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Basel III News, October 2012
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Basel III News, October 2012

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Basel III News, October 2012

Basel III News, October 2012

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  • 1. 1 Basel iii Compliance Professionals Association (BiiiCPA) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.comDear Member,There are some interesting job openingsand descriptions:Vice President - Bank Regulatory Policy /BaselManhattan, NY, Salary $120,000-$180,000 / yr., Full -Time“This individual will assist in interpreting and developing firm policy forU.S. and international banking regulations related to capital and andother regulatory reporting matters. They are seeking individuals withprior Basel II and III and bank capital regulations experience.”Finance and Risk Solution ArchitectLondon, Salary £80,000 - £115,000 + Bonus“We are currently looking for profiles with a consulting or businessstream background in the following areas for a new business practice inthe finance sector: we are looking for individuals with the followingbackground or experience: Risk Management in Capital or Liquidityrequirements, Financial Industry Regulatory Reporting such as FSA,Dodd Frank, Basel II/III & Industry Best Practice, reporting strategies& Global Transactions. Individuals will have a Business/TechnicalArchitectural Background ideally with some Business Analysis &Consulting background.”Business Analyst with Basel III Job“We are actively seeking a contractor to lead a team in documentation,design, and traceability of requirements in support of Basel IIIimplementation. This includes defining solutions to business/systems Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 2. 2problems and ensuring the integrity of delivery through customeracceptance and final disposition of solution for the Basel III project.This is a minimum 6-8 month project with strong possibility of extensionor conversion to full time” employment.”Very interesting job descriptions…… and very interesting salary.Dealing with financial systemic risk: thecontribution of macroprudential policiesPanel remarks by Jaime Caruana, GeneralManager of the Bank for InternationalSettlements, Central Bank of Turkey/G20Conference on "Financial systemic risk",IstanbulAbstractThere are important two-way interactionsbetween macroprudential policy and other areas of public policy.These interactions put a premium on cooperative institutionalframeworks that recognise the complementarities between policy actions.This means that, within a single jurisdiction, macroprudential authoritiesshould be independent and should focus primarily on mitigating systemicrisk while recognising that other policies will have an impact on the sameobjective.Cooperation between macroprudential policies across national bordersstarts from the high level set by various international regulatory standardsand is improving with the explicit macroprudential frameworks recentlyintroduced for countercyclical capital buffers and the higher lossabsorbency requirements for systemically important banks. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 3. 3Greater cooperation, however, does not mean that we should disregardthat individual policies have specific objectives and that some hierarchyof action is necessary.Full speechLet me thank the Central Bank of the Republic of Turkey and the G20presidency of Mexico for having invited me to attend such an interestingconference addressing the topic of financial systemic risk.In my remarks today, I would like to explain how macroprudentialpolicies can greatly contribute to dealing with systemic risk and fosteringfinancial stability.I will highlight a few key issues that we should focus on in order to makethis effective.1. Trend towards strengthening the macroprudentialorientation of policyThe term "macroprudential" has gained currency in policy discussionsduring the past four years.Indeed, the recent financial crisis has given rise to a general trend towardsstrengthening the macroprudential orientation of policy in countries withvery diverse institutional frameworks and financial structures.This is very welcome: recent experience has taught us that we need to bemore focused on addressing system-wide risk, and this is precisely whatmacroprudential policy is all about.Macroprudential frameworks may be new, but mainly in the sense ofbecoming explicit.Many countries have been using prudential instruments to addresssystem-wide vulnerabilities without making reference to macroprudentialpolicies. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 4. 4For example, variable ceilings for loan-to-value (LTV) ratios have beenused repeatedly in Hong Kong and other Asian economies to slow downfrothy mortgage lending and ensure that banks do not overexposethemselves to property risk.Nevertheless, the more recent introduction of formal structures brings tothe fore issues of definition, delineation of responsibilities andgovernance.In my remarks today, I would like to underscore a critical aspect ofmacroprudential policy and to offer a word of caution.The critical aspect I am referring to is the strong two-way interactionsbetween macroprudential policy and other areas of public policy.These interactions put a premium on cooperative institutionalframeworks that recognise the complementarities between policy actions,both within and across jurisdictions.This is a particularly important issue at the national level; but cooperativeframeworks are also essential at the international level, requiring bothsufficient information-sharing and reciprocity.The word of caution is that we should be mindful that individual policieshave specific primary objectives and that some hierarchy of action isnecessary.Let me explain.2. Macroprudential policy is not the only area of policy thatinfluences systemic riskMany other policies can affect the resilience of the financial system andits ability to provide valuable services to the economy.Quite apart from microprudential policy, the influence of monetary, fiscaland tax policies, of financial reporting standards and of legal frameworksis also very strong. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 5. 5 For instance, prolonged periods of low policy rates affect leverage,encourage financial market participants to take on risks and may at timesfuel asset price bubbles. Conversely, instruments and actions aimed at mitigating and managingsystemic risk can have very important effects on the macroeconomy andthus impinge on the objective of other policies. For example, tightening capital requirements to protect banks from thebuild-up of systemic risk during a credit boom can also cool down creditexpansion and, by extension, aggregate demand. To be sure, a more stable, more resilient and less procyclical financialsystem will improve the effectiveness of monetary and other policies.So there are externalities in the interaction of different policies: there canbe positive complementarities when the policies are mutually reinforcing,but also negative spillovers when one policy weakens the effectiveness ofanother.Hence, there is a need for coordination.This is true both within a given jurisdiction and across borders.3. The need for coordination within a single jurisdictionLet me talk first about coordination within a single jurisdiction.The interactions between policies suggest a few principles for instrumentdesign and deployment.One such principle is that macroprudential policy instruments should bein the hands of an independent authority with the explicit objective ofmaintaining financial stability.This is important, for two reasons: the lack of precise measurement toquantify this objective, and policymakers inevitable reliance onjudgment in pursuing it. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 6. 6Measurement presents a serious challenge for the design, governance andaccountability of macroprudential policy.There are no readily available and widely accepted metrics of systemicrisk to help calibrate instruments or gauge policy performance, even expost, with much precision.And it is notoriously difficult to answer the counterfactual question ofhow things would have evolved had an alternative action plan beenadopted.As a result, more than ever, policy needs to rely on a significant degree ofjudgment.One telling example relates to anticyclical policies.All anticyclical policies have to work with real-time information that isincomplete and imprecise.Decisions rely on judgment to interpret the multitude of inputs.This is not unique to macroprudential policy, but it is particularly evidentin this case: current technology provides far less in the way of robustquantitative models to guide macroprudential policy in addressing boththe time and the cross-sectional dimensions of systemic risk.As regards the time dimension, only recently have researchers beenattempting to be specific about what the financial cycle is and how tocharacterise it.A few features are worth mentioning: It is possible to identify a well defined financial cycle that is bestcharacterised by the co-movement of medium-term cycles in credit andproperty prices.Such financial cycles are longer and more severe than business cycles.The duration and amplitude of the financial cycle has increased since themid-1980s: financial cycles last, on average, around 16 years; but when Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 7. 7considering only cycles that peaked after 1998, the average duration isnearly 20 years, compared with 11 for previous ones. Peaks in the financial cycle are closely associated with systemic bankingcrises (henceforth "financial crises" for short).Finally, the financial cycle and the business cycle are differentphenomena, but they are related.Recessions associated with financial disruptions tend to be longer anddeeper.As regards the cross-sectional dimension of systemic risk, we are alsouncertain about how best to map the systemic importance of financialinstitutions onto their size, the extent and density of their links to others,and the uniqueness of their economic function.The need for judgment, combined with the need to resist powerfulpolitical economy pressures, puts a premium on operationalindependence.Pressures may be high because the future rewards of macroprudentialpolicy actions tend to be uncertain, difficult to quantify and distant in thefuture, whereas the costs are immediate and can be easily exaggerated.Operational independence is easier to achieve if the relevant authority hasa clear mandate.And it has to go hand in hand with accountability and clarity ofcommunication.Policymakers need to be transparent about how policy decisions relate totheir mandate and to their economic assessments.This helps anchor the publics expectations and the holding of theauthorities to account.From this perspective, it is key to ensure the adequate involvement of thecentral bank. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 8. 8One may even argue that it is preferable for the central bank to be themacroprudential authority.A second principle is that the control over instruments should becommensurate with the objective of managing systemic risk.Not many tools are purely macroprudential.The vast majority are simply prudential tools tailored for use from amacroprudential perspective through adjustments to their design andcalibration.Capital requirements are a key tool but are not sufficient.They need to be complemented with other instruments and moreintrusive supervision.Given that we have to deal with human behaviour that is imperfectlyunderstood, combining instruments is more promising than relying on asingle one.Liquidity requirements and instruments such as loan-to-value ratios orlimits on exposures have all been used and proven effective.In addition, explicit resolution plans are also important: they address thesource of the problem, as they reduce the costs of (disorderly) failure.More generally, all tools are inadequate in the absence of effective and attimes intrusive supervision: the incentives for regulatory arbitrage aresimply too powerful.This means that there is a need for coordination in the use of variousinstruments, through both the sharing of information and thecommunication of assessments.Moreover, this should be supported by a framework that allocatesresponsibilities and accountability clearly. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 9. 94. The international dimensionLet me now turn to the international dimension.As long as we have open financial systems, risks in one country can affectothers.Similarly, macroprudential policy can have spillovers across borders.To what extent does this call for formal coordination?Countries are developing their own policy frameworks to deal with thecross-sectional and the time dimensions of systemic risk.They are introducing arrangements to assess the banks that aresystemically important from a domestic perspective.They are also introducing policy measures linked to rough indicators ofbanks systemic significance.I would argue that, despite being the new kid on the block,macroprudential policy is one of the economic policy areas in whichinternational coordination has gone furthest.To be sure, we started from a very good basis, namely the existinginternational regulatory framework for markets and institutions.A number of independent international committees have proposed, andcountries around the globe have adopted, minimum prudential standardsfor banks and market infrastructures.And, importantly, more recently there have been concerted efforts topromote consistent implementation across jurisdictions.The Basel Committee on Banking Supervision has conducted significantwork in this area under the leadership of Stefan Ingves.For my part, I would simply like to highlight two examples ofcoordination in the macroprudential area: as regards its time dimension,the design of the countercyclical capital buffers; and, as regards the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 10. 