingsintospecific investments, mostlydebt-like instruments.In part, the rapid growthof shadow bankingreflectedvarioustypes ofregulatoryarbitrage--for example, the minimization of capitalrequirements.However,instrumentsthat fund the shadow banking system, such asBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 209moneymarket mutual fundsand repos, alsomet a rapidlygrowingdemand among investors,generallylargeinstitutionsandcorporations,seekingcash-like assetsfor usein managingtheirliquidity.Commercial bankswerelimited in their ability tomeet thisgrowingdemand by prohibitionson the payment of interest on businesscheckingaccountsand by relativelylow limitson the size of deposit accountsthatcan be insured by theFederal Deposit InsuranceCorporation(FDIC).As becameapparent during the crisis,a keyvulnerabilityof the systemwasthe heavyrelianceof theshadow banking sector, aswell assomeofthelargest global banks, on variousformsof short-term wholesalefunding, includingcommercial paper, repos, securitieslendingtransactions,and interbank loans.Theease, flexibility, and lowperceived cost of short-term fundingalsosupported a broader trend towardhigher leverageand greater maturitymismatchin individualshadowbankinginstitutionsand in thesectorasawhole.While banksalsorely on short-term fundingand leverage, theybenefitfrom a government-provided safetynet, includingdeposit insuranceandbackstopliquidityprovision by the central bank.Shadowbanking activitiesdo not havethese safeguards, sotheyemployalternativemechanismsto gain investorconfidence.Among thesemechanismsarethe collateralizationof many shadowbankingliabilities;regulatory or contractual restrictionsplacedonportfolio holdings, such asthe liquidityand credit qualityrequirementsapplicabletomoneymarket mutual funds;and the imprimatursof creditratingagencies.Indeed, the very foundation of shadow bankingand itsrapid growthbeforethecrisiswasthe widelyheld view (amongboth investorsandregulators)that thesesafeguardswouldprotect shadowbankingactivitiesBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 210against runsand panics, similar tothe protection given to commercialbankingby thegovernment safetynet.Unfortunately, this view turned out tobe wrong.Whenit becameclear toinvestorsthat thesealternativeprotectionsmightnot be adequateto protect againstlosses,widespreadflight from theshadowbankingsystem occurred, withperniciousdynamicsreminiscentof the bankingpanicsof an earlier era.Although the vulnerabilitiesassociatedwith short-term wholesalefundingand excessiveleveragecan be seen asstructural weaknessesof the globalfinancial system, theycan alsobe viewedasa consequence of poor riskmanagement by financial institutionsand investors,whichI wouldcountasanothermajor vulnerabilityofthesystem beforethecrisis.Unfortunately, the crisis revealed a number of significant defectsinprivate-sectorrisk management and risk controls, importantlyincludinginsufficientcapacitybymanylargefirmstotrackfirm wideriskexposures,such asoff-balance-sheet exposures.Thislackofcapacitybymajorfinancialinstitutionstotrackfirm wideriskexposuresled in turn to inadequaterisk diversification, sothatlosses--ratherthanbeingdispersed broadly--proved in some casestobeheavily concentratedamongrelativelyfew, highly leveragedcompanies.Here, I think, is theprincipal explanationof whythe bustsin dot-comstockpricesandin thehousingandmortgagemarketshadsuchmarkedlydifferent effects.In the caseof dot-com stocks,losseswerespread relativelywidelyacrossmanytypes of investors.In contrast, following the housing and mortgage bust, losses were feltdisproportionately at key nodes of the financial system, notably highlyleveragedbanks, broker-dealers,and securitizationvehicles.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 211Someof theseentitieswereforced toengagein rapid asset salesatfire-saleprices,whichundermined confidencein counterpartiesexposedtotheseassets,ledtosharp withdrawalsof funding, and disruptedfinancial intermediation, withsevere consequencesfor theeconomy.Private-sectorrisk management alsofailed to keepup withfinancialinnovation in many cases.An important exampleis the extension of thetraditionaloriginate-to-distributebusinessmodel toencompassincreasinglycomplex securitizedcredit products,with wholesalemarket fundingplaying a key role.In general, the originate-to-distributemodel breaksdownthe processofcredit extensionintocomponentsorstages--fromoriginationtofinancingandtothepostfinancingmonitoringof theborrowers abilitytorepay--ina manner reminiscent of how manufacturersdistributethe stagesofproduction acrossfirms and locations.Thisgeneralapproachhasbeenused invariousformsfor manyyearsandcan producesignificant benefits, includinglowercredit costsandincreasedaccessof consumersand small and medium-sizedbusinessestocapital markets.However,theexpandeduse of thismodel tofinancesubprimemortgagesthrough securitizationwasmismanagedat several points, includingtheinitial underwriting, whichdeterioratedmarkedly, in part becauseofincentiveschemesthat effectivelyrewardedoriginatorsfor thequantityrather than the qualityof the mortgagesextended.Loanswerethen packagedintosecuritiesthat provedcomplex, opaque, and unwieldy; for example, whendefaultsbecamewidespread, the legalagreementsunderlying the securitizationsmadereasonablemodificationsof troubled mortgagesdifficult.Ratingagencies ratingsof asset-backed securitieswererevealedto beBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 212subjecttoconflictsof interestand faultymodels.At the end of thechain wereinvestorswhooften reliedmainlyon ratingsanddid not make distinctionsamongAAA-rated securities.Even if the ultimateinvestorswantedtodo their owncredit analysis, theinformation neededtodo sowasoften difficult or impossibleto obtain.Dependenceon short-term funding, high leverage, and inadequateriskmanagement werecriticalvulnerabilitiesof the privatesector prior tothecrisis.Derivativetransactionsfurther increased risk concentrationsand thevulnerabilityof the system, notablyby shifting thelocationand apparentnature of exposuresin waysthat werenot transparent to many marketparticipants.But even asprivate-sectoractivitiesincreasedsystemic risk, thepublicsectoralsofailed toappreciate or sufficientlyrespond to thebuildingvulnerabilitiesin thefinancial system--both becausethe statutoryframeworkof financial regulation wasnot well suited to addressingsomekeyvulnerabilitiesandbecausesomeoftheauthoritiesthat did exist werenot used effectively.In retrospect, it is clear that thestatutoryframeworkof financialregulation in placebeforethe crisiscontained seriousgaps.Critically, shadow bankingactivitieswere, for themost part, not subjecttoconsistent and effectiveregulatory oversight.Much shadow banking lackedmeaningful prudentialregulation, includingvariousspecial purposevehicles,ABCPconduits,and manynonbank mortgage-originationcompanies.No regulatory body restricted the leverage and liquidity policies of theseentities, and few if any regulatory standards were imposed on the qualityof their risk management or theprudenceof their risk-taking.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 213Market discipline,imposed by creditorsand counterparties, helped onsomedimensionsbut did not effectively limit thesystemic riskstheseentitiesposed.Other shadow banking activitieswerepotentiallysubject tosomeprudential oversight, but weaknessesin the statutoryand regulatoryframeworkmeant that in practice theywereinadequately regulated andsupervised.For example, theSecurities and ExchangeCommission supervisedthelargest broker-dealerholdingcompanies but only through an opt-inarrangement that lacked theforce of a statutoryregulatory regime.Largebroker-dealerholdingcompaniesfaced seriouslossesand fundingproblemsduring thecrisis,and theinstability of such firms asBearStearnsand LehmanBrothers severelydamagedthefinancial system.Similarly, theinsuranceoperationsofAmerican International Group, Inc.(AIG), weresupervisedand regulated byvariousstate and internationalinsuranceregulators, andtheOffice of Thrift SupervisionhadauthoritytosuperviseAIG asa thrift holding company.However,oversight ofAIG Financial Products,whichhoused thederivativesactivitiesthat imposedmajorlossesonthefirm, wasextremelylimitedin practice.Thegapsin statutory authority had the additional effect of limitingtheinformation availableto regulatorsand, consequently, may havemade itmore difficult torecognize theunderlying vulnerabilitiesand complexlinkagesin theoverall financial system.Shadowbanking institutionsthat wereunregulatedor lightlyregulatedweretypically not required toreport data that wouldhave adequatelyrevealed their risk positionsor practices.Moreover,the lack of preexistingreportingand supervisory relationshipsBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 214hinderedsystematic gatheringof information that might have helpedpolicymakers in theearlydaysof thecrisis.Abroader failing wasthat regulatory agenciesand supervisory practiceswerefocused on the safetyand soundnessof individual financialinstitutionsor markets--what wenow refer toasmicroprudentialsupervision.In the United Statesand most other advanced economies,nogovernmental entityhad either a mandateor sufficient authority--nowoften called macroprudential authority--to take actionstolimit systemicrisksthat couldresult from thecollectivebehavioroffinancialinstitutionsandmarkets.Gaps in the statutoryframeworkwerean important reason for thebuildup of risk in certain partsof thesystem and for the inadequateresponseof the public sector tothat buildup.But even whenthe relevant statutory authoritiesdid exist, theywerenotalwaysusedforcefullyoreffectivelyenoughbyregulatorsandsupervisors, includingthe Federal Reserve.Notably, bank regulatorsdid not do enough to force largefinancialinstitutionsto strengthen their internal risk-management systemsor tocurtail risky practices.TheFederal Reserves SupervisoryCapitalAssessmentProgram, undertaken in thespring of 2009and popularlyknownasthe"stresstests," played a critical rolein restoringconfidencein the U.S.bankingsystem, but it alsodemonstrated that many institutionsinformationsystemscould not providetimely, accurateinformation aboutbank exposurestocounterpartiesor completeinformation about theaggregate risksposed by different positionsand portfolios.Regulatorshad recognized these problemsin some casesbut did notpressfirmsvigorouslyenough to fix them.