10cross-sectional dimension, the imposition of capital surcharges forsystemically important banks.The countercyclical buffer is intended to counterbalance the procyclicalbehaviour of banks by building up buffers in good times that can absorblosses in times of stress.It is a prudential instrument calibrated to achieve a macroprudentialobjective.Critically, the level of the buffer depends on the state of the financial cyclein a given jurisdiction.The framework allows for a large degree of judgment and tailoring tolocal circumstances - there is no one-size-fits-all solution.It also provides for international reciprocity: supervisors of foreign banksshould apply the same surcharge on these banks exposures as thesupervisor in the host jurisdiction demands of the local banks.This levels the playing field and addresses regulatory arbitrage. A similar degree of coordination applies to the treatment of systemicallyimportant banks.The Basel Committee and the Financial Stability Board have developed aframework to assess the banks that are globally systemically important(G-SIBs).By necessity, the assessment of capital surcharges and their application tothose banks comprise a joint decision at the international level, since therelevant system is global.Furthermore, the proposed framework to deal with the banks that aresystemically important from a domestic perspective (these are morenumerous than the G-SIBs) sets out principles that govern the interactionbetween the assessment and actions of a banks host supervisor and thoseof its home supervisor. Cooperation is built into the framework. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 11. 11Macroprudential policy may be a recent addition to the toolbox ofpolicymakers, but it already embeds international cooperation.I believe that this approach to international cooperation is a good one.It fully recognises international spillovers while preserving national roomfor manoeuvre in applying agreed principles.Coordination is advanced through information-sharing, commonminimum standards and reciprocity.5. The hierarchy of actionLet me now close by offering a cautionary remark concerning theinteraction between macroprudential policy and other policies.As I noted earlier, macroprudential policy may have macroeconomiceffects.Attempts to mitigate the financial cycle are likely to influence thebusiness cycle.Prudential tools may affect credit and asset price dynamics and, byextension, aggregate demand.Because of that, it is essential to ensure that the hierarchy of policy toolsis clarified.Macroeconomic management should first rely on macroeconomic tools(monetary and fiscal policies) before asking for help frommacroprudential policy.Financial stability is already a large enough job for macroprudentialpolicy.It should remain focused on its main objective rather than trying tosmooth the business cycle. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 12. 12The temptation to bend prudential tools away from their primaryobjective of financial stability to tackle shorter-term macroeconomicfluctuations can be quite strong.Given measurement uncertainties, the case for doing so is less compellingthan it appears.It is in situations like these that the independence and accountability ofmacroprudential frameworks are particularly valuable.Moreover, financial stability is too big a burden to rest exclusively onprudential and macroprudential policies; it needs the cooperation of otherpolicies: a more symmetrical monetary policy across the financial cycle,fiscal policies that create additional space in financial booms, etc.Finally, let me finish on a positive note.Despite our limited knowledge about the impact of macroprudentialpolicies, there is significant room for effective action - for at least threereasons:First, potential policy conflicts are usually exaggerated.It seems likely that, in most circumstances, macroprudential policy andmonetary policy will be complementary, tending to support each otherinstead of conflicting.It is important to realise that the financial cycles that matter for prudentialpolicy are of a much lower frequency than business cycles.This suggests that, most of the time, monetary policy should be able totreat macroprudential policy developments as a relatively slow-movingbackground.However, it also requires monetary policy to keep an eye ondevelopments over longer horizons in order to take into account theeffects of the gradual build-up and unwinding of financial imbalances.This longer horizon diffuses some of the possible tensions betweenmonetary policy and macroprudential decisions. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 13. 13Second, there is already a growing body of research and experience thathas led to significant progress being made both conceptually andoperationally, for instance in the design and calibration ofmacroprudential tools.Third, some tools and indicators seem to produce reasonable results -certainly better than doing nothing.In particular, the credit gap indicator embedded in the Basel IIIcountercyclical capital buffer seems to provide good guidance for action.Simulations indicate that following this indicator would help to producemeaningful action (eg raising capital) at an early stage, before thebeginning of a financial crisis.For example, the United States and the United Kingdom would havestarted setting aside more capital in 1999, and the 2.5% buffers would havebeen completed by 2002 and 2006 respectively, ie well before the financialcrisis.Spain would have started even earlier, in 1997 (with the 2.5% buffercompleted in 1999).Of course, the indicator would not have worked so well in some othercountries.For instance, in the case of the Netherlands, it would have peaked tooearly compared to the evolution of the financial cycle; nonetheless,healthy buffers would have been built.Also, the credit gap indicator has proved to be noisy for some largeemerging market economies such as Brazil and Turkey.To be sure, this indicator can be supplemented with the informationcoming from the analysis of other indicators.These are just a few examples of the possibilities of one of theinstruments of macroprudential policies. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 14. 14They illustrate the potential but also the need to continue to work on howthe macroprudential approach can be formalised and applied to differentinstitutional frameworks in a way that strengthens other policies andmitigates systemic risk. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 15. 15Chairman Ben S. BernankeAt the "Challenges of the Global Financial System:Risks and Governance under Evolving Globalization,"A High-Level Seminar sponsored by Bank ofJapan-International Monetary Fund, Tokyo, JapanU.S. Monetary Policy and InternationalImplicationsThank you. It is a pleasure to be here. This morning I will first brieflyreview the U.S. and global economic outlook.I will then discuss the basic rationale underlying the Federal Reservesrecent policy decisions and place these actions in an internationalcontext.U.S. and Global Outlook The U.S. economy has faced significant headwinds, and, although theeconomy has been expanding since mid-2009, the pace of our recoveryhas been frustratingly slow.The headwinds include the effects of deleveraging by households, thestill-weak U.S. housing market, tight credit conditions in some sectors,spillovers from the situation in Europe, fiscal contraction at all levels ofgovernment, and concerns about the medium-term U.S. fiscal outlook.In this environment, households and businesses have been quite cautiousin increasing spending.Accordingly, the pace of economic growth has been insufficient tosupport significant improvement in the job market; indeed, theunemployment rate, at 7.8 percent, is well above what we judge to be itslong-run normal level. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 16. 16With large and persistent margins of resource slack, U.S. inflation hasgenerally been subdued despite periodic fluctuations in commodityprices.Consumer price inflation is running somewhat below the FederalReserves 2 percent longer-run objective, and survey- and market-basedmeasures of longer-term inflation expectations have remained wellanchored.The global economic outlook also presents many challenges, as youknow.Fiscal and financial strains have pushed Europe back into recession.Japans economy is recovering from last years tragic earthquake andtsunami, and it continues to struggle with deflation and persistent weakdemand.And in the emerging market economies, the rapid snap-back from theglobal financial crisis has given way to slower growth in the face of weakexport demand from the advanced economies.The soft tone of global activity is yet another headwind for the U.S.economy.Looking ahead, economic projections of Federal Open MarketCommittee (FOMC) participants prepared for the CommitteesSeptember meeting called for the economic recovery to proceed at amoderate pace in coming quarters, with the unemployment rate decliningonly gradually.FOMC participants generally expected that inflation was likely to run ator below the Committees inflation goal of 2 percent over the next fewyears. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 17. 17The Committee also judged that there were significant downside risks tothis outlook, importantly including the potential for an intensification ofstrains in Europe and an associated slowing in global growth.Federal Reserves Recent Policy ActionsAll of the Federal Reserves monetary policy decisions are guided by ourdual mandate to promote maximum employment and stable prices.With the disappointing progress in job markets and with inflationpressures remaining subdued, the FOMC has taken several importantsteps this year to provide additional policy accommodation.In January, the Committee noted that it anticipated that economicconditions were likely to warrant exceptionally low levels of the federalfunds rate at least through late 2014--a year and a half later than inprevious statements.In June, policymakers decided to continue through year-end the maturityextension program (MEP), under which the Federal Reserve purchaseslong-term Treasury securities and sells short-term ones to help depresslong-term yields. At its September meeting, with the data continuing to signal weak labormarkets and no signs of significant inflation pressures, the FOMCdecided to take several additional steps to provide policyaccommodation.It extended the period over which it expects to maintain exceptionally lowlevels of the federal funds rate from late 2014 to mid-2015.Moreover, the Committee clarified that it expects to maintain a highlyaccommodative stance of monetary policy for a considerable period afterthe economic recovery strengthens. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 18. 18The FOMC coupled these changes in forward guidance with additionalasset purchases, announcing that it will purchase agencymortgage-backed securities (MBS) at a pace of $40 billion per month, ontop of the $45 billion in monthly purchases of long-term Treasurysecurities planned for the remainder of this year under the MEP.The FOMC also indicated that it would continue to purchase agencyMBS, undertake additional asset purchases, and employ other tools asappropriate until the outlook for the labor market improves substantiallyin a context of price stability.The open-ended nature of these new asset purchases, together with theirexplicit conditioning on improvements in labor market conditions, willprovide the Committee with flexibility in responding to economicdevelopments and instill greater public confidence that the FederalReserve will take the actions necessary to foster a stronger economicrecovery in a context of price stability.An easing in financial conditions and greater public confidence shouldhelp promote more rapid economic growth and faster job gains overcoming quarters.As I have said many times, however, monetary policy is not a panacea.Although we expect our policies to provide meaningful help to theeconomy, the most effective approach would combine a range ofeconomic policies and tackle longer-term fiscal and structural issues aswell as the near-term shortfall in aggregate demand.Moreover, we recognize that unconventional monetary policies comewith possible risks and costs; accordingly, the Federal Reserve hasgenerally employed a high hurdle for using these tools and carefullyweighs the costs and benefits of any proposed policy action.International Aspects of Federal Reserve Asset Purchases Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 19. 19 Although the monetary accommodation we are providing is playing acritical role in supporting the U.S. economy, concerns have been raisedabout the spillover effects of our policies on our trading partners.In particular, some critics have argued that the Feds asset purchases, andaccommodative monetary policy more generally, encourage capital flowsto emerging market economies.These capital flows are said to cause undesirable currency appreciation,too much liquidity leading to asset bubbles or inflation, or economicdisruptions as capital inflows quickly give way to outflows.I am sympathetic to the challenges faced by many economies in a worldof volatile international capital flows.And, to be sure, highly accommodative monetary policies in the UnitedStates, as well as in other advanced economies, shift interest ratedifferentials in favor of emerging markets and thus probably contribute toprivate capital flows to these markets.I would argue, though, that it is not at all clear that accommodativepolicies in advanced economies impose net costs on emerging marketeconomies, for several reasons. First, the linkage between advanced-economy monetary policies andinternational capital flows is looser than is sometimes asserted.Even in normal times, differences in growth prospects amongcountries--and the resulting differences in expected returns--are the mostimportant determinant of capital flows.The rebound in emerging market economies from the global financialcrisis, even as the advanced economies remained weak, provided stillgreater encouragement to these flows.Another important determinant of capital flows is the appetite for risk byglobal investors. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 20. 20Over the past few years, swings in investor sentiment between "risk-on"and "risk-off," often in response to developments in Europe, have led tocorresponding swings in capital flows.All told, recent research, including studies by the International MonetaryFund, does not support the view that advanced-economy monetarypolicies are the dominant factor behind emerging market capital flows.Consistent with such findings, these flows have diminished in the pastcouple of years or so, even as monetary policies in advanced economieshave continued to ease and longer-term interest rates in those economieshave continued to decline.Second, the effects of capital inflows, whatever their cause, on emergingmarket economies are not predetermined, but instead depend greatly onthe choices made by policymakers in those economies.In some emerging markets, policymakers have chosen to systematicallyresist currency appreciation as a means of promoting exports anddomestic growth.However, the perceived benefits of currency management inevitablycome with costs, including reduced monetary independence and theconsequent susceptibility to imported inflation.In other words, the perceived advantages of undervaluation and theproblem of unwanted capital inflows must be understood as apackage--you cant have one without the other. Of course, an alternative strategy--one consistent with classicalprinciples of international adjustment--is to refrain from intervening inforeign exchange markets, thereby allowing the currency to rise andhelping insulate the financial system from external pressures. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 21. 21Under a flexible exchange-rate regime, a fully independent monetarypolicy, together with fiscal policy as needed, would be available to helpcounteract any adverse effects of currency appreciation on growth.The resultant rebalancing from external to domestic demand would notonly preserve near-term growth in the emerging market economies whilesupporting recovery in the advanced economies, it would redound toeveryones benefit in the long run by putting the global economy on amore stable and sustainable path.Finally, any costs for emerging market economies of monetary easing inadvanced economies should be set against the very real benefits of thosepolicies.The slowing of growth in the emerging market economies this year inlarge part reflects their decelerating exports to the United States, Europe,and other advanced economies.Therefore, monetary easing that supports the recovery in the advancedeconomies should stimulate trade and boost growth in emerging marketeconomies as well.In principle, depreciation of the dollar and other advanced-economycurrencies could reduce (although not eliminate) the positive effect ontrade and growth in emerging markets.However, since mid-2008, in fact, before the intensification of thefinancial crisis triggered wide swings in the dollar, the real multilateralvalue of the dollar has changed little, and it has fallen just a bit against thecurrencies of the emerging market economies.Conclusion To conclude, the Federal Reserve is providing additional monetaryaccommodation to achieve its dual mandate of maximum employmentand price stability. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 22. 22This policy not only helps strengthen the U.S. economic recovery, but byboosting U.S. spending and growth, it has the effect of helping supportthe global economy as well. Assessments of the international impact ofU.S. monetary policies should give appropriate weight to their beneficialeffects on global growth and stability. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 23. 23The new UK Regulator:The Financial Conduct AuthorityThe Financial Conduct Authority (FCA)will be the new regulator whose vision it is to make markets work well soconsumers get a fair deal.It will be responsible forrequiring firms to put thewell-being of their customers atthe heart of how they run theirbusiness, promoting effectivecompetition and ensuring thatmarkets operate with integrity.The FCA will start work in 2013,when it will receive new powersfrom the Financial Services Billthat is currently going throughparliament.The Journey to the FCA sets outhow we will approach ourregulatory objectives, how weintend to achieve a fair deal infinancial services for consumersand where we are on thisjourney.Changes to authorisationsThe UK regulatory structure will be changing in 2013, when the FSA willsplit into two regulatory bodies the Financial Conduct Authority (FCA)and the Prudential Regulation Authority (PRA). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 24. 24In April 2012, Supervision adopted the internal-twin peaks structure, andnow Authorisations are implementing a similar structure, withassessments carried out by both the Prudential Business Unit (PBU) andthe Conduct Business Unit (CBU).This change will only affect firms that will be dual regulated in future.The application submission process will not change and we will continueto seek to meet our statutory deadlines.What will change is how the application is processed internally.There will be a CBU case officer and a PBU supervisor responsible foreach application and they will coordinate to minimise duplication or theimpact on applicant firms and individuals.The final decision will need to be agreed by both the PBU and the CBU toensure a single FSA decision during transition to the new regulatorystructure.These changes will allow us to start to deliver, as far as possible, a modelthat will mirror the future authorisation procedures in the PRA and theFCA.What is happening to the FSA Handbook?At legal cutover, the FSA Handbook will be split between the FCA andthe PRA to form two new Handbooks, one for the PRA and one for theFCA.Most provisions in the FSA Handbook will be incorporated into thePRA’s Handbook, the FCA’s Handbook, or both, in line with each newregulator’s set of responsibilities and objectives.Users of the Handbook will be able to access the following online: Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 25. 25 1. The PRA Handbook, displaying provisions which apply to PRA-regulated firms 2. The FCA Handbook, displaying all provisions which apply to FCA-regulated firms; and 3. To support the transition, a central version which will show the provisions of both Handbooks, with clear labels indicating which regulator applies a provision to firms.The new Handbooks will reflect the new regulatory regime (for example,references to the FSA will be replaced with the appropriate regulator), andin some areas more substantive changes will be made to reflect theexistence of the two regulators, their roles and powers.(This is likely to include such aspects as the future processes forpermissions, passporting, controlled functions, threshold conditions andenforcement powers.)The more substantive changes will be consulted on before the PRA andthe FCA acquire their legal powers.Changes to the FSA Handbook as a result of EU legislation and FSApolicy initiatives will continue throughout this work.After acquiring their powers, the FCA and the PRA will amend their ownsuites of policy material as independent bodies in accordance with theprocesses laid down in the Financial Services Bill, including cooperationbetween them and external consultation.What does this mean for firms?This approach to the Handbooks for the FCA and the PRA has beenplanned to ensure a safe transition for firms and the new regulators as thenew regime is introduced.Firms will have a new regulator or regulators, and will consequently needto assess how the new Handbooks of these bodies will apply to them. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 26. 26Dual regulated firms will need to look to both the PRA and the FCAHandbooks, and FCA regulated firms to the FCA Handbook.When will the changes be in the Handbook?We expect to publish the new Handbooks before legal cutover.This will allow firms and others time to adjust to the application of thenew Handbooks before the FCA and the PRA are fully operational.The new Handbooks will not be available in detail before this.Alongside the publication, we will publish material on how to interpretthe application of the Handbooks, where this is not dealt with in theHandbooks themselves.The FSA will continue to make changes to its Handbook in accordancewith the normal procedure, until the new bodies acquire their legalpowers.The FSA Handbook will remain in force until the FCA and PRA acquiretheir legal powers. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 27. 27Launch of the Journey to the FCASpeech by Martin Wheatley - Managing Director,FSA, and CEO Designate, FCA at the Launch ofthe Journey to the FCA eventGood morning. I would like to thank the MinisterGreg Clark for joining us today, for his supportivewords – and for demonstrating the Government’scommitment to working alongside us to deliver better conduct regulation.I would also like to thank Thomson-Reuters for hosting this morning.Today is a big step forward on the road to becoming the new regulator,and I am glad that you are all here to join us as we launch the Journey tothe FCA.The FCA offers a huge opportunity for the regulator and firms to startafresh, and work in partnership to reset how we deal with conduct infinancial services.We see it as the role of the regulator to not only make the relevant marketswork well but also to help firms get back to putting their customers at theheart of how they do business.Regulation has a huge impact on the people and businesses that rely onfinancial services, and we should never forget this.We have approached the creation of the FCA in a thoughtful andconsidered way, as the document we are sharing with you today shows.We will regulate one of our most successful industries, central to thehealth of our economy and a provider of two million UK jobs.This makes our job an important one, and it will mean that we carry outour work in a way that is as open and accountable as possible.We spent the summer engaging with consumer organisations, and 500firms from all areas of financial services, as we developed our thinking onthe FCA. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 28. 28This allowed us to gather useful feedback and we will continue this openworking in the FCA.We aim in the Journey to the FCA to demonstrate what our neworganisation will mean for the firms we regulate and the consumers weare here to help protect.I encourage you all to read it, and to give us your views.We are clear about the type of regulator we want to become, and we wantto work with all of our stakeholders to get there and deliver regulation thatworks better.You have not yet had a chance to read the document, so let me explain abit more about what the FCA is going to be about.The FCA has been set up to work with firms to ensure they put consumersat the heart of their business.Underlining this are three outcomes:1. Consumers get financial services and products that meet their needsfrom firms they can trust.2. Firms compete effectively with the interests of their customers and theintegrity of the market at the heart of how they run their business.3. Markets and financial systems are sound, stable and resilient withtransparent pricing information.Reforming regulation is not just good for consumers, it will also be goodfor firms. The industry’s standing has suffered as the mis-selling scandalsand other problems have taken their toll.This has damaged the reputation of firms across the industry, whetherdirectly involved or not. We need to work with you to put that right.While much of what we will do is new, we will also build on what hasworked well under the FSA. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 29. 29We will keep up our policy of credible deterrence, pursuing enforcementcases to punish wrongdoing.And our markets regulation will continue to promote integrity and carryon the FSA’s fight against insider dealing, which has secured 20 criminalconvictions since 2009.We will continue to keep unauthorised firms from trying to takeadvantage of consumers.We will set high expectations for those firms that want to enter financialservices, while still allowing innovation and good ideas to flourish.And we will take forward a strong interest in the fair treatment ofcustomers – an agenda that has been around for many years, but is stillkey to the FCA.There will, however, be important changes, and our approach will bemore forward-looking, better informed, and we will have a greaterappetite to get things done.A new department will act as the radar of our new organisation –combining better research into what is happening in the market, andanalysis of the risks to our objectives.This will then feed into our policymaking and our supervision of firms.We want to really understand what is happening to your customers, thedeal they are getting and the issues they face.This will include getting a better understanding of why consumers act inthe way they do, so we can adapt our regulation to their commonbehavioural traits.Fewer firms will have regular direct contact with supervisors, as we shiftresources to allow us to deal more quickly and effectively with emergingissues, and run more cross-industry projects to get to the root cause ofproblems. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 30. 30We will have new partners to work with and our relationship with the newPrudential Regulation Authority will be crucial, and driven by a culture ofcooperation.We will aim to bring our expertise to international debates, so that EUand international policymaking works for UK consumers and firms.All of this will be delivered by a new culture in the FCA. We willencourage our staff to be more confident in making bold, firm andpredictable decisions.To help us do our job, the Government intends to give the FCA new toolsto ensure that consumers get products that meet their needs.This builds on one of the key lessons from past problems, which is thatregulation is often more effective if it steps in early to pre-empt andprevent widespread harm.We will reflect this in our supervision work when we look at how firmsdesign and sell their products.But a key new power will mean that we can step in and ban the sale ofproducts that pose unacceptable risks to consumers for up to 12 months,without consulting first.We will also be able to ban misleading advertising.We will use these new tools in a measured way – and while we will actsooner, and more decisively, our approach will be based on a properunderstanding of the issues and a full consideration of the potentialsolutions.So whilst there may be times when we have to act rapidly, this is notsomething that firms should be afraid of.Firms selling the right products, in the right way, to the right consumershave little to fear.Our new approach will mean that we will take competition into account inall our work. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 31. 