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 215Even without amacroprudential mandate, regulatorscould alsohavedone more totry tomitigaterisksto thebroader financial system.In retrospect, stronger bank capital standards--notablythoserelatingtothequalityof capital and the amount of capital required for banks tradingbookassets--andmore attentiontotheliquidityrisksfacedbythelargest, most interconnectedfirmswouldhave made the financial systemasa wholemore resilient.The Crisisasa Classic Financial PanicHaving laid out some of thetriggersand vulnerabilitiesthat set the stageforthecrisis,I canbrieflysketchtheevolutionofthecrisisitself.AsI havenoted, developmentsin housing and mortgage marketsplayed animportant role astriggers.Beginning in 2007, declining house prices and rising rates of foreclosureraised serious concerns about the values of mortgage-related assets andconsiderable uncertaintyabout wherethoselosseswouldfall.Theeconomy officiallyfell intorecession in December 2007, followingseveral monthsof financial stress.However,the most severe economic consequencesfollowedtheextrememarket movementsin the fall of 2008.Toa significant extent, the crisis is best understood asa classic financialpanic--differingin details but fundamentallysimilar to thepanicsdescribedby Bagehot and many others.Themost familiar type of panic that hasoccurred historically, involvingrunson banksby retail depositors, had been made largely obsoletebydeposit insurance,central bank backstop liquidityfacilities,and theassociated government supervisionof banks.But a panicis possiblein any situationin whichlonger-term, illiquidBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 216assetsare financedbyshort-term, liquidliabilitiesand in whichprovidersof short-term fundingeither loseconfidencein the borroweror becomeworriedthat other short-term lendersmay loseconfidence.Thecombination of dependenceon wholesale,short-term financing;excessiveleverage;generallypoor risk management;and thegapsandweaknessesin regulatoryoversight createdanenvironment in whichapowerful, self-reinforcingpanic could begin.Indeed, panic-like phenomena arosein multiplecontextsand in multiplewaysduring the crisis.Therepomarket, a major sourceof short-term credit for many financialinstitutions,notablyincludingtheindependent investment banks, wasanimportant example.In repoagreements,loansare collateralizedby financial assets, and themaximum amount of the loanisthe current assessedvalueof thecollateral lessa safety margin, or haircut.Thesecured nature of repo agreementsgavefirms and regulatorsconfidencethat runswereunlikely.But thisconfidencewasmisplaced.Oncethecrisisbegan, repolendersbecameincreasinglyconcernedaboutthepossibility that theywouldbe forcedtoreceivecollateral instead ofcash, collateralthat wouldthenhave to be disposed of in fallingandilliquidmarkets.In some contexts,lendersresponded by imposingincreasinglyhigherhaircuts,cuttingtheeffectiveamount of fundingavailabletoborrowers.In othercontexts,lenderssimplypulledaway,asinadeposit run;inthesecases,some borrowerslost accesstorepoentirely, and some securitiesbecame unfundablein therepomarket.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 217In either case,absent sufficient funding, borrowerswerefrequentlyleftwith no option but tosell assetsintoilliquid markets.Theseforced salesdrove downasset prices,increased volatility, andweakenedthe financial positionsof all holdersof similar assets.Volatileasset pricesand weakerborrower balancesheetsin turnheightened the risksborneby repolenders,furtherboosting theincentivestodemand higher haircutsor withdraw funding entirely.This unstabledynamic wasoperatingin full force around thetime of thenear failure of Bear Stearnsin March2008, and again during theworseningof thecrisisin mid-September of that year.Classicpanic-typephenomenaoccurredin othercontextsaswell.Earlyinthecrisis,structuredinvestment vehicles and manyother asset-backedprogramswereunableto roll over their commercial paper asinvestorspulledback, and theprogramswereforcedtodraw on liquiditylinesfrombanksor to sell assets.Theresultingpressure on the bank liquidityproviders,evident especiallyin themarket fordollar-denominatedloansin short-termfundingmarkets,impeded the functioningof the financial system throughout thecrisis.FollowingtheLehman collapseand the"breakingof the buck" by amoneymarket mutual fund that held commercial paper issuedbyLehman, both money market mutual fundsand the commercial papermarket werealsosubjectto runs.Moregenerally, during the crisis,runsof short-term uninsuredcreditorscreated severe fundingproblemsfor a number of financialfirms, includingseveral largebroker-dealersand alsosome bank holdingcompanies.In some cases,withdrawalsof fundsbycreditorswereaugmentedby"runs" in other guises--forexample, byprime brokerage customers ofBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 218investment banks concernedabout the safetyof cash and securitiesheldat thosefirmsor by derivativescounterparties demanding additionalmargin.Overall, the emergenceof run-like phenomena in a variety of contextshelps explain the remarkably sharp and sudden intensificationof thefinancial crisis,itsrapid global spread, and the fact that standard marketindicatorslargely failed toforecast the abrupt deterioration in financialconditions.Themultipleinstancesof run-like behavior during thecrisis, togetherwith the associatedsharp increasesin liquiditypremiumsanddysfunction in many markets,motivatedmuch of the Federal Reservespolicyresponse.Bagehot advised central banks--the only institutions that have the powerto increase the aggregate liquidity in the system--to respond to panics bylendingfreelyagainst sound collateral.Followingthat advice,from thebeginningof thecrisis,theFed, like othermajor central banks, provided largeamountsof short-term liquiditytofinancial institutions, includingprimarydealersaswell asbanks, on abroad rangeof collateral.Reflectingthe contemporaryinstitutional environment, it alsoprovidedbackstopliquiditysupport forcomponentsoftheshadowbankingsystem, includingmoneymarket mutual funds, the commercialpapermarket, and the asset-backedsecuritiesmarkets.Tobe sure, theprovision of liquidityalonecan by no meanssolve theproblemsof credit riskand credit losses,but it can reduce liquiditypremiums, help restorethe confidenceof investors,and thuspromotestability.It can alsoreducepanic-drivencredit problemsin casesin which suchproblemsresult from price declinesduring liquidity-driven fire salesofBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 219assets.Thepricing of the liquidityfacilitieswasan important part of theFederalReservesstrategy.Ratescould not betoohigh; tohaveapositiveeffect, and tominimizethestigma of borrowing, the facilitieshad tobe attractiverelativeto ratesavailable(or nominallyavailable)in illiquid, dysfunctional markets.At the same time, pricinghad tobe sufficientlyunattractivethatborrowerswouldvoluntarily withdraw from these facilitiesasmarketconditionsnormalized.This desiredoutcome in fact occurred:By early2010,emergencylendinghadbeen drasticallyreduced, alongwiththe demand for suchlending.TheFederalReserves responsestothefailureornearfailureofanumberof systemically critical firms reflectedthebest of bad options,given theabsenceof a legal framework for windingdownsuch firmsin an orderlywayin themidst of a crisis--aframework that wenowhave.However,thoseactionswere, again, consistent withthe Bagehotapproachof lendingagainst collateral to illiquid but solvent firms.Theacquisitionof Bear Stearnsby JPMorganChase wasfacilitatedby aFederalReserve loan against a designatedset of assets,and the provisionofliquiditytoAIG wascollateralizedbytheassetsofthelargestinsurancecompany in theUnited States.In both casesthe Federal Reserve determinedthat the loanswereadequatelysecured, andinbothcasestheFederalReservehaseitherbeenrepaid with interest or holds assetswhoseassessedvaluescomfortablycover remainingloans.Tosaythat the crisiswaspurelya liquidity-based panicwouldbe tooverstatethe case.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 220Certainly, an important part of the resolution of the crisisinvolvedassuringmarketsand counterpartiesof the solvency of key financialinstitutions,and that assurancewasprovided in significant part by theinjectionof capital, includingpublic capital, and theissuanceofguarantees--measuresnot available tothe Federal Reserve.In theserespects,the Treasury-managed TroubledAsset Relief ProgramandtheFDICs Temporary LiquidityGuaranteeProgram played criticalroles.As I have noted, theFederal Reserve did help restore confidenceinthesolvencyof the bankingsystem by leadingthe stresstestsof the19largest U.S.bank holdingcompaniesin the spring of 2009.Thesestresstests, whichwereboth rigorousand transparent, helpedmakeit possibleforthetested bankstoraise$120billioninprivatecapitalin theensuingmonths.Theresponsetothepanic alsoinvolvedan extraordinaryamount ofinternational consultationand coordination.Followinga key meetingof the Group of Seven financeministersandcentral bank governorsin Washingtonon October 10,2008, thegovernmentsof other industrial countriestook strong measurestostabilize key financial institutionsand markets.Central bankscollaborated closelythroughout thecrisis;inparticular,theFederal Reserve undertook swapagreementswith14other central bankstohelp ensure adequate dollar liquidityin global marketsand thuskeepcredit flowingtoU.S. householdsand businesses.ConclusionThefinancial crisisof 2007-09wasdifficult to anticipate for tworeasons:First, financial panics, beingto a significant extent self-fulfillingcrisesofconfidence, are inherentlydifficult to foresee.