31We will weigh up the impact on competition of new measures wepropose.We will also consider whether competition could lead to better resultsthan other action we could take.In our work here, and in other areas, I am very conscious that we have towork with firms.Making regulation work better for us is also about allowing firms room totry new ideas and develop their business.Promoting competition will play an important part in this.We are not here to stand in the way of progress that will be of benefit toconsumers.Our goals as the FCA are clear: we will work for an industry that is betterat serving the needs of its customers.I see this as an opportunity – not just for us but for the industry.We can do our job better if we work with you, and I am pleased that somany of the chief executives that I speak to are talking the same languageand have committed to rebuilding confidence and trust, and reconnectingwith their customers.It is great hearing about these good intentions, but the difficult bit for usall is to make sure this change actually happens.There are challenges and opportunities for both us the regulator, and youthe industry.It is a journey we have to walk together, as we put consumers back at theheart of what we do. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 32. 32Andrew G Haldane: The Bank and thebanksSpeech by Mr Andrew G Haldane, ExecutiveDirector, Financial Stability, Bank of England,at Queen’s University, Belfast***The views expressed within are not necessarilythose of the Bank of England or the FinancialPolicy Committee.I would like to thank Bethany Blowers, Forrest Capie, John Keyworth,Victoria Kinahan, Emma Murphy, Varun Paul, Richard Roberts, and thestaff of the Bank’s archives for their comments and contributions.In the light of the financial crisis, there is much to explain.Doing so is not just important for reasons of accountability to the public.Explaining and understanding errors of the past is absolutely essential ifpolicymakers are to learn lessons for the future.To misquote someone none of you have ever heard of, those who forgetthe errors of the past are doomed to repeat them.During the course of its 318-year history, the Bank of England has hadplenty of crisis experience.And encouragingly, on my reading of history, there is evidence of ithaving learnt from this experience.In response, radical reform of the Bank’s policymaking framework hasbeen commonplace.There are few better examples than the radical reform of the Bank’stransparency and accountability practices over the past twenty-five years. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 33. 33Those reforms are continuing to the present day.A wholly new framework for financial stability policy is being put in placein the UK, perhaps the most radical in the Bank’s history.I will discuss that framework later on.This framework can be seen as an evolutionary response to crisisexperience, not just this crisis but a great many previous ones.It is impossible to know if this framework will proof us against futurecrises.But in remembering those errors of the past, it gives us a fighting chanceof not repeating them.So I want to take you on an historical journey charting the Bank ofEngland’s role in financial crises and its response to them.Now, I know what you are thinking.The evolution of financial stability in the UK viewed through the lens ofthe Bank of England sounds deadly dull.So I am going at least to try to add a touch of colour to the events andpersonalities of the time.The very beginningLet’s start at the very beginning.The Bank of England was put on earth, way back in 1694, to do none ofthe things it does today – namely, preserving monetary and financialstability. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 34. 34Instead, it was a confection of the then monarchs, William III and MaryII, to pay for their war debts.At the time the Bank was little more than a branch, with a mere twentystaff.Pretty early in its life, however, the Bank began to involve itself in thebusiness of banking.It began to grow its balance sheet by taking deposits from and extendingloans to other banks, typically by the practice of “discounting” bills ofexchange.The Bank also issued its own notes which, due to the implicit backing ofthe government, circulated as currency with the public.At this stage, the Bank was far from being the nationalised, policymakingbody we know today.Rather, the Bank was a quasi-private bank conducting its business forquasi commercial ends.Other banks at the time were engaged in similar commercial pursuits,including often issuing their own notes.Except, of course, they lacked the government as guarantor.This made for a competitive, and at times rather antagonistic,relationship between the Bank and the commercial banks.This strained relationship lasted for the whole of the 18th and a goodchunk of the 19th centuries.Was the Bank friend or foe, collaborator or competitor? Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 35. 35The commercial banks did not know. And the Bank – private in name butpublic in finances – was itself in a state of mild schizophrenia.These psychological flaws were exposed in the middle of the 19th century.By then, the Bank had been granted monopoly rights to issue currency.Quite literally, this cut the commercial banks out of a lucrativemoney-making scheme.This did little to ease competitive tensions between the Bank and thebanks.This tension bubbled over in the famous case of Overend and GurneyBank. In the early part of the 19th century, Overend had grown rapidly tobecome the largest discount house in London.If not too big to fail, it was certainly large enough to look after itself – asthe Bank found out in 1860.Two years earlier, the Bank had abolished the right of other banks tocome to it for cash by discounting bills.The banks took umbrage.With Overend and Gurney playing the role of shop steward, theycollectively withdrew £1.6 million from the Bank over three days in anattempt to bring the Bank, if not to its knees, then at least to its senses.Dark, anonymous messages were sent to the Bank, presumably not byTwitter, warning: “Overends can pull out every note you have”.In the event Overend eventually caved, returning to the Bank the notesthey had withdrawn apologetically – or at least semi-apologetically, as thenotes actually came back cut in half. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 36. 36Six years later in 1866, when Overend and Gurney asked the Bank for anemergency loan of £400,000, the answer was “No”.The Bank won this battle, but was to lose decisively the war. Overend andGurney failed.The City shook. Panic took hold.The Bank was forced to lend £4 million – ten times the initial sum – tosupport other banks.There was a chorus of disapproval.The Bank’s role in crisis management would never be the same again.Supporting the financial systemCriticism of the Bank’s role in the Overend crisis came prominently fromWalter Bagehot, then-editor of The Economist and Bank-of-Englandbasher of his day.He lambasted the Bank’s acting “hesitatingly, reluctantly and withmisgiving”.Henry Gibbs, Governor of the Bank from 1875 to 1877, highlighted theOverend experience as “the Bank’s only real blunder”.Yet the Bank had also learned from this experience.It had discovered that its role could be neither commercial norcompetitive.Instead its role was as guardian of the financial system as a whole,protecting banks from what is today called systemic risk. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 37. 37In Bagehot’s words, the Bank should act as last resort lender to solventinstitutions against good collateral at a penalty rate.It has done so ever since.The Bank did not have to wait long to put its new-found role into practice.On Saturday 8 November 1890 the Bank Governor of the day, WilliamLidderdale, summoned his Directors. This itself aroused suspicion.Bank directors were never seen at work at the weekend.They typically departed for the country around Friday lunchtime.(Let me tell you, things have changed for Bank of England Directorssince then.)What Lidderdale told his Directors was electric.There were serious liquidity problems at another big and famous bank,Baring Brothers and Company.But the Bank had not the faintest clue as to Barings’ true financialposition.To rectify that, Lidderdale ordered an accountant’s report on Barings tobe brought to him with immediate effect.And with that, he departed to London Zoo with his son.The accountant’s report showed a solvent but illiquid Barings.Back from the Zoo, Lidderdale began to construct a financial “lifeboat”for Barings, with a contribution from the Bank but also from thecommercial banks.This was the system acting in support of the system. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 38. 38The lifeboat was launched and Barings was saved, in what has becomeknown as the “crisis that never became a drama”.The Bank’s lifeboat has since been re-launched on more than oneoccasion.A second financial lifeboat – different in detail, but identical in principle –was launched by the Bank of England in the early 1970s.Then, it was intended to save the small banks rather than the large.It, too, steadied some sinking ships.Third time, however, was not so lucky.On 24 February 1995, it was Barings Bank who were again knocking onthe Bank of England’s door for help.Bank Directors were again summoned on a Saturday.I myself was caught by a TV crew entering the Bank on that Saturdaymorning, arousing suspicion something was amiss.In fact, I had not been recalled to save the day.(I believe I was filmed wearing a tracksuit.)And I was as blissfully unaware of Barings’ problems as most of the rest ofthe world.(I was at the Bank completing a research paper on “A Structural VectorAutoregressive Model of the Monetary Transmission Mechanism”.)Life was easier then. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 39. 39Nick Leeson, at the time a despised and corrupt rogue-trader, today amuch-admired reality- TV star and after-dinner speaker, had put a hugehole in the Barings boat.Over the weekend, then-Governor Eddie George tried hard to assemble alifeboat.All visits to London Zoo were cancelled.But the lifeboat failed and with it Barings.That Barings was allowed to fail, and did so without rupturing the system,is a key lesson for today, to which I will return later.So what does this tell us about how the Bank of England’s role hadevolved on entering the 20th century?The Bank now spoke and acted as steward of the financial system,marshalling its own and others’ financial resources to keep the financialsystem panic-free.The Bank was at the frontline of crisis management.But these episodes also contained lessons.When the first Barings crisis came, the Bank had been reactive andbackfoot.It had been blindsided by the risk to its own and the financial system’sbalance sheet.The Bank was finding its feet as a crisis-container.But in attitude and expertise, it was a world away from being an effectivecrisis-preventer. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 40. 40Supporting the economyFast forward to the start of the First World War.William Lidderdale had been replaced as Bank Governor by WalterCunliffe.Cunliffe was not what would these days be called an equal opportunitiesemployer.The Bank’s staff rules were stifling and sexist – although were ahead oftheir time compared to other City firms.The Bank went 150 years without employing any women at all.When they did, it was to do the work of 15–18 year old boys, sorting andlisting returned notes.On getting married, women at the Bank were required to resign theirposition.The Bank was “Old Lady” by name but “Young Lady” by nature.Cunliffe’s greatest achievement was his contribution to solving thefinancial panic of 1914.On Friday 24 July, the City woke to the threat of war as Austria made anultimatum to Serbia.There was a worldwide scramble for the safety of cash.Mass-selling led to stock markets closing in Europe, then New York, thenAustralia.London was not exempt. By 31 July, the London Stock Exchange hadclosed for the first time in its near 150-year history. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 41. 41Panic soon spread to the money markets, sucking liquidity and life out ofthe financial system.Unable to finance themselves, lending by the banks began to drain away,starving the economy of credit and causing it too to crater.This was truly a credit crunch.Cunliffe’s plan, hatched with the Treasury, was to lift the liquidity burdenon the banks by purchasing the IOUs they were holding from overseasborrowers which had become understandably illiquid on the outbreak ofwar.These bills were bought by the Bank and stored in its vaults, in whatbecame known as the “cold storage” scheme.By freeing the banks’ balance sheets in this way, the cold storage schemewas intended to stimulate credit.It was only a limited success, with the banks still fearful about makingnew loans because of the rising risk of default by overseas borrowers.In response, the government announced an extension to the scheme, withthe government effectively insuring the banks against the credit risk onthese assets too.It worked.Within a couple of months, money market conditions had stabilised andcredit was once more flowing.Cunliffe’s cold storage plan had averted a credit crisis.The cold storage scheme was a piece of clever financial engineering bythe Bank, designed to support credit and the wider economy. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 42. 42In the past few years, with credit growth and the economy weak, the Bankhas been in the vanguard of creating new pieces of machinery to serve asimilar end.In 2008, the Bank introduced a Special Liquidity Scheme, or SLS, to helpfinance UK banks’ legacy asset portfolio.Over £180 billion of support was provided to the banks and has sincebeen repaid.The SLS bears more than a passing resemblance to the first phase of thecold storage scheme.In June this year, the Bank announced a second scheme, the Funding forLending Scheme, or FLS. It provides liquidity support to UK banks onterms which depend on their lending to the UK economy, thereby actingas a direct incentive to stimulate new lending.The FLS bears some resemblance to the second phase of cold storage.The SLS and FLS may be less famous than JLS, the London R&Bboy-band.But they are an important recognition of the Bank’s role in supportingcredit intermediation.That role began in the early part of the 20th century with schemes likecold storage.The Bank’s role had expanded beyond its own doorstep, on which thebanks stood, to the doorsteps of households and companies up and downthe country seeking credit. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 43. 43Supporting financial infrastructureYet one thing at least had stayed the same: in 1914, the Bank had onlyacted when jolted into doing so by war.Its role was still as crisis-container rather than preventer.During the 1920s and 1930s, the Bank of England became MontaguNorman’s Bank.And Norman set about changing that.Norman was not Cunliffe’s greatest fan and the feeling was clearlymutual.“There goes that queer-looking fish with the ginger beard again”,Cunliffe is said to have observed about Norman.“Do you know who he is? I keep seeing him creep about this place like alost soul with nothing better to do.”Nor would Norman necessarily have ingratiated himself to today’s armyof Bank economists.“You are not here to tell us what to do, but to explain why we havedone it” is the way Norman rebuked the Bank’s Chief Economist of theday.Norman saw the Bank’s role in expansive terms, as provider not just ofemergency help but as builder of infrastructure and supporter of industry.The Bank became part of the post-war reconstruction effort.Having spent 200 years tending to its back garden, the Bank began toexplore pastures new. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 44. 44To take one example, in 1928 the Lancashire cotton industry was on itsknees.These problems risked ricocheting back to the financial system, with atleast two of the big five UK banks up to their neck in cotton.A plan was conceived involving consolidating the industry into aLancashire Textile Corporation.This was to be financed with debt and shares issued and supported by –you’ve guessed it – the Bank of England.It was a bold and cunning plan. Unfortunately, it flopped.The share issue by the Corporation in 1931 was a resounding failure,leaving the underwriter with a large chunk of the shares.The Bank ended up having to support the market.It, too, found itself up to its neck in cotton.Undaunted, the stage had nonetheless been set for the Bank’s on-goinginvolvement in financial infrastructure.This came not a moment too soon. In the immediate post-war period,the UK faced pressing financial infrastructure problems – the so-called“Macmillan gaps”.These gaps referred the inability of small firms to finance themselves withlong-term loans.If these gaps sound strangely familiar, then they should.The post-war Bank set about closing these Macmillan gaps with gusto. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 45. 45In 1945 it set up two new financing entities – the Finance Corporation forIndustry (FCI) and the Industrial and Commercial Finance Corporation(ICFC).These were financially supported by banks and institutional investors,providing a platform for the supply of longer term funding and venturecapital finance to small firms.In 1973, the two corporations combined to form Finance for Industry(FFI).During the early 1980s, the company was rebranded as Investors inIndustry, commonly known as 3i.In 1987, the entity went public as 3i Group.This was not a flop.Arguably, 3i and its predecessors were one of the largest feathers in theBank’s post-war cap, helping support generations of new businesses andstart-ups.And those MacMillan gaps?Regrettably, the crisis has re-opened them.Today, small firms are once more starved of finance, including many herein Northern Ireland.Once again, the quest is on for a new financial infrastructure to help closethese gaps.Through the 1980s and 1990s, there were further examples of the Bankstepping in to close structural financial gaps.When the UK’s high-value payment system started creaking in the early1980s, the Bank designed and built a new, bullet-proof system. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 46. 46Given the Bank’s somewhat chequered record on gender diversity up tothat point, it was rather unfortunately named CHAPS.And indeed still is.In 1993, the Bank stepped-in to rescue a flagging project to upgrade thesecurities settlement process in the UK.The Bank designed and built a new, safety-first, system which againexists to this day.Fortunately, we did not call this one BLOKES, but rather thegender-neutral CREST.Most recently, in the light of the crisis, the Bank has been at the forefrontof the debate about re-organising the structure of banking, with aring-fence or firewall between the basic retail and investment bankingsides of the business.This structural approach is increasingly finding favour both in the UK(through the proposals of the Vickers Commission) and internationally(for example, through the Volcker proposals in the US and the recentLiikanen proposals in Europe).For the past half-century, the Bank’s structural agenda has become acentral feature.But at the time it marked a radical departure from the Bank’s past.Designing what are in effect financial public goods is a front-foot activity.The Bank had grown a new limb, augmenting its crisis-managementright arm with a crisis-prevention left arm. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 47. 47Stitching it all togetherSo far, I have made no real mention of monetary policy.That is because, for much of its life up to the early 1970s, monetary controlat the Bank of England was pretty simple.It came care of fixing the exchange rate – first to gold under the GoldStandard and latterly in the post war period to the dollar.With the demise of the dollar standard in the early 1970s, however, theexchange rate anchor had been tossed overboard.At the Bank of England, as elsewhere, the search was on for a newnominal anchor.Into this vacuum stepped Andrew Duncan Crockett. Crockett joined theBank in 1966 as a graduate entrant, just before the break-up of the BrettonWoods dollar standard.He set to work on the biggest problem of the day, locating a new nominalanchor.In so doing, he began working alongside another young(ish) new Bankentrant, Charles Goodhart.The result was a joint paper published in the Bank’s Quarterly Bulletin inJune 1970.It was titled “The Importance of Money”.Re-reading it now, it was a prophetic piece of work.In the UK, it laid some of the analytical foundations for what, during thelate 1970s and 1980s, became monetarism. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 48. 48More than that, the paper placed commercial bank money and credit atthe centre of the macro-economy.It could as well have been titled “The Importance of Credit” or indeed“The Importance of Banks”.After a successful spell at the IMF, Crockett returned to the Bank ofEngland in 1989.In 1994, he then became General Manager of the Bank for InternationalSettlements, the central banks’ central bank.In central bank circles, change was in the air. Monetary policy wasembarking on a path which targeted inflation and which, unlikemonetarism before it, downplayed money and credit.And the regulation of banks, long the preserve of central banks, was inmany countries being hived off to separate regulatory agencies.What happened next was truly extra-ordinary.Whether by coincidence or causality, the world experienced the largestbanking bubble in history.Between 1990 and 2007, global bank balance sheets rose by a factor four.On the eve of the crisis they had reached around $75 trillion, or almost 1.5times the annual output of the entire planet.At the Bank for International Settlements, Andrew Crockett saw troublebrewing.In 2000, he gave a speech calling for a “macro-prudential” approach toregulation. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 49. 49Crockett argued that central banks needed to look at, and act on,developments across the whole financial system if systemic risk was to beheaded-off.Credit booms, the like of which was occurring for real at the time, sowedthe seeds of that systemic risk.The rest is of course history, as pre-crisis credit boom turned toshuddering bust.Or rather it would be history were it not for the fact that this crisis, whoseseeds were sown in the credit boom, is still with us.Output in the UK is still well below its 2007 level.The so-called Great Recession in the UK is already as severe as the GreatDepression of the 1930s.In response, the policy framework has, once more, been radicallyaugmented.Macroprudential policy is the next big thing.It is now widely acknowledged as the missing policy link during thepre-crisis period, the essential bridge between monetary policy andregulation.As I discuss below, this bridge is now being constructed through newframeworks in the UK and internationally.The Bank tomorrowSo where does all of this leave the Bank today and, indeed, tomorrow?In the light of the crisis, we are moving to a wholly new structure forfinancial policymaking in the UK. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 50. 50In many important respects, this can be seen as building on the lessons ofhistory.To illustrate that, let me set out some of its main features.First, there is to be a radical shift in the organisation and approach tosupervising individual financial institutions.The UK will move to a so-called “twin-peaks” regime.That means in practice separating the safety and soundness aspects of theregulation (so-called prudential) from the consumer protection aspects(so-called conduct).The prudential part will from next year sit in the Bank of England in anew Prudential Regulatory Authority, or PRA.This is much more than deck-chair rearrangement.Accompanying this change will be a rootand-branch change in ourapproach to supervision.There will be a focus on the big risks – the Barings of yesteryear, the RBSof yesterday.Supervision will be front-foot, testing for stress before it strikes and visitsto the zoo need to be cancelled.It will be also tolerant of bank failure – Barings Mark 2 rather than Mark 1– so that market discipline can work its magic.Second, during the course of the crisis, there has been a radical, ifunderplayed, rethink of the Bank’s approach to supplying liquidity to thebanking system. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 51. 51While not quite a change on the scale of the Overend and Gurney crisis,this allows banks to access the Bank’s facilities against a much widerrange of collateral.The Bank’s liquidity menu is now crystal clear, from which banks cannow themselves choose.Third, an entirely-new piece of policy machinery has been introduced –new not just for the UK, but internationally too.In the UK, this is called the Financial Policy Committee or FPC.It was put on earth to do macro-prudential policy, to act as the bridge, toprovide the missing link, to monitor the punchbowl before it is emptiedand before aspirin needs administering.A year on, the FPC is doing just that.Most recently the FPC has been navigating a particularly hazardouscourse.The financial system and economy are suffering the hangover from hell.The FPC’s task is to keep the system safe in the face of heightened risksof a relapse, while at the same time keeping the banks’ credit arteriesopen to support the economy.Both objectives are steeped in the Bank’s history – and both objectives areembodied in the FPC’s remit.The FPC has a remit, too, to strengthen the structural fabric of thefinancial system, including through improved financial infrastructure.That objective has a place deep in the Bank of England’s heart – fromLancashire cotton mills of the 1930s, to 3i of the post-war years, toCHAPs of the 1980s, to Vickers of the past few years. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 52. 52Supporting and executing these new responsibilities will be a massivetask.First and foremost, it will require the Bank to have a rich and diverse setof skills.Historically at least, the Bank has been skills-rich but diversity-poor.But I am pleased to say that, too, has been changing for the better.This year’s graduate intake has close to a 50/50 gender split.One in seven of the intake is drawn from ethnic minorities.Only a fifth come from Oxford or Cambridge.The PRA’s arrival next year will broaden further the diversity of theBank’s skills and experience – legal, accountancy, banking, insurance.The Bank’s policy committees, meanwhile, bring diversity of experienceand expertise to the decision-making table, from academe and the privatesector.There has been a transformation, too, in the Bank’s approach to externalcommunications and transparency.Think back twenty years.Then, there were no quarterly Inflation Reports, no six-monthly FinancialStability Reports and certainly no press conferences to accompany both.Twenty years ago, there were no minutes of the deliberations of theBank’s policy committees (today, the MPC and FPC).Back then, press interviews were rare and scripted to within an inch oftheir life. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 53. 53In the past year, Bank officials gave around 65 speeches and over 200press interviews.In Montagu Norman’s day, the combined total was one.The days of “keeping the Bank out of the press and the press out of theBank” are well and truly gone.Earlier this year, the Governor gave the Bank’s first live peacetime radioaddress to the nation for 73 years.The Bank Tweets, fortunately with rather less vigour than your averagePremiership footballer.Soon we will have, for the first time in history, published minutes of theBank’s Court of Directors.The Governor has appeared before the Treasury Committee on no lessthan 47 occasions since he took office.In 2011, a word search of “Mervyn King” in the press revealed more hitsthan “Kylie Minogue”.To my knowledge, this is the first time a sitting Bank of EnglandGovernor has toppled the Aussie pop princess in the media opinion polls.Given its new responsibilities, the Bank cannot fail to remain in thepublic’s eye in the period ahead.Transparency and accountability will remain the watchwords – andrightly so.ConclusionWhen pressed by the Macmillan Committee in 1930 to explain the Bank’sactions, Montagu Norman replied: “Reasons, Mr Chairman? I don’t havereasons, I have instincts”. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 54. 54I suspect such an answer would work less well with today’s TreasuryCommittee, to say nothing of today’s media.All public policymakers have an obligation to explain.And all policymakers have an obligation to learn from past crises and pastmistakes.That is the only way credibility can be built: not the avoidance of crisesand mistakes, which is impossible, but the recognition by the public that,when they do happen, the crises are contained and the mistakes arehonest ones.The Bank of England is embarking on the latest chapter in its 318-yearhistory.We cannot avoid a crisis but, as with Barings in 1890, we can endeavour toprevent it becoming a drama.We will certainly be doing our best to prevent it becoming a tragedy likethat of the past few years.If nothing else, this new chapter will have learnt from, and will build on,the lessons of history.Thank you. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 55. 