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 221Second, although thecrisisbore some resemblanceat a conceptual leveltothe panicsknownto Bagehot, it occurred in a rather differentinstitutional context and waspropagatedand amplifiedby a number ofvulnerabilitiesthat had developed outsidethetraditional bankingsector.Onceidentified, however, thepanic could be addressed to a significantextent using classictools, includingbackstop liquidityprovision bycentral banks, both here and abroad.Toavoid or at least mitigatefuture panics,thevulnerabilitiesthatunderlaytherecent crisismust be fullyaddressed.As you know, this processis well under wayat both thenational andinternational levels.I will have to leave to another time a discussion of the extensive changesin regulatory frameworks, as well as the changesin the Federal Reservesownorganization and practices,that havebeen or are beingput in place.Instead, I will closeby noting that theeventsof the past few years haveforciblyremindedusof thedamagethat severefinancial crisescan cause.Going forward, for the Federal Reserve aswellasother central banks, thepromotion of financial stabilitymust be on an equal footing withthemanagement of monetary policyasthemost criticalpolicypriorities.Notes- See Ben S.Bernanke (2010), "Causesof the Recent FinancialandEconomicCrisis," statement beforetheFinancial Crisis InquiryCommission, Washington, September 2- According to the Federal Reserves statistical release"Flowof FundsAccountsof the UnitedStates," thevalue of real estate held byhouseholdsfell from $22.7 trillion in thefirst quarter of 2006to$20.9trillion in the fourth quarter of 2007(down 8.1percent from thefirstBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 222quarter of 2006).It then declined to $18.5 trillion in the third quarter of 2008 (down 18.6percent from the first quarter of 2006) and to $16.0 trillion in the fourthquarter of 2011(down 29.7percent from the first quarter of 2006).The stock market wealth of U.S. householdspeaked at $18.1trillion inthe first quarter of 2000 and fell $6.2 trillion to $11.9 trillion through thethird quarter of 2001.After a short-livedrecovery, stock market wealthbottomed at $9.9trillion in the third quarter of 2002.Overall, stock market wealth fell $8.3trillion (or 46percent) betweenitspeakin thefirst quarterof2000anditstroughinthethirdquarterof2002.- See Walter Bagehot ([1873] 1897), Lombard Street:A Description oftheMoneyMarket (New York: CharlesScribnersSons).Theclassictheoretical analysis of "pure" banking panicsis inDouglasW. Diamond and Philip H. Dybvig (1983), "BankRuns,Deposit Insurance,and Liquidity," Journal of PoliticalEconomy, vol. 91(3), pp. 401-19).Note that theterm "panic" doesnot necessarilyimplyirrationalbehavioron thepart of depositorsor investors;it isperfectlyrational toparticipatein arun if onefearsthat thebank will beforcedtoclose.However,the collectiveaction of many depositorsor investorscanlead to outcomesthat are undesirablefrom thepoint of view of theeconomy asa whole.Return totext- For an analysisof the determinantsof runson moneymarket mutualfundsduring the crisis, seePatrick McCabe(2010), "TheCrossSection of MoneyMarket Fund Risksand Financial Crises," FinanceandEconomics Discussion Series2010-51(Washington:Board ofBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 223Governorsof the Federal Reserve System, September).- Prime brokersprovide a variety of servicesfor hedge fundsand othersophisticated institutional investors.Their services include clearing of trades, financing of long securitiespositions, and borrowing of securities to facilitate the establishmentof short positions.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 224UBS launcheseducation initiative to mark its150th anniversaryUBS is markingits150th anniversary with the launchof a broad-basedinternational education initiative.Its main focuswill be theestablishment of the UBSInternational Centerof Economicsin Societyat the Universityof Zurich.Fiveadditional fieldsof education will be supported through thefundingof projectsfor different agegroupswiththe goal of strengtheningSwitzerlandsreputation asa location for educationand business.Switzerlandseconomicsuccessisdue in largepart toits attractiveoperatingenvironment and itsoutstandingeducation system.Education will continuetobe Switzerlands most important resource.UBS hasdecidedtomark its150th anniversaryby launchingabroad-basedinternational education initiative.Thiswill bemadeup of six distinct elementsand isaimedat primaryandhigh school students, university students,academics,entrepreneursandpeopleover 50.For UBS, thisrepresentsasustainable,long-term investment in thefutureof Switzerlandasan education and businesslocation.Collaboration withthe University of Zurich enablestop-flight researchThecore of the UBSeducationinitiativewill be thecreation of the UBSInternational Center of Economicsin Societyat the UniversityofZurich, whichwill be led by Professor Ernst Fehr.UBS will support theestablishment of up to five chairs, thefirst of whichwill be endowedin 2012,at the Department of Economicsof theBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 225Universityof Zurich.Thesechairs will facilitatecutting-edgeresearch intoissuesrelatedtoeconomicsand financial markets, coveringa wide rangeof subjectsandpromotinginterdisciplinaryresearch.TheUBS International Center will emphasize thepracticalapplicationofknowledgeby combiningworld-classresearch and entrepreneurialthinking.Kaspar Villiger, Chairman of UBSsBoard ofDirectors,commented, "The UBSInternational Center ofEconomicsin Societyisa uniqueeducationalproject withinSwitzerlandthat will have outstandinginternational reach.We are particularly proud to be working in partnership with ProfessorErnst Fehr, one of the most renowned economists of our time, on thisproject.Under hisleadershipand guidance, theDepartment of Economicsat theUniversityof Zurich has long been regarded asone of the top Europeaninstitutionsin thefield of economics."Wide range of education projectsIn additiontothepartnershipwiththeUniversityofZurich, theeducationinitiativeincludesprojectsfor the followingstagesof education:Primary and high schoolEnhanced support for Explore-it, a platform that enablesup to 20,000primaryschool studentstodevelop a greater interestin variousscientifictopics.ThefundsprovidedbyUBSwill beused toextend theproject nationwideanddevelop innovativeteachingand learningmaterials.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 226With this expanded support, UBSwill becomethemain sponsorofExplore-it.Extension of UBSscurrent partnership with theYoung EnterpriseSwitzerland(YES) organization, whichorganizeseducationalprojectsforyoung people jointlywithbusinesses, schoolsand the government.This initiativeis designedto teach young peopletoapplycollaborativethinking, demonstrateentrepreneurialism and presentthemselvesasconfident and persuasive.With this extended commitment under the education initiative,UBS willbecome thenew main sponsorof YES.ApprenticeshipsCreation of 150additional apprenticeshippositionswithin Switzerlandover thenext five years.Theannual number of apprenticeswill increaseby about 10%.UBS today employs approximately900apprenticesmaking it one of thelargest private employers of apprenticesin Switzerland.InternshipsCreation of 150additional internship positionsaround the worldforstudentsover the next three years aspart of a special anniversaryprogram.This program targetsstudentsat thebeginningof their academiccareer.EntrepreneursSupport forGenilem, anindependent associationthat supportsinnovativebusinessesduring their start-upphase.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 227Genilem analyzesthebusinessplansof start-up companies and alsoprovidesa networkof mentorsand partners,specializedtraining forbuddingentrepreneursand professionallong-term coachingwhichwilllast for a three-year period.UBS will alsoprovideitsownexpert mentorsand coachesfor thisinitiative.Support for the non-profit foundation KMU Next, which provides SMEsand micro-enterprises with the tools they need for the successful transferor acquisitionof companies.UBS will become a member of thefoundation and a special advisoronsuccessionmanagement topics,an areaof particular expertise.People over 50Support for the Passerelle50plusproject run by Switzerlands Speranzafoundation.Theproject supportsjobseekersover theage of 50in finding suitableemployment in theopen job market.UBS hasbeen adonor totheSperanza foundation for some years now.Additional fundsfrom the UBS education initiativewill be used tosupport and promote theactivitiesof Passerelle50plusacrossSwitzerland.Support for Zeitmaschine.TV, a project for encouraginginter-generational dialog.TheUBS education initiativewill providesupport to expand thisshowcaseproject and make it availabletoa larger number of schoolstudents.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 228UBS will provide information on these specific educational projects atregular intervals and an inaugural symposium will be held at the UBSInternational Center of Economicsin Societythis autumn.Lukas Gähwiler, CEO UBS Switzerland, and MarkusDiethelm, GroupGeneralCounsel, will act asambassadorsfor this majorcommitment, developing the initiativeand driving it forward.For Group CEO Sergio P. Ermotti, the education initiativerepresentsauniqueopportunity: "Education will become Switzerlands greatestresourceasit competesin the global arena, and this is especiallytrue intheservicesector.Thatswhyit wasimportant to ustoincludea wide range of projectsintheUBS educationinitiativewhich will benefit different agegroupsaswell asshowingUBSscommitment toSwitzerlandtoour clientsandemployeesand the general public."For further information on the UBSEducation Initiative, visitwww.ubs.com/ learnBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 229Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 23018April 2012Speech by the Chancellor of the Exchequer,Rt Hon George Osborne MP, at the City ofLondon RMB launch eventI am delightedto behere todayto celebrate Londonasa centre for international Renminbi (RMB)business.This is a significant moment.This morning, wesaw the launch of the first RMB bond outsideofChinesesovereign territories.And it happened here in London.This buildson theprogressLondon hasalreadymadetoward becomingthe westernhub for RMB.By theend of lastyear, thevolume of RMB depositsin London had alreadyreached 109bn RMB –equivalent toaround 11bnpounds, of which35bnRMB – around 3.5bn pounds- are customerdeposits.Theannual tradingvolume in offshoreRMB bondshad reached 28billion RMB – around 3billion pounds.And London alreadyrepresents26% of the global offshore RMB spotforex market – the majorityisbased in Hong Kong.This is a market which grew by over 80% last year.Let me be clear– London isnot in competitionwithHong Kong, it is acomplement – providing a Western hub for RMB business.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 231Thesedevelopmentsare theculmination of a team effort by global bankswith operationsin London and Hong Kong, stronglysupportedby theUK, mainland Chineseand Hong KongAuthorities.Ayear ago, whenVicePremier Wang Qishanmet withme and my teamherein LondonfortheEconomic andFinancialDialogue, theBritishandChinese Governmentsset out a joint communiquéwelcomingprivatesectorinterest in developing the offshoreRMB market in London.TheHong KongAuthorities‘announced at the end of theyear theirintentionto extend the operatinghoursof the Hong Kong RMBpaymentssystem, makingit easier for RMB transactionsto be settled inLondon.I want tocommend theHong Kong authorities on their pioneeringworkin developingthe internationalRMB market.In January, at theAsia Financial Forum, Norman Chan, theChiefExecutiveof the Hong Kong MonetaryAuthority, and I announcedthelaunchof theLondon-Hong Kong private-sectorforum, tobefacilitatedbyHM Treasury and the Hong Kong MonetaryAuthority.Thegrowthof its excitingnew RMB businessis a natural developmentfor this great city of London.London hasa longhistory of global financial inventiveness- fromfounding the first organisedmarket for insurancefor tradingaround theworldhundredsof years ago, to the development of theEurodollarmarketsthrough the1960s,70sand 80s, and global foreign equitiestradingin more recent times.RMB trading is thenext step along a 400year road.And it isnatural that whenChinesebankslook westwards,theychooseLondonasthehub forRMB intheWest, givenLondon‘spre-eminenceasafinancial centre,and itsexpertisein areassuch asforeignexchangeandBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 232bond issuance.It‘s an important reminder tous in theUK that – while, of course,thereare vital questionsweneed to answerabout howweprotect taxpayersfrom banks that are toobig tofail, and that weneedtoensure theBritisheconomy hasother strings toitsbow aswell asfinancial services– weshould havethe confidencetolook not onlyat theproblems, but alsocelebrateour successes.London is theworld‘spre-eminent financial centre, and it‘s actuallybecomingmore successful.Onlylastmonth, London retained itsposition at top of the GlobalFinancial CentrescompetitivenessIndex.In fact, weweretheonlyone of the top fivefinancial centreswhichhadincreasedits competitivenesssincethe previousyear.Here in London, wearecurrentlyundertaking Europe‘slargestinfrastructure project – Crossrail – whichwill provideeven bettertransport linkstotheCity.We‘ve taken the difficult but right decisionto make our tax system morecompetitive– cuttingcorporation tax ratesto24% from this month toamongthe lowest in thedeveloped world.And we‘retakingthecontroversial but necessarydecision toreducethetop rateof income tax from next year.Today‘s event emphasisesthat wearenot prepared to let anyone steal amarch on usin termsof new productsand new markets.We are thenatural home in the West for thosewhowant toinvest in theChinese economicsuccessstory.Theincreasinginternational useof RMB is an important developmentBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 233for China and for theWorld Economy.Thegrowthof the Chineseeconomy hasbeen quite remarkable.We all know the statistics.China hasexperienced growthof around 10% a year for the last 30years.In a generation, China‘smiddleclassisforecast to be over three timesthesize of that of the wholeof Western Europe combined.And it isthe strength ofAsia‘seconomywhichmeansthat despiteturbulent timesfor the worldeconomy, global growthin this decade andthenext will be higher than thepast 30 years.But this growthhassofar not been matched by theincreasein theinternational useof itscurrency, soit isclearthat the substantialexpansion of RMB will be one of the major developmentsin globalmarketsin thecoming decades.Extension of the market to the Western time zone is a crucial part of itsexpansion.It is the ambition of the British Government to make London a Westernhub for the sector – with all thebenefitsthat this will bringtoour owneconomy.And what‘ssospecialabout todayisthatnot onlydoesit mark thelaunchof the first RMB bond outsideof outsidemainlandChina and HongKong.Today, wealsomark theofficial launchof the City of London initiativeon London asa centre for RMB business.I want tothank Stuart Fraser, and the Cityof London CorporationSteeringCommitteeand ExpertAdvisory Group for their hard workandleadershipin gettingto this point today.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 234Theinvolvement of companies like Bank of China, Barclays, DeutscheBank,HSBC andStandardCharteredwill providethedepthofexperienceon technical, infrastructureand regulatoryissuesthat areneededtodevelop themarket.Its first output – the BourseConsult‘sreport intoLondon‘scapabilitiesasan offshore RMB centre - is a demonstration of this expertise,providinga clear directionfor themarket‘sfuture development.It‘s taken a lot of hard work from peoplein this room.But today isnot theend of theprocess;it‘s the beginning.I hopethat othermajorEuropeanbanksandcorporatewill followtoday‘slead, and that wewill seeChinese institutionsand corporationsissuingRMB bondsin theLondon market in thevery near future.In thecoming decades,it isChina that will act asone of thegreatpowerhousesof theworldeconomy.By acting as a bridge between East and West, we can secure London‘sposition as the leading financial centre in the years to come – securinggrowth and prosperityfor Britain.Note for (really new) membersWhat is the City of London?TheCity of Londonprovideslocalgovernment and policingservicesforthefinancial and commercial heart of Britain, theSquare Mile.It is committedtosupportingand promoting The City asthe worldleader in international financeand businessservicesthrough thepoliciesit pursuesand thehigh standard of servicesit provides.Its responsibilitiesextend far beyond theCityboundariesin that it alsoprovidesa host of additional facilitiesfor thebenefit of thenation.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 235Theserangefrom open spacessuch asEpping Forest and HampsteadHeath to the famousBarbicanArtsCentre.TheCity of London combinesits ancient traditionsand ceremonialfunctionswiththeroleof a modern and efficient localauthority, lookingafter the needsof itsresidents,businessesand over 320,000peoplewhocometoworkin theSquare Mile every day.Among localauthoritiesthe City of London is unique; not only is it theoldest inthecountrybut it operateson anon-partypoliticalbasisthroughitsLord Mayor, Aldermen and membersof the Court of CommonCouncil.TheLord Mayor in particular playsanimportant diplomaticrolewithhisoverseasvisitsand functionsat the historic Guildhalland MansionHouse for visitingheadsofState.In additiontothe usual servicesprovided by a localauthoritysuch ashousing, refusecollection, education, social services, environmentalhealth and townplanning, theCity of London performs a number of veryspecial functions.It runsitsownpoliceforce and the nations Central Criminal Court, theOld Bailey.It providesfive Thamesbridges, runsthe quarantine station at HeathrowAirport and isthe Port Health Authorityfor thewhole of the Thamestidalestuary.Three premier wholesalefood markets(Billingsgate, Spitalfields andSmithfield) whichsupplyLondon and the South East withfreshproducealsobelong to the City of London.Many of theseservicesare funded from the City of Londons ownBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 236investmentsat nocost to thepublic.The City of London is committed to an extensive programme of activitiesdesigned to assist itsneighbours to combat social deprivation sothat theycan benefit from the wealththeSquare Mile generates.Staff and members of the City of London have, through centuries ofcareful stewardship, ensured that the Square Mile has continued tothrive.Todays Cityof London, through itsphilosophyof sustainabledevelopment, aimstoshare thesebenefitswithfuture generationsofresidents,businessesand workers.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 237Joint PressReleaseBoard of Governorsof the Federal ReserveSystemCommodity FuturesTrading CommissionFederal Deposit InsuranceCorporationOffice of the Comptroller of the CurrencySecuritiesand Exchange CommissionApril 19, 2012Volcker Rule Conformance Period ClarifiedTheFederal Reserve Boardannounceditsapproval of astatement clarifyingthat anentitycovered by section 619of the Dodd-Frank WallStreet Reform andConsumerProtectionAct, or theso-calledVolcker Rule, hasthefull two-year periodprovided by the statutetofullyconform itsactivitiesand investments, unlesstheBoard extendstheconformanceperiod.Section 619generallyrequiresbankingentitiesto conform their activitiesand investmentsto theprohibitionsand restrictionsincludedin thestatuteon proprietarytradingactivitiesand on hedgefund and privateequityfund activitiesand investments.Section 619 required the Board to adopt rules governing the conformanceperiodsfor activitiesand investmentsrestricted by that section, which theBoard did on February 9, 2011.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 238Subsequently, theBoardreceivedanumber of requestsfor clarificationofthemanner in whichthis conformance period wouldapplyand how theprohibitionswill be enforced.TheBoard isissuingthis statement to addressthis question.TheBoard‘sconformance rule providesentitiescovered by section 619oftheDodd-FrankAct aperiod of twoyearsafterthestatutoryeffectivedate, which wouldbe until July21, 2014, to fullyconform their activitiesand investmentstotherequirementsofsection619oftheDodd-FrankActand anyimplementingrulesadopted in final under that section, unlessthat period is extended by theBoard.TheBoard, theOfficeof theComptrollerof the Currency, the FederalDeposit InsuranceCorporation, theSecuritiesand ExchangeCommission, and theCommodityFuturesTradingCommission (theagencies)plantoadminister their oversight of banking entitiesunder theirrespectivejurisdictionsinaccordancewiththeBoard‘sconformanceruleand the attached statement.Theagencieshave invited publiccomment on a proposal toimplementtheVolcker rule, but have not adopteda final rule.Thestatement is included in the attachedFederal Registernotice, publication of whichis expected shortly.Statement of Policy Regarding the Conformance Period forEntitiesEngaged in Prohibited Proprietary Trading or PrivateEquity Fund or Hedge Fund ActivitiesOn February 9, 2011, theBoard issued itsfinal rule toimplement theprovisionsof section619of the Dodd-Frank Wall Street Reform andConsumerProtectionAct (―Dodd-FrankAct‖) that grant bankingentitiesandnonbank financial companiessupervised by theBoard a period oftimetoconform their activitiesand investmentswiththeprohibitionsandBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 239restrictionsimposedby that section on proprietary tradingactivitiesandon hedgefund and private equityfundsactivities.Subsequently, theBoardreceivedanumber of requestsfor clarificationofthemanner in whichthis conformance period wouldapplyto variousactivitiesand investmentscovered by therequirementsof section619of the Dodd-Frank Act.TheBoard isissuingthis interpretation toaddressthisquestion.As more fullyexplainedin thisstatement, theBoard confirmsthatbankingentitiesbystatute have twoyearsfrom July21, 2012,toconformall of their activitiesand investmentsto section619, unlessthat period isextendedby the Board.During the conformanceperiod, bankingentitiesshould engageingood-faithplanningefforts, appropriatefor their activitiesandinvestments,toenablethemtoconform theiractivitiesandinvestmentstotherequirementsof section 619and final implementingrulesby nolaterthan the end of the conformanceperiod.This may includecomplying with reportingor recordkeepingrequirementsif such elementsare includedin the final rulesimplementingsection 619 and the agenciesdeterminesuch actionsarerequiredduring theconformanceperiod.BackgroundSection 619of the Dodd-FrankAct added a new section 13 to theBankHolding CompanyAct (―BHC Act‖) that imposescertain prohibitionsand requirementson a banking entityand a nonbank financial companysupervised by the Board that engagesin proprietary tradingand hascertaininterestsin, or relationshipswith, a hedge fund or private equityfund (each a ―covered fund‖).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 240As required by section 13(b)(2) of theBHC Act, the Board, the OfficeoftheComptroller of the Currency(―OCC‖), Federal Deposit InsuranceCorporation (―FDIC‖), and Securities and Exchange Commission(―SEC‖) in October2011invitedthepublic tocomment on proposedrulesimplementingthat section‘sprohibitionsand requirements.Theperiod for filingpublic commentson this proposal wasextended foran additional 30days, until February 13,2012.On January11, 2012,the CFTC requestedcomment on a substantiallysimilar proposed ruletoimplement section13of theBHCAct and invitedpublic comment throughApril 16, 2012.Section13(c)(6)oftheBHCAct requiredtheBoard, actingalone,toadoptrules regarding the conformanceperiodsfor activitiesand investmentsrestricted by section 13.TheBoard issueditsfinal conformancerule(―ConformanceRule‖) onFebruary9, 2011.Board GuidanceAfter adoption by the Board of the Conformance Rule, a number ofcommenterson the interagencyproposed rulestoimplement section13requestedadvice regardingtheperiod of time a banking entitywouldhaveto conform itsactivitiesand investmentstothe requirementsofsection 13and the implementingrulesand whethercertain activitieswouldbe prohibited prior totheexpiration of theconformanceperiod.In particular, commenterssought confirmationthat theConformanceRulewould allowa bankingentitythe full period permittedby statutetoconform all of its investmentsand activitiestosection 13and the finalimplementingrules.In addition, commenterssought confirmationthat activitiesconductedand investmentsmade during the conformanceperiod wouldnot beBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 241subjectedtothe requirementsof the implementingrulesduring theconformanceperiod.Section 13of the BHC Act generallyprovidesthat, unlesstheperiod forconformanceisextendedbytheBoard, abankingentitymust conform itsactivitiesand investmentstothe prohibitionsand requirementsof thatsection and any final implementingrulesno later than 2years after thestatutoryeffectivedate of section 13.Theeffectivedateof section13 isJuly21,2012.As noted in the issuingrelease for the Conformance Ruleand thelegislativehistory of section 13, the conformanceperiod for bankingentitiesis intended togive marketsand firms anopportunitytoadjusttotheprohibitionsand requirementsof that section and any implementingrules adoptedby theagencies.Consistent withthispurposeand the statute, the Conformance Ruleprovideseach banking entitywith a periodof 2 years after theeffectivedate of section 13 (i.e., until July 21,2014) in whichtofullyconform itsactivitiesand investmentstotheprohibitionsandrequirementsof section13and the final implementingrules,unlessthat period is extended bytheBoard (the―conformanceperiod‖).TheConformance Rule alsoprovidesa nonbank financial companysupervised bythe Board with2years afterthedatethecompanybecomesanonbank financialcompanysupervisedbytheBoardtocomplywithanyapplicablerequirementsof section 13of the BHCAct, includinganyapplicablecapital requirementsor quantitativelimitationsadoptedthereunder, unlessthat period is extendedby the Board.Under the ConformanceRule, all proprietary tradingactivityconductedbyeach bankingentitymust conform totheprohibitionsandrequirementsof section 13 of theBHC Act and any final implementingrules by no later than the end of the conformanceperiod.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 242Similarly, all activities,investmentsand transactionswithor involving acoveredfund, includinga covered fund organized and offeredorsponsoredby thebanking entity, must conform tosection 13of the BHCAct and final implementingrulesby no later than theend of the relevantconformanceperiod.During the conformanceperiod, everybankingentitythat engagesin anactivityor holdsan investment covered by section13 is expectedtoengageingood-faithefforts, appropriatefor itsactivitiesand investments,that willresult in theconformanceof all of itsactivitiesand investments totherequirementsof section 13 of theBHC Act by nolater than the end of theconformanceperiod.This includesevaluatingthe extent to which thebankingentity isengagedinactivitiesandinvestmentsthat arecoveredbysection13of theBHC Act, aswell asdeveloping and implementinga conformanceplanthat is asspecific aspossibleabout how the banking entitywill fullyconform all of itscovered activitiesandinvestmentswithsection 13of theBHC Act and any final implementingrulesby July21,2014,unlessthatperiod is extended by the Board.Thesegood-faitheffortsshouldtakeaccount ofthestatutoryprovisionsinsection 13of the BHC Act astheywill applyto the activitiesandinvestmentsofthebankingentityat theendof theconformanceperiod aswellasanyapplicableimplementingrulesadoptedin final bytheprimaryfinancial regulatoryagencyfor thebanking entity.Good-faith conformanceeffortsmay alsoincludecomplying withreportingor recordkeepingrequirementsif suchelementsareincludedinthefinal rulesimplementingsection 13of the BHC Act and theagenciesdeterminesuch actionsare required during the conformanceperiod.Nothing in thisguidancerestrictsin anywaytheauthorityof any agencytouse itssupervisoryor other authoritytolimit any activitythe agencydeterminestobe unsafeor unsound or otherwisein violationof law.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 243Supervisory policies and bank deleveraging: a EuropeanperspectiveAndrea EnriaChairperson European Banking Authority21st Annual Hyman P. Minsky Conferenceon theState of the U.S.and WorldEconomiesDebt, Deficitsand Financial InstabilityLadies and gentlemen,ThiseveningI wouldlike tosharewithyousomethoughtson thefuture landscapeof the banking sector and discusshowpolicy makerscould accompanytheprocessof de-riskingthat banksare undertaking.I will present my assessment of what is currentlyhappening in the EUbankingsector and what weexpect may happen over the next years.In particular, I will try to addressthree questions.1.Thefirst question is whetherweareheadingtowardsa significantdeleveragingin theEU banking sector.2.Thesecond one iswhetheradequatepolicy measurescan ensure thatthisprocessoccurswithout major damageto thereal economy.3.Thethird questioniswhethermacroprudential supervisorytoolscanbedesignedtoprevent excessiveleveragetobe built up again in the futureand operated in a smooth fashion whenapplied to cross-border business.Do EU banksneed to undertake a significant deleveragingprocess?Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 244Thefinancial crisishasitsrootsin multipleimbalancesat theglobal levelandhasbeen triggeredby the fall of asset prices.How a decline in asset value ledtoa major crisis at the global level hasbeen vividlyillustratedby Olivier Blanchard(2009)First, the underestimationof risksand disastermyopia, somethingnotreallynew in prolongedperiodsof benign market conditions.Second, thedifficultiestovalue some categories of assetsand newfinancial products.Third, the interconnectionsamong financial institutionsduetothegrowthof securitisation and globalisation.Finally, the increase of leverage, with financial institutions financing theirportfolios ―with less and less capital, thus increasing the rate of return ofcapital‖.It is clearthat thehigher the leverage, themore likely it is that decline inasset valuesdeterminesthedepletionof capital.In fact, extensive research in this respect demonstratesthat theprocyclicalityof leverageacts asamplificationmechanism propagatingadverseshocksto the real economy.Encouraged by a low-interestrateenvironment and by regulationslaggingbehindfinancial innovation, banks could boost thesizeof theirbalancesheetsand activities.This processentailed the growthof tradingactivitiesand investmentbanking, but alsoof retail lending, primarilyof residential mortgages.Themain driversof leveraginghavebeen real estateand structuredfinanceand, more generally, trading book activities.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 245For 70of thelargestEU banks, theexposuresin the―held for trading‖and ―availablefor sale‖ portfolios increasedby68 per cent between2005and 2008, witha sharp 24per cent decreasein 2009.Thedifferent driverswere deeplyinterlinkedand workedtogether, withoptimismand theunderestimation of risk contributing to banks‘excessiveleverage.Leveraging up wasconsidered asa legitimatestrategy tomaximiseearningsand, thus, tosatisfythe searchfor yield of market investors.Indeed, until 2007,thebankingsectorexperiencedprofitabilitylevelswellaboveany other economic sector and banks reported returnson equityexceedingtheir normalised earningscapacityon a risk-discountedbasis.Since2007,confrontedwithanunprecedentedfinancial crisis, bankshaveshiftedtoliability-driven strategies:obtainingthenecessaryfunding intheform of depositsor of market resourcesbecame the paramountstrategic goal.Both in the USand the EU, deleveraging was seen as part of a necessaryadjustment to remove excesscapacity and restructure balance sheets, andtoset the basisfor a more stableand soundbankingsector.Indeed, empirical researchsuggeststhat somedeleveragingisunavoidableafter a crisis:accordingto theBIS(2010), debt reductionfollowed17 out of 20banking crisesthat wereprecededby a surge incredit.However,theresponsetothecrisis hasbeen diverse on the twosidesoftheocean.While USbankshave reduced their leverageand relianceon wholesalefunding, until recently, European banksremained, on average, morereliant on wholesalefundingand leveragelevels– whiledecreasing–remainedcomparatively high.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 246This makestheEU bankingsector more prone tostructural and cyclicaldeleveragingpressures.In the US, deleveraginghasbeen significant.Thefigures on the level of leverageshould be interpreted withgreatcaution.Thereareinfact afewexplanationsforthedifferencebetweentheUSandtheEU that are not linked to banks‘behaviour but rather tothe localregulationsand thecharacteristicsof thefinancial markets.Let me providesome examples.First of all, off-balancesheet exposures– that are typicallyexcluded fromthecomputation of traditional leveragemeasures– are of different sizeacrossbanks, with US investment banksbeingtypicallyoutliers.Moreover,and most importantly, accountingrulesmay hamper thecomparison, asmeasuresof leveragediffer toa significant extent underUS GAAP and IFRSstandards.Finally,afterthefreezein thesecuritisationmarket, Europeanbankshavefurther developedthe practice of fundingmortgagesthrough coveredbonds.Therefore, European banks keep mortgageexposures in their balancesheets,asopposed toUS banks, whichcan securitize and easily divesttheir mortgageportfolio, primarily via theGovernment SponsoredEntities(GSEs).Furthermore, other factorsmay explainwhythechange in banks‘leveragehasbeenmore pronounced in theUSthan in the EU.In the US, it iseasier for banks tosell assetsdue to thedis-intermediatedstructure of the financial sector, wherecapital marketsplaya pivotal role.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 247Bank deleveraging is therefore structurally easier, but indebtedness is infact transferred from banks to other players, often not subject to equallystringent regulationsor not regulated at all.Also, asthe crisis kicked-in, wehave been witnessingaggressivereduction in indebtednesslevelsby both householdsand businessesintheUS, which, sofar, hasnot been thecasein theeuro zone.This suggeststhat demand factorsalsomatter and that theyareintertwinedwiththedebt level of theprivate sector at the onset of thecrisis.On the last point, the data providesa mixed picture.In the US, householdsconfronted the crisiswithhigher debt levelsthantheeuro-areaones.In 2007, thedebt todisposable income ratiowasabout 140per centagainst 110in the euro-area.Thedivide is even clearerlookingat the mortgage todisposableincomeratio (about 100in the US per cent versus60in the euro-zone).In 2010,notwithstandingthedebt reductionintheUS,theratiowasstill at120per cent.As for thecorporate sector, in 2007, theleverageratio (measured astheratio of financialdebt tofinancial debt pluscapital) wasabout 30per centin theUS compared to37in theeuro-area(35and42per centrespectivelyin 2010).It is alsofair toacknowledgethat deleveraginghasbeen prevalent atfinancial institutions– larger banks and brokers/ dealers– that grew theirbalancesheetsaggressivelybyincreasingdebt and assetsin theupswing, a trend that hasbeen more pronounced in theUS.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 248All theseargumentspoint toacomplexpicturein deleveragingdynamics,but a simplefact still holds true: differentlyfrom their USpeers,EU banks,until recently, had reduced their leveragealmostexclusivelythrough an increasein their capital levels, while thesize oftheir balancesheetshad remained almostunchanged – if anything, it hadgrownfurther (Charts 1and 2).For thetop 10banks, thetangiblecommon equityratio(theratiobetweentangibleequityand tangibleassets) increasedfrom 5.7 to7.8per centbetween2005and 2011.In the EU, the same ratioshifted from 3.4to 4.5 percent for the70banksparticipatingin theEBA recapitalisationexerciseBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 249All thishaschangedwiththe burstingof the sovereign debt crisis in theeuroarea.Strong pressurefor deleveragingemerged in Europe during the finalquarter of 2011, withthe freeze of the marketsfor medium and long termbank funding.While thishasbeenasourceof concern, at thisstage,thereisnoevidencethat the deleveragingprocesshasbecome excessiveor disorderly, withdisruptiveconsequenceson the real economy.AccordingtotheBIS(2012), Europeanbanksofferedfor saleasignificantvolume of assets,mostlythose withhigher risk-weights,includinglow-ratedsecuritised assets,distressedbondsand commercial property.In the last quarter of 2011, credit to non-bank private-sectorborrowersintheeuro-zonefell by around 0.5per cent, whileexposurestowardsnon-euro-arearesidentsdeclined by almost 4 per cent.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 250Thehome/ regional bias in deleveragingis partly theresult of banks‘deleveragingpeckingorder and partly of difficultiesin the USdollarfunding, whichremainedmore expensive and lessreadily availablethanhome-currencyfundingfor manyEuropeanbanksduetothereductionofprime moneymarket funds‘exposure toeuro area banks.I wouldsuggest some of therationalesfor bank deleveragein the EU.Fundingshortageshavebeen certainlya key driver.We have all witnessedthe dramatic market funding freeze during thesecondhalf of lastyear for EU banks,alleviatedsomemonthsagobynewregulatoryand policy initiatives,primarily theECB‘s3-year Long TermRefinancingOperations(LTRO), but alsostate guaranteesfor new bankbonds.EU banks arenow facinglonger-term challengesand deleveragingis thewayfor aligningthebusinessmodel to markets‘expectationsand totheincentivesposed by regulatory changes.Unquestionably, there is a need for de-risking, bringingleverageto moreconservative levels.Indeed, a number of Europeanbanks have not yet completed theclean-up of their balancesheetsand sheddingof legacyassets.In addition, thosebanksthat received public support are required underEU State aid regulation todismisspart of their businesstominimizecompetitivedistortions.Banks may alsoneed to rethink their involvement in investment bankingand related activitiesaswell asattempt toreducetheir dependenceonlessstablesourcesof funding – such asshort-term wholesalefinancing–asa response to thenew rulesintroducedby Basel 2.5and 3.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 251Hence,my answertothefirstquestionisthat theEU hasavoidedsofar adisordereddeleveragingprocessdriven by a massivefundingsqueeze, thanks in particulartothe actionstakenby the European CentralBank. But a downsizingof banks‘balancesheetshasstartedand hastotakeplace,in order tounravel some of the processesthat have triggeredthefinancial crisis.This is necessaryto bring banksback tosounder and more stablebusinessmodels.Several estimateshave been put forwardby analysts on the likelydimension of this deleveragingprocess.I don‘t think regulatorsshould have a view on theoverall sizeof theadjustment, but theyshould be awarethat there is still some wayto goandtheyshould keep putting pressure on banksto completethe repair oftheir balancesheets.What policy actionsto avoid negative repercussions on the realeconomy?Arecurrent theme in the recent debatehasbeen the claim of thebankingindustrythat theregulatory reforms wouldhave a major adverse impacton growthand employment.Deleveraginghasoftenbeencharacterisedas―bad‖, asimplying reducedflowsof lendingintothereal economy.But deleveragingcould beboth ―bad‖ and ―good‖, simplybecausereducingthe sizeof different componentsof a bank‘sbalancesheet canhavedifferent impacts.Thepoint is whether wecan disentanglepossibletrajectoriesfordeleveragingand deploypoliciesthat favour an orderlydeleveragingprocess, whichdoesnot hurt growthprospects.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 252For example, deleveragingis welcomewhenit entails dismissingorwritingdown troubled assetsaccumulatedby banksbeforethe crisis.In most post-crisesperiods, wehave witnesseda massivedeleveragingprocess, whichoften is simplyreflectingthe cleaningof the banks‘balancesheets.Thesizeof banks‘balancesheetsshrinkssimplybecauselossesarerecognisedand accountingvaluesrevised downwards.Thisprocesshasnoadversereal impact, asit doesnot changein anywaytheamount of loans.On thecontrary, there is a good amount of evidencethat if residualcreditriskisnot recognisedand dealt with, it islikelythat theeconomyremainsin a prolongedperiod of stagnation associatedwitha failuretoaddressnon-performingassets.Forbearancecan bea force for good wherea loanhasa reasonableprospect of an imminent return to performance.However,it can be perniciousfor both theborrower and the lender tomaintainnon-performingloanson balancesheetsfor prolonged periods.When a universal bank withextensiveactivitiesin both investment andwholesalebanking on theone hand, and retail and commercial bankingon the other hand, decidestode-riskawayfrom market activities,theinvestment banking/ tradingportion of the balancesheet will naturallyshrink.This may in fact be a good thinginsofarasde-riskingis concerned, andindeedsome regulatorsrequired banks todo that at the height of thecrisis.On the other hand, indiscriminatelycutting lendingto the real economymay lead toaneconomicslowdown and possiblytoa credit crunch.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 253And I includehere not only lendingto thedomestic economy by theparent bank but alsoreal economy lendingin other countrieswherethebank hassubsidiaries.ThisisaverysensitiveissueintheEU where,forinstance,subsidiariesofWestern EU banksplaya major role in Central and Eastern Europe.Disentanglinggoodandbaddeleveragingispart oftheusualdilemmaforpolicy makersduring a crisis.On the one hand, there is the willingnessto prevent a sharp contraction incredit supply to firms and households and, in turn, negative repercussionon economicgrowth.On the other, some adjustmentsand repairs in banks‘balancesheetsarevital torestorethe confidencein thefinancial sector and restart creditmarkets.And theJapaneseexperiencewarnsusthat forbearance– late recognitionof losses,delayed restructuring of balancesheets,deferred capital raising– can produce harmful consequences.Tang and Upper (2010)remind usof thislesson: ―fix thebankingsystemfirst‖.It hasbeen noted that ―gettingrid of thenon-strategic assetsthatnormallyhangaround after alongmerger-wave […] is aresponsibility ofindividual banks and their senior management, but moral persuasionfromregulatorsand governmentsis alsoneeded. Managers anddirectorscanhave avested interest in preserving thepresent size, whichcan makeit easier toextract privatebenefitsandpursuerent-seeking behaviour‖.In that respect, weshould welcome thefact that the waterfall ofdeleveragingis alsodrivenby regulation.This leadsme tothesecond question.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 254What policyactionscan beset up to ensure that onlygooddeleveragetakes place?Thefirst element of the policy toolkit should be an incentive-compatibleregulation.If rulesare properly designed, the cost in terms of capital and liquidityrequirementsof holdingriskier assetsis higher, providingthe rightincentivestowhat I calledgood deleveraging.And I assume there is still agreement on the fact that certain activitieshave contributed more than others to the build-up of vulnerabilities inbanks‘balancesheets.For example, deleveragingtrading and investment assetsis theconsequenceof a more demanding regulatoryframework – Basel 2.5 and3andtheDodd-Frank Act – that affectsprimarilymarket risk andtradingbook exposures.Thesecond element is to put banks in thecondition to keep grantingcredit to theeconomy.In Europe, the initiativesfor restoring market confidencehave beenincisive.Theoperationstosupport liquidityapprovedby theEuropean CentralBankhavealleviatedthepressureonbank funding, eventhoughrestoringtheaccessto private marketsfor longterm fundsremainsan importantpolicy objective.While easingfundingpressureson bankswasessential to avoid adisordereddeleveragingprocess, policiesneed to beput in placethatencouragebankstorepairtheir balancesheet andstrengthentheir capitalposition.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 255TheEBA required bankstoform a capital buffer that will enablethem toreach a Core Tier 1ratioof 9 per cent, after a prudent valuation of thebanks‘sovereign exposures.This is a temporaryand exceptional buffer toaddressthesystemic riskarisingfrom thesovereign debt crisis.In order to discourage banks from complying with the recommendationby simply curtailing lending, we laid down precise guidelinesand askedthe banks to submit plans for recapitalisation, describing the steps theyintendtotake in order toreach therequired level of capital.Onlya limited number of measuresto reduceassetsare allowedtomeetour request: while it will be possibleto transfer certain categories ofactivitiesto third parties – sincethisdoesnot reducetheleverageof thesystem asa whole– reductionsin lendingwill not determineany capitalrelief for banks, unlesstheyoccur withinrestructuring plansrequired bytheEU and theIMF or per requested by supervisors.Theplanssubmittedbybanks– andcurrentlybeingcarriedout underthescrutinyof national supervisoryauthoritiesand theEBA – areencouraging.Theactionsthat banks intend toput in placefor reaching thetargetcapital level focuspredominatelyon direct capital measures– issuanceofnew capital, retained earnings,conversion of hybrid instrumentsintocommon equity.Overall, direct capital measurescover 96per cent of theshortfall.In a small number of casesreductionsin lendingintotheeconomyareincludedin the plans.Themajorityof these deleveragingactivitiescorrespond toconditionslaid out in EU StateAid rulesor other official programmestoensureappropriaterestructuring and return to long term viability.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 256In practice, lessthan 1per cent of thetotal measureswill be representedbydecreasein lending.But let me turn to another important point.Over the last months, there hasbeen some disputeon therole thatsupervisorypressure for strengtheningcapital levelsplayed in thedeleveragingprocess,particularlyin theEU.In fact, asset deleveragehasbeenprimarily drivenbyachangein strategyandde-risking, reduced credit demand and fundingconstraints, muchlessby additional needson thecapital side.In Europe, thedeleveragingprocessbeganlongbeforetheEBAstartedtoconsider banks‘recapitalisationneeds,and it wascloselylinked withthedifficultiesbanks had in collectingfundson the market at a reasonablecost.On this,I want tobeblunt:I donot believethat high levelsofcapitalareadeterrent to new lending.On the contrary, bankswithlowcapital levels– or perceived by themarket asbeingso– are thosethat havehad problems in increasinglending.Theyeither facemajor fundingdifficulties– which, in turn, donot allowthem togrant loans– or focusprimarily on preserving their meagrecapital.Banks withlargecapital positions,by contrast, arelesssensitive tocyclical shocks and more likely topursue lendinggrowthstrategies.Indeed, lastSeptember, the IMF warnedthat ―anumberof [European]banksmust raise capital tohelp ensure theconfidence ontheir creditoranddepositors.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 257Without additional capital buffers, problemsin accessing fundingarelikely tocreate deleveraging pressuresat banks, whichwill force them tocut credit to thereal economy‖ and the European Systemic Risk Board(ESRB) emphasisedtheneed for coordinated effortsto strengthen EUbanks‘capital.TheEBA‘s recommendation for temporarycapital buffersis consistentwith the lessonslearnt from previouscrisesand respondstotheIMF andESRB warningsand meetsmarket expectationsfor higher capital levels.It haspushed a rebalancingof thedeleveragingthrough a major increasein capital (€115bn) and, at thesame time, it onlyallowed for gooddeleveraging.Going forward, supervisors need to maintain their focus on assetquality, making sure that residual credit risk is properly addressed andlossesare fully recognised.This should alsohelp drivingmarket valuesand book valuescloser toeach other, thussupportingthe issuanceof new equity.At the same time, supervisorsneed to work withbanks to identifypathwaystonew and diverse sourcesof funding, withlessrelianceonshort term wholesalefunding than in thepast.This rebalancingin the funding models isa necessary component of aprocessthat will lead banks tograduallyexit from theextraordinarysupport measuresprovidedby their central banks.An important component of this strategycouldbe supportingindustryinitiativesto re-establisha sound and well controlledmarket forsecuritisation.Theseactionson assetsand fundingshould help banks refocusingtheirbusinessmodelssothat their activitiesare sustainableand reflect theirareasof comparative advantage.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 258Which policytoolsto prevent boom andbust cyclesin integratedfinancial markets?Thefinal issueI want totacklethis eveningis whetherpolicymakerscanreducetheprobabilityof futureboom and bust cyclesdevisingeffectivepreventivetools.TheBasel 3framework doesenvisageinstrumentsthat should contributetosmoothing the fluctuationsin thefinancial sector.At the micro-prudential level, higher requirementsin termsof quantityandqualityof capital should structurallyreducebanks‘risk-taking.In addition, theleverageratiowill set a ceilingto non-risk-weightedexposuresin buoyant economic conditions.At the macro-prudential level, the countercyclical buffer regime willrequirebankstobuild-up capital cushionsin good times– whenrisk isunderestimated– tobe deployed for covering losseswhenthecyclerevertsand, thus, supporting the economy whenthis is most critical.Theeffectivenessof thistoolkit in preventing excessiveleveragingandabrupt deleveragingis still debated at theglobal level and, particularlyintheEU, with some jurisdictionsclaimingthat thecurrent stepstowardsstrengtheningprudential rulesmay not be sufficient.In the EU, weare workingfor completing theimplementationof Basel 3in our legislationassoonaspossible.Indeed, werealisethat the breadth of theregulatory reform issuch that itis producingsome degreeof uncertaintyin the market place.Ourpriorityisthustoreducethisuncertaintyandprovideanenvironmentin whichbanks– and investorsprovidingbankswith thenecessaryfunds– can again dotheir planningin a long term perspective.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 259What makes Europe– I believe– aninterestingcasestudyis thefact thatweare committedtoachieving a singlerule-book for financialmarkets,that is a common set of fullyharmonisedrulesthat will bebindingand directlyenforceablein all EU Member States.While thesinglerule-bookremainsa shared goal, there isat the sametimeacall for greater flexibilityat thenationallevel, in ordertofavourtheimplementationof macroprudential policies.Undoubtedly, there are strong argumentsin favour of some flexibility intheuseof macroprudential instruments.First, systemic riskmay materialisein different waysand nopredeterminedrulescould addressit.Second, sincecredit and economiccyclesare not fullysynchronisedacrossEU countries and financial marketsare stillheterogeneous,Member Statesmaynecessitatesome room formanoeuvre in theactivationof policy measures.Third, thedevelopment of macroprudential instrumentsis still at an earlystageand some flexibility may contributeto the learning-by-doingprocess.At the same time, the establishment of any flexiblemacroprudentialframeworkin Europe should not jeopardise the SingleMarket.What happenedduring the crisishaswarnedusthat the integrationoffinancial and banking marketscannot be considereda permanentaccomplishment if it isnot underpinnedbyeffectiveharmonizationof thelegal frameworkand its consistent application throughout theUnion.We have all witnessed how the Single Market may well prosper when theeconomic cycle is upward, but it may well implode in downturn cycles ifnocoordinatedresponsesare developed.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 260We are currentlywitnessinga major retrenchment of bankingbusinesswithinnational borders.Cross-border banking issignificantlydownsizing.Themoney market, whichwasthe mostintegratedmarket sincetheintroductionoftheeuro,hasvirtuallydisappearedandthelimitedsignsofrecoveryin interbank transactionsthat materialisedsincetheECB‘sLTRO are remainingmostlywithin national borders.Thedeleveragingprocessis being driven by therequestsof authoritiestohold significant capital and liquiditylevelsin domestic marketsand torefinancethe localeconomy.At the moment, weare facinga high likelihoodthat the deleveragingprocesswill occur witha segmentationof the SingleMarket in banking.This might well endanger its ultimategoal:widerand deeper financialmarketsofferingbetter and more financingopportunitiesfor realeconomies.This doesnot implythat no discretionshould be left to the nationalauthoritiesin shapingtheir macroprudential toolkit, but rather that thisshould happen under a coordinated approach based on strongex-anteguidanceand credibleex-post reviewsof themeasuresadoptedat thenational level.Thelevel of flexibilitytobeleft tothe macroprudential supervisorsis alsolinkedtotheobjectivesthat macroprudential policiesare expectedtoachieve.And it isfair toacknowledgethat there isnoclearagreement on this.According to a firstviewpoint, macroprudential policy playsprimarily apassiverole, complementingtraditional microprudentialsupervision, whichneglectsthe time-dynamicsof credit markets,andensuring that capital resources are adequatelyallocatedacrosstime, building reservesBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 261in good timesthat can be run-downwhen economicconditionsdeteriorate.Thesecond perspectiveregardsmacroprudential toolsasaneffectiveandwide-rangingmechanism for leaningagainst the wind, i.e. for reducingbanks‘incentivestoexpand credit and leveragein buoyant economicconditions,thusavoidingcredit bubbles.While thetwoperspectivesare not necessarily mutuallyexclusive, theyhavedifferent consequencesin termsof design and useof thepolicytools.In the first case, they aim at being neutral and rule-based.Somediscretion may be left tothe policymaker, but it is typicallyresidual.In thesecond case, much morediscretionisneededand thepolicy makeris endowedwith a significant degreeof freedom in adaptingthepoliciestothe specificjuncture.In thiscase, however,it iscrucial topreserveconsistencyintheactivationof macroprudential toolsand to avoid unintendedconsequenceswhentheyinteract withmicroprudential tools.In a nutshell, greater discretionneedstobe balanced with some pre-agreedprincipleson how discretioncan (or cannot) be exercised.Thefunctioningof the countercyclical buffer – a key element of the Basel3macroprudential toolbox – is a good example.As currently foreseen, national authorities will be given the possibility toactivate additional buffers reflecting the conditions of the credit cycle intheir jurisdiction.In Europe, the ex ante guidance, tobe issued by the European SystemicRiskBoard(ESRB), coupledwithaneffectiveexpost peerreview processBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 262should guaranteethat thesetoolsdonot alter the level playing field andare compatiblewiththesinglerulebook.Theapproach followedfor designing such a tool could be followedalsofor the introductionof other componentsof themacroprudential suite.My answerto the initial question is thereforemixed.We have some tools– the leverageratio and the countercyclical buffers –but westill do not havea well structuredsuiteof macroprudential toolsand specific rulesof engagement for their employment.In addition, all measureshavebeenfocusingsofar onthebankingsector, while a sizeableshareof the leveragingup of the system in the pastwasdriven by other financial institutions.Looking at the implementation, wearerunning the risk to open a widearea for discretionin national supervisoryimplementation, withnationalpolicy makers– not onlyin Europe – potentiallyable to hideeverythingunder the macroprudential umbrella.In that respect, a constraineddiscretionregimefor macroprudentialpolicies– alongwithharmonised microprudential rules and homogenoussupervisorypractices– is the onlyavenuefor ensuring that the samesourcesof systemic risk areaddressedin a consistent wayacrosscountries,levellingtheplaying field and reducing spill-over from lesstomore conservativejurisdictions.Systemic risk cannot anymore be containedwithin national borders andrequirescoordinatedpolicy responses.ConclusionsTodayI tried to argue that a deleveragingprocessisneeded in thebankingsector.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 263It hasalreadystarted, witha different pacein different areasof the globalfinancial system.Thefirststephasbeentheincreasein capitallevels,longoverdueandoneof the cornerstonesof the regulatory reforms endorsed by theG20Leaders.Thesecond stepimplies a reduction in size of balancesheets, especiallybyaddressingnon-performingassetsand de-riskingin areassuch ascapital market activities and real estatelending, whichgrew toomuch intherun-up to thecrisis.Thethird stepentailsa refocusing of businessmodels,especiallytowardsmore stablefundingstructuresand the gradual exit from theextraordinarysupport measuresput in place by central banks.I have seen no compellingevidencesupportingthe industry‘sargumentthat the regulatoryreformswill bringabout an unwarranteddeleveragingprocess, badlyhurtingthe real economy.On the contrary, I am convinced that without an ordereddeleveragingprocess, through a significant strengthening of capital and a selectivedownsizingof asset levels,wewouldfail addressingthefragilitiesthat arepreventingbanksfrom performingtheir fundamental functions.Apoint I acknowledgein theindustry‘scriticism is that in thepath tothenew equilibrium, authoritiesneed toprovidefor regulatory certaintyandclosecoordinationof actions.Supervisorsandcentralbankshavetocarefullycoordinatetheir actionstoaccompanythis processand make sure that it occursin an orderlyfashion, without hampering thecontinuedflowof lendingintothe realeconomy.In particular, in deploying their armoury of tools, includingthenewmacroprudential instruments,national authorities should avoid policiesBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 264toonarrowly focused on domestic objectives:if thedeleveragingprocessis shaped by policies aimed at maintainingdomestic assetswhilede-riskingin foreign jurisdictions,werisk triggeringa segmentation offinancial marketsthat may wellhamper growthand employment.This is particularlytrue in the euro area and theEU, but hasa moregeneral relevancefor global financial markets.Thank you for your attention.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com
  • 265TheBaseliii ComplianceProfessionalsAssociation (BiiiCPA) is thelargest associationof Basel iii Professionalsin theworld. It is a businessunit of theBasel ii ComplianceProfessionalsAssociation (BCPA), whichis alsothe largest associationof Baselii Professionalsin theworld.Basel III SpeakersBureauTheBasel iii ComplianceProfessionalsAssociation (BiiiCPA) hasestablished the Basel III Speakers Bureau for firmsand organizationsthat want to accessthe 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
  • 266B. 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
  • 267Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com