55The Federal Reserve BoardTwo final rules with stress testingrequirements for certain bank holdingcompanies, state member banks, andsavings and loan holding companiesThe Federal Reserve Board on Tuesdaypublished two final rules with stress testing requirements for certain bankholding companies, state member banks, and savings and loan holdingcompanies.The final rules implement sections 165(i)(1) and (i)(2) of the Dodd-FrankWall Street Reform and Consumer Protection Act that require supervisoryand company-run stress tests.Nonbank financial companies designated by the Financial StabilityOversight Council will also be subject to certain stress testingrequirements contained in the rules."Implementation of the Dodd-Frank stress test requirement is animportant step in the Federal Reserves efforts to promote the health ofthe financial sector," Governor Daniel K. Tarullo said."Stress testing is a key tool to ensure that financial companies haveenough capital to weather a severe economic downturn without posing arisk to their communities, other financial institutions, or to the generaleconomy."The Federal Reserve will begin conducting supervisory stress tests underthe final rules this fall for the 19 bank holding companies that participatedin the 2009 Supervisory Capital Assessment Program and subsequentComprehensive Capital Analysis and Reviews. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 56. 56The final rules also require these companies and their state-member banksubsidiaries to conduct their own Dodd-Frank company-run stress teststhis fall, with the results to be publicly disclosed in March 2013.In general, other companies subject to the Boards final rules forDodd-Frank stress testing will be required to comply with the final rulebeginning in October 2013.Companies with between $10 billion and $50 billion in total assets thatbegin conducting their first company-run stress test in in the fall of 2013will not have to publicly disclose the results of that first stress test.The Boards two final rules revise portions of the Federal Reserves noticeof proposed rulemaking to implement the enhanced prudential standardsand early remediation requirements established under the Dodd-FrankAct.The Board coordinated closely with the Office of the Comptroller of theCurrency and the Federal Deposit Insurance Corporation to ensure thatfinal stress testing rules issued by the agencies are consistent andcomparable.The Board also coordinated with the Federal Insurance Office as requiredby the Dodd-Frank Act.The Federal Reserve will release the scenarios for this years supervisoryand company-run stress tests no later than November 15, 2012.As required by the Dodd-Frank Act, the scenarios will describehypothetical baseline, adverse, and severely adverse conditions, withpaths for key macroeconomic and financial variables.To help firms prepare to estimate their losses and revenues under thescenarios, the Federal Reserve on Tuesday released historical data forvariables likely to be used in the scenarios. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 57. 57A revised version of these historical data, reflecting the latest information,will be published along with the scenarios.Important PartsFEDERAL RESERVE SYSTEMAnnual Company-Run Stress Test Requirements for BankingOrganizations with Total Consolidated Assets over $10 Billion Other thanCovered CompaniesAGENCY: Board of Governors of the Federal Reserve System (Board).ACTION: Final rule.SUMMARY: The Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank Act or Act) requires the Board to issueregulations that require financial companies with total consolidatedassets of more than $10 billion and for which the Board is the primaryfederal financial regulatory agency to conduct stress tests on an annualbasis.The Board is adopting this final rule to implement the company-runstress test requirements in section 165(i)(2) of the Dodd-Frank Actregarding company-run stress tests for bank holding companies with totalconsolidated assets greater than $10 billion but less than $50 billion andstate member banks and savings and loan holding companies with totalconsolidated assets greater than $10 billon.This final rule does not apply to any banking organization with totalconsolidated assets of less than $10 billion.Furthermore, implementation of the stress testing requirements for bankholding companies, savings and loan holding companies, and statemember banks with total consolidated assets of greater than $10 billionbut less than $50 billion is delayed until September 2013. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 58. 58DATES: The rule is effective on November 15, 2012.BackgroundThe Board has long held the view that a banking organization, such as abank holding company or insured depository institution, should operatewith capital levels well above its minimum regulatory capital ratios andcommensurate with its risk profile.A banking organization should also have internal processes for assessingits capital adequacy that reflect a full understanding of its risks andensure that it holds capital commensurate with those risks.Moreover, a banking organization that is subject to the Board’s advancedapproaches risk-based capital requirements must satisfy specificrequirements relating to their internal capital adequacy processes in orderto use the advanced approaches to calculate its minimum risk-basedcapital requirements.Stress testing is one tool that helps both bank supervisors and a bankingorganization measure the sufficiency of capital available to support thebanking organization’s operations throughout periods of stress.The Board and the other federal banking agencies previously havehighlighted the use of stress testing as a means to better understand therange of a banking organization’s potential risk exposures.In particular, as part of its effort to stabilize the U.S. financial systemduring the recent financial crisis, the Board, along with other federalfinancial regulatory agencies and the Federal Reserve system, conductedstress tests of large, complex bank holding companies through theSupervisory Capital Assessment Program (SCAP). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 59. 59The SCAP was a forward-looking exercise designed to estimate revenue,losses, and capital needs under an adverse economic and financial marketscenario.By looking at the broad capital needs of the financial system and thespecific needs of individual companies, these stress tests providedvaluable information to market participants, reduced uncertainty aboutthe financial condition of the participating bank holding companiesunder a scenario that was more adverse than that which was anticipatedto occur at the time, and had an overall stabilizing effect.Building on the SCAP and other supervisory work coming out of thecrisis, the Board initiated the annual Comprehensive Capital Analysis andReview (CCAR) in late 2010 to assess the capital adequacy and theinternal capital planning processes of large, complex bank holdingcompanies and to incorporate stress testing as part of the Board’s regularsupervisory program for assessing capital adequacy and capital planningpractices at large bank holding companies.The CCAR represents a substantial strengthening of previous approachesto assessing capital adequacy and promotes thorough and robustprocesses at large banking organizations for measuring capital needs andfor managing and allocating capital resources.The CCAR focuses on the risk measurement and management practicessupporting organizations’ capital adequacy assessments, including theirability to deliver credible inputs to their loss estimation techniques, aswell as the governance processes around capital planning practices.In the wake of the financial crisis, Congress enacted the Dodd-Frank Act,which requires the Board to issue regulations that require bank holdingcompanies with total consolidated assets of $50 billion or more (largebank holding companies) and nonbank financial companies that theFinancial Stability Oversight Committee has designated to be supervisedby the Board (together, covered companies) to conduct stress testssemi-annually, and requires other financial companies with total Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 60. 60consolidated assets of more than $10 billion and for which the Board is theprimary federal financial regulatory agency to conduct stress tests on anannual basis (company-run stress tests).The Act requires that the Board issue regulations that:(i) Define the term “stress test”(ii) Establish methodologies for the conduct of the company-run stresstests that provide for at least three different sets of conditions, includingbaseline, adverse, and severely adverse conditions(iii) Establish the form and content of the report that companies subjectto the regulation must submit to the Board(iv) Require companies to publish a summary of the results of therequired stress tests.On January 5, 2012, the Board invited public comment on a notice ofproposed rulemaking (proposal or NPR) that would implement theenhanced prudential standards required to be established under section165 of the Dodd-Frank Act and the early remediation requirementsestablished under Section 166 of the Act, including proposed rulesregarding company-run stress tests.The proposed rules would have required each bank holding company,state member bank, and savings and loan holding company with morethan $10 billion in total consolidated assets to conduct an annualcompany-run stress test using data as of September 30 of each year andthe three scenarios provided by the Board.In addition, each state member bank, bank holding company, andsavings and loan holding company would be required to disclose asummary of the results of its company-run stress tests within 90 days ofsubmitting the results to the Board. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 61. 61The Dodd-Frank Act mandates that the OCC and the FDIC adopt rulesimplementing stress testing requirements for the depository institutionsthat they supervise, and the OCC and FDIC invited public comment onproposed rules in January of 2012.The Board is finalizing the stress testing frameworks in two separaterules.First, the Board is issuing this final rule, which implements thecompany-run stress testing requirements applicable to bank holdingcompanies with total consolidated assets greater than $10 billion but lessthan $50 billion and savings and loan holding companies and statemember banks with total consolidated assets greater than $10 billion.Second, the Board is concurrently issuing a final rule implementing thesupervisory and semi-annual company-run stress testing requirementsapplicable to large bank holding companies and nonbank financialcompanies supervised by the Board.Overview of CommentsThe Board received approximately 100 comments on its NPR onenhanced prudential standards and early remediation requirements.Approximately 40 of these comments pertained to the proposed stresstesting requirements.Commenters ranged from individual banking organizations to trade andindustry groups and public interest groups.In general, commenters expressed support for stress testing as a valuabletool for identifying and managing both microand macro-prudential risk.However, several commenters recommended changes to, or clarificationof, certain provisions of the proposed rule, including its timeline forimplementation, reporting requirements, and disclosure requirements. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 62. 62Commenters also urged greater interagency coordination regarding stresstests.A. Delayed compliance dateCommenters suggested that companies with total consolidated assets lessthan $50 billion that have not previously been subject to stress-testingrequirements need more time to develop the systems and procedures tobe able to conduct company-run stress tests and to collect the informationthat the Board may require in connection with these tests.In response to these comments and to reduce burden on theseinstitutions, the final rule requires most bank holding companies, savingsand loan holding companies, and state member banks to conduct theirfirst stress test in the fall of 2013.In addition, the final rule requires bank holding companies, savings andloan holding companies, and state member banks with less than $50billion in total consolidated assets to begin publicly disclosing their stresstest results in 2015 with respect to the stress test conducted in the fall of2014.Banking organizations that become subject to the rule’s requirementsafter November 15, 2012 must comply with the requirements beginning inthe fall of the calendar year that follows the year the company meets theasset threshold, unless that time is extended by the Board in writing.For example, a company that becomes subject to the rule on March 31,2013 must conduct its first stress test in the fall of 2014 and report theresults in 2015.B. TailoringThe proposed rule would have applied consistent annual company-runstress test requirements, including the compliance date and the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 63. 63disclosure requirements, to all banking organizations with totalconsolidated assets of more than $10 billion.The Board sought public comment on whether the stress testingrequirements should be tailored, particularly for financial companies thatare not large bank holding companies.Several commenters expressed concern that the NPR that would haveapplied stress testing requirements previously applicable only to largebank holding companies, such as those conducted under the CCAR, tosmaller, less complex banking organizations with smaller systemicfootprints.The Board recognizes that bank holding companies, savings and loanholdings companies, and state member banks with total consolidatedassets less than $50 billion are generally less complex and pose morelimited risk to U.S. financial stability than larger banking organizations.As a result, the Board has modified the requirements in the final rule forthese institutions, and expects to use a tailored approach inimplementation.The final rule modifies the requirements for smaller bankingorganizations in a number of ways.First, as noted above, most banking organizations, other than statemember bank subsidiaries of the large bank holding companies thatparticipated in the SCAP, are not required to conduct their first stress testuntil 2013.The final rule also provides a longer period for smaller bankingorganizations to conduct their stress tests.Under the final rule, smaller banking organizations, other than statemember bank subsidiaries of SCAP bank holding companies, are notrequired to report the results of the stress test until March 31. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 64. 64The final rule also modifies the public disclosure requirements, generallyrequiring less detailed disclosure for smaller banking organizations thanfor larger banking organizations.Separately, the Board intends to seek comment on reporting forms thatsmaller banking organizations would use in reporting the results of theirstress tests to the Board, which are expected to be significantly morelimited than the reporting forms applicable to large bankingorganizations.Banking organizations may be required to include additionalcomponents in their adverse and severely adverse scenarios or to useadditional scenarios in their stress tests.The Board expects to apply such additional components and additionalscenarios to large, complex banking organizations.For example, the Board expects to require large banking organizationswith significant trading activities to include global market shockcomponents in their adverse and severely adverse scenarios, and mayrequire large or complex banking organizations to use additionalcomponents in the adverse and severely adverse scenarios or to useadditional scenarios that are designed to capture salient risks to specificlines of business.Finally, the Board plans to issue supervisory guidance to provide moredetail describing supervisory expectation for company-run stress tests.This guidance will be tailored to banking organizations with totalconsolidated assets greater than $10 billion but less than $50 billion.C. CoordinationMany commenters emphasized the need for the federal banking agenciesto coordinate stress testing requirements for parent holding companiesand depository institution subsidiaries and more generally in regard tostress testing frameworks. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 65. 65Commenters recommended that the Board, the Office of the Comptrollerof the Currency (OCC), and the Federal Deposit Insurance Corporation(FDIC) coordinate in implementing the Dodd-Frank Act stress testingrequirements in order to minimize regulatory burden.Commenters asked that the agencies eliminate duplicative requirementsand use an interagency forum, like the Federal Financial InstitutionsExamination Council, to develop common forms, policies, procedures,assumptions, methodologies, and application of results.The Board has coordinated closely with the FDIC and the OCC to help toensure that the company-run stress testing regulations are consistent andcomparable across depository institutions and depository institutionholding companies and to address any burden that may be associatedwith having multiple entities within one organizational structure subjectto stress testing requirements.The Board anticipates that it will continue to consult with the FDIC andOCC in the implementation of the final rule, and in particular, in thedevelopment of stress scenarios.The Board plans to develop scenarios each year in close consultation withthe FDIC and the OCC, so that, to the greatest extent possible, a commonset of scenarios can be used for the supervisory stress tests and the annualcompany-run stress tests across various banking entities within the sameorganizational structure.D. Consolidated publication and group-wide systems andmodelsIn addition to requesting better coordination, commenters inquired as towhether a company-run stress test conducted by a parent holdingcompany would satisfy the stress testing requirements applicable to thatholding company’s subsidiary depository institutions. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 66. 66Commenters recommended that, in order to reduce burden, the Boarddevelop and require the use of a single set of scenarios for a bank holdingcompany and any depository institution subsidiary of the bank holdingcompany, if the Board imposed separate stress testing requirements onboth the bank holding company and bank.In order to reduce burden on banking organizations, the final ruleprovides that a subsidiary depository institution generally will disclose itsstress testing results as part of the results disclosed by its bank holdingcompany parent.Disclosure by the bank holding company of its stress test results andthose of any subsidiary state member bank generally will satisfy anydisclosure requirements applicable to the state member bank subsidiary.Moreover, a state member bank that is controlled by a bank holdingcompany may rely on the systems and models of its parent bank holdingcompany if its systems and models fully capture the state member bank’srisks.For example, under those circumstances, the bank holding company andstate member bank may use the same data collection processes andmethods and models for projecting and calculating potential losses,pre-provision net revenues, provision for loan and lease losses, and proforma capital positions over the stress testing planning horizon.Description of the Final RuleScope of ApplicationThe final rule applies to any bank holding company with average totalconsolidated assets of greater than $10 billion but less than $50 billion,and any state member bank and savings and loan holding company thathave average total consolidated assets of more than $10 billion (“assetthreshold”). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 67. 67Average total consolidated assets is based on the average of the totalconsolidated assets as reported on bank holding company’s or savingsand loan holding company’s four most recent Consolidated FinancialStatement for Bank Holding Companies (FR Y-9C) or a state memberbank’s four most recent Consolidated Report of Condition and Income(Call Report).If the bank holding company, savings and loan holding company, or statemember bank has not filed the FR Y-9C or Call Report, as applicable, foreach of the four most recent quarters, average total consolidated assetswill be based on the average of the company’s total consolidated assets, asreported on the company’s FR Y-9C or Call Report, as applicable, for themost recent quarter or consecutive quarters.In either case, average total consolidated assets are measured on the as-ofdate of the relevant regulatory report.Once a bank holding company, savings and loan holding company, orstate member bank meets the asset threshold, the company will remainsubject to the final rule’s requirements unless and until the totalconsolidated assets of the company are less than $10 billion, as reportedon four consecutively filed FR Y-9C or Call Report, as applicable(measured on the as-of date of the relevant FR Y-9C or Call Report, asapplicable).A bank holding company, state member bank, or savings and loanholding company that has reduced its total consolidated assets to below$10 billion will again become subject to the requirements of this rule if itmeets the asset threshold again at a later date.However, if a bank holding company’s total consolidated assets equal orexceed $50 billion or a savings and loan holding company becomesdesignated as a nonbank financial company supervised by the Board,such companies will be required to conduct stress tests under subpart Gof the Board’s Regulation YY (12 CFR Part 252 Subpart G). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 68. 68Such a company will be required to comply with this final rule until it isrequired to conduct stress tests under subpart G.The final rule does not apply to foreign banking organizations.The Board expects to issue a separate rulemaking on the application ofenhanced prudential standards to foreign banking organizations.A U.S.-domiciled bank holding company subsidiary of a foreign bankingorganization that has total consolidated assets of $10 billion or more issubject to the requirements of this rule.Effective DateUnder the proposal, the company-run stress testing requirementsapplicable to bank holding companies and state member banks wouldhave become effective upon adoption of the final rule.A bank holding company, savings and loan holding company, or statemember bank that met the rule’s asset threshold as of the adoption of therule would have been required to immediately comply with itsrequirements.A bank holding company, savings and loan holding company, or statemember bank that met the proposal’s asset threshold more than 90 daysbefore September 30 of a given year would be subject to stress testingrequirements beginning in that calendar year.The Board received comments with regard to the timing of the first stresstest for institutions that meet the asset threshold upon the rule’s effectivedate and for institutions that meet the asset threshold at a later date, andhas modified both aspects of the final rule. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 69. 691. First Stress Test for Bank Holding Companies and State MemberBanks that Meet the Asset Threshold on or before December 31, 2012Commenters indicated that smaller and mid-sized banking organizationsneed more time to develop the systems and procedures to conductcompany-run stress tests and to collect the information requested by theBoard in connection with these tests.In response to these comments, the Board is delaying the date thatexisting, smaller companies are required to conduct their first stress test,as described below.a. Bank Holding CompaniesUnder the final rule, a bank holding company that meets the assetthreshold on or before December 31, 2012, must conduct its first stress testbeginning in the fall of 2013, unless that time is extended by the Board inwriting.Such a bank holding company is not required to publicly disclose theresults of its stress test until June 2015.b. State Member BanksUnder the final rule, a state member bank that meets the asset thresholdon or before November 15, 2012, and is a subsidiary of a bank holdingcompany that participated in the SCAP, or successor to such bankholding company, must comply with the requirements of this subpartbeginning in the fall of 2012, unless that time is extended by the Board inwriting.Any other state member bank that meets the asset threshold on or beforeDecember 31, 2012, must comply with the requirements of this subpartbeginning in the fall of 2013, unless that time is extended by the Board inwriting. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 70. 70If such a state member bank has total consolidated assets of less than $50billion as of December 31, 2012, it is not required to publicly disclose theresults of its stress test until June 2015.2. First Stress Test for Bank Holding Companies and State MemberBanks Subject to Stress Testing Requirements After December 31,2012Commenters similarly expressed concern that bank holding companies,state member banks, and savings and loan holding companies met therule’s asset threshold after the effective date of the final rule would nothave sufficient time to build the systems, contract with outside vendors,recruit experienced personnel, and develop stress testing models that areunique to their organization under the proposed compliance date.In addition, the Federal Advisory Council recommended that the Boardphase in disclosure requirements to minimize risk, build precedent, andallow banks and supervisors to gain experience, expertise, and mutualunderstanding of stress testing models.In response to these comments, the Board extended the compliance dateapplicable to bank holding companies and state member banks thatexceed the final rule’s asset threshold after December 31, 2012.Under the final rule, these companies will be required to conduct theirfirst stress tests beginning in the fall of the calendar year after they meetthe asset threshold, unless that time is extended by the Board in writing.3. First Stress Test for Savings and Loan Holding CompaniesUnder the final rule, a savings and loan holding company will not berequired to conduct its first stress test until after it is subject to minimumcapital requirements.A savings and loan holding company that meets the asset threshold whenit becomes subject to minimum capital requirements will be required toconduct this first stress test in the fall of the calendar year after it first Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 71. 71becomes subject to capital requirements, unless the Board accelerates orextends the time in writing.A savings and loan holding company that meets the asset threshold afterit becomes subject to capital requirements will be required to conduct itsfirst stress test beginning in the fall of the calendar year after it meets theasset threshold, unless that time is extended by the Board in writing.Annual Stress Tests RequirementsTiming of Stress Testing RequirementsThe Board proposed the following timeline for company-run tests in theNPR.The Board would have required an as-of date of September 30 ofinformation to be submitted to the Board.By no later than mid-November of each calendar year, the Board wouldprovide bank holding companies, state member banks, and savings andloan holding companies with scenarios for annual stress tests.By January 5 of the following calendar year, these companies would berequired to submit regulatory reports to the Board on their stress tests.By early April of that calendar year, companies would be required to makepublic disclosure of results.Several commenters provided suggestions on the proposed timeline.Those comments focused on the as-of date for data to be submitted bybank holding companies, state member banks, and savings and loanholding companies, the date for submitting results to the Board, and thedates when public disclosures of stress test results are to be made. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 72. 72For instance, some commenters suggested that the Board should use datacollected at as-of dates other than September 30, such as June 30 orDecember 31, and make corresponding changes to the timing of publicdisclosure in order to reduce burden on companies during the year-endperiod.One commenter suggested having a floating submission date, allowingorganizations to submit their results at the point in the year when it ismost convenient.Some commenters also requested that the Board release the scenariosearlier to provide banking organizations more time to prepare therequired reports for the stress tests.The final rule maintains the as-of date for data for the purposes of theannual company-run stress tests so that the same set of scenarios can beused to conduct annual company-run stress tests for large bank holdingcompanies and their subsidiary state-member banks.The Board believes, and several commenters noted, that such alignmentis beneficial.Furthermore, using the same scenarios for all firms subject to stresstesting requirements will decrease market confusion, minimize burdenon institutions, and provide for comparability across institutions.As stated in the concurrent final rule for covered companies, it wasnecessary to maintain the September 30 as-of date for stress testrequirements for large bank holding companies in order to align thestress testing requirements with the capital planning requirementsapplicable to these institutions under section 225.8 of the Board’sRegulation Y.Commenters requested that the Board release the scenarios earlier in theannual stress test cycle to provide banking organizations more time toprepare the reports for company-run stress tests. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 73. 73Under the final rule, the Board will provide descriptions of the baseline,adverse, and severely adverse scenarios generally applicable to companiesno later than November 15 of each year, and provide any additionalcomponents or scenarios by December 1.The Board believes that providing scenarios earlier than November couldresult in the scenarios being stale, particularly in a rapidly changingeconomic environment, and that it is important to incorporate economicor financial market data that are as current as possible while providingsufficient time for companies to incorporate the scenarios in their annualcompany-run stress tests.Commenters suggested that smaller banking organizations be allowedadditional time to conduct their company-run stress tests in light ofresource constraints faced by these institutions.In response to these comments, the Board has delayed the timing ofreport submission to the Board for most banking organizations.Consistent with the requirements imposed on large bank holdingcompanies under subpart G, the final rule requires a state member bankthat is controlled by a bank holding company that has average totalconsolidated assets of $50 billion or more and a savings and loan holdingcompany that has average total consolidated assets of $50 billion or moreto conduct its stress test and submit its results to the Board by January 5,unless that time is extended by the Board in writing.All other bank holding companies, savings and loan holding companies,and state member banks are required to conduct their stress tests andsubmit the results to the Board by March 31.Commenters also noted that the proposed public disclosure deadlineswould interfere with so-called “quiet periods” that some publicly tradedbanking organizations enforce in the lead up to earnings announcements. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 74. 74These quiet periods are designed to limit communications that coulddisseminate proprietary company information prior to earningsannouncements.In light of these comments, the Board adjusted the disclosure date toavoid interfering with firms’ quiet periods.Under the final rule, a savings and loan holding company with totalconsolidated assets of $50 billion or more or a state member bank that is asubsidiary of a bank holding company with total consolidated assets of$50 billion or more is required to disclose the results of its stress testsbetween March 15 and March 31 of each year.All other banking organizations will be required to disclose their resultsbetween June 15 and June 31.ScenariosThe proposal provided that the Board would publish a minimum of threedifferent sets of economic and financial conditions, including baseline,adverse, and severely adverse scenarios, under which the Board wouldconduct its annual analyses and companies would conduct their annualcompany-run stress tests.The Board would update, make additions to, or otherwise revise thesescenarios as appropriate, and would publish any such changes to thescenarios in advance of conducting each year’s stress test.Commenters suggested that significant changes in scenarios from year toyear could cause a banking organization’s stress testing results todramatically change.To ameliorate this volatility, commenters suggest that the federalbanking agencies have a uniform approach for identifying stressscenarios or establish a “quantitative severity limit” in the final rule toensure that scenarios do not drastically change from year to year. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 75. 75Commenters pointed out that consistency in annual scenariodevelopment will make comparability of stress test results betweeninstitutions and across time periods more accurate, increase marketconfidence in the results of stress tests, and make for more dependablecapital planning by banking organizations.Commenters also requested the opportunity to provide input on thescenarios.The Board believes that it is important to have a consistent andtransparent framework to support scenario design.To further this goal, the final rule clarifies the definition of “scenarios”and includes definitions of baseline, adverse, and severely adversescenarios.In the final rule, “scenarios” are defined as those sets of conditions thataffect the U.S. economy or the financial condition of a bank holdingcompany, savings and loan holding company, or state member bank thatthe Board annually determines are appropriate for use in thecompany-run stress tests, including, but not limited to, baseline, adverse,and severely adverse scenarios.The baseline scenario is defined as a set of conditions that affect the U.S.economy or the financial condition of a bank holding company, savingsand loan holding company, or state member bank, and that reflect theconsensus views of the economic and financial outlook.The adverse scenario is defined as a set of conditions that affect the U.S.economy or the financial condition of a bank holding company, savingsand loan holding company, or state member bank that are more adversethan those associated with the baseline scenario and may include tradingor other additional components.The severely adverse scenario is defined as a set of conditions that affectthe U.S. economy or the financial condition of a bank holding company, Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 76. 76savings and loan holding company, or state member bank and that overallare more severe than those associated with the adverse scenario and mayinclude trading or other additional components.In general, the baseline scenario will reflect the consensus views of themacroeconomic outlook expressed by professional forecasters,government agencies, and other public-sector organizations as of thebeginning of the annual stress-test cycle.The Board expects that the severely adverse scenario will, at a minimum,include the paths of economic variables that are generally consistent withthe paths observed during severe post-war U.S. recessions.Each year, the Board expects to take into account of salient risks thataffect the U.S. economy or the financial condition of a bank holdingcompany, savings and loan holding company, and state member bankthat may not be observed in a typical severe recession.The Board expects that the adverse scenario will, at a minimum, includethe paths of economic variables that are generally consistent with mild tomoderate recessions.The Board may vary the approach it uses for the adverse scenario eachyear so that the results of the scenario provide the most value tosupervisors, given the current conditions of the economy and the bankingindustry.Some of the approaches the Board may consider using include, but arenot limited to, a less severe version of the severely adverse scenario orspecifically capturing, in the adverse scenario, risks that the Boardbelieves should be understood better or should be monitored.The scenarios will consist of a set of conditions that affect the U.S.economy or the financial condition of a bank holding company, savingsand loan holding company, or state member bank over the stress testplanning horizon. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 77. 77These conditions will include projections for a range of macroeconomicand financial indicators, such as real Gross Domestic Product (GDP), theunemployment rate, equity and property prices, and various other keyfinancial variables, and will be updated each year to reflect changes in theoutlook for economic and financial conditions.The paths of these economic variables could reflect risks to the economicand financial outlook that are especially salient but were not prevalent inrecessions of the past.Depending on the systemic footprint and scope of operations andactivities of a company, the Board may require that company to includeadditional components in its adverse or severely adverse scenarios or touse additional scenarios or more complex scenarios that are designed tocapture salient risks to specific lines of business.For example, the Board recognizes that certain trading positions andtrading-related exposures are highly sensitive to adverse market events,potentially leading to large short-term volatility in certain companies’earnings.To address this risk, the Board will require companies with significanttrading activities to include market price and rate “shocks,” as specifiedby the Board, that are consistent with historical or other adverse marketevents.The final rule also provides that the Board may impose this trading shockon a state member bank that is subject to the Board’s market risk rule (12CFR part 208, appendix E) and that is a subsidiary of a bank holdingcompany subject to the trading shock under the final rule or under theBoard’s company-run stress test rule for covered companies (12 CFR252.144(b)(2)(i)).The Board is making this modification to allow for coordination of thetrading shock between a bank holding company and any state memberbank subsidiary that is subject to the market risk rule. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 78. 78In addition, the scenarios, in some cases, may also include stress factorsthat may not be directly correlated to macroeconomic or financialassumptions but nevertheless can materially affect covered companies’risks, such as factors that affect operational risks.The process by which the Board may require a company to includeadditional components or use additional scenarios is described undersection D.2 of this preamble.Some commenters suggested that the Board adopt a tailored approach toscenarios to better capture idiosyncratic characteristics of each company.For example, commenters representing the insurance industry suggestedthat any stress testing regime applicable to insurance companiesincorporate shocks relating to the exogenous factors that actually impacta particular company, such as a shock to the insurance companysinsurance policy portfolio arising from a natural disaster, andde-emphasize shocks arising from traditional banking activities.In the Board’s view, a generally uniform set of scenarios is necessary toprovide a basis for comparison across companies.However, the Board expects that each company’s stress testing practiceswill be tailored to its business model and lines of business, and that thecompany may not use all of the variables provided in the scenario, if thosevariables are not appropriate to the firm’s line of business, or may addadditional variables, as appropriate.In addition, the Board expects banking organizations to consider otherscenarios that are more idiosyncratic to their operations and associatedrisks, as part of their ongoing internal analyses of capital adequacy. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 79. 79FEDERAL RESERVE SYSTEMSupervisory and Company-Run Stress Test Requirements forCovered CompaniesAGENCY: Board of Governors of the Federal Reserve System(Board).ACTION: Final rule.SUMMARY: The Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank Act or Act) requires the Board to conductannual stress tests of bank holding companies with total consolidatedassets of $50 billion or more and nonbank financial companies theFinancial Stability Oversight Council (Council) designates forsupervision by the Board (nonbank covered companies, and together,with bank holding companies with total consolidated assets of $50 billionor more, covered companies) and also requires the Board to issueregulations that require covered companies to conduct stress testssemi-annually.The Board is adopting this final rule to implement the stress testrequirements for covered companies established in section 165(i)(1) and(2) of the Dodd-Frank Act.This final rule does not apply to any banking organization with totalconsolidated assets of less than $50 billion.Furthermore, implementation of the stress testing requirements for bankholding companies that did not participate in the Supervisory CapitalAssessment Program is delayed until September 2013.DATES: The rule is effective on November 15, 2012 Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 80. 80BackgroundThe Board has long held the view that a banking organization, such as abank holding company or insured depository institution, should operatewith capital levels well above its minimum regulatory capital ratios andcommensurate with its risk profile.A banking organization should also have internal processes for assessingits capital adequacy that reflect a full understanding of its risks andensure that it holds capital commensurate with those risks.Moreover, a banking organization that is subject to the Board’s advancedapproaches risk-based capital requirements must satisfy specificrequirements relating to their internal capital adequacy processes in orderto use the advanced approaches to calculate its minimum risk-basedcapital requirements.Stress testing is one tool that helps both bank supervisors and a bankingorganization measure the sufficiency of capital available to support thebanking organization’s operations throughout periods of stress.The Board and the other federal banking agencies previously havehighlighted the use of stress testing as a means to better understand therange of a banking organization’s potential risk exposures.In particular, as part of its effort to stabilize the U.S. financial systemduring the recent financial crisis, the Board, along with other federalfinancial regulatory agencies and the Federal Reserve system, conductedstress tests of large, complex bank holding companies through theSupervisory Capital Assessment Program (SCAP).The SCAP was a forward-looking exercise designed to estimate revenue,losses, and capital needs under an adverse economic and financial marketscenario. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 81. 81By looking at the broad capital needs of the financial system and thespecific needs of individual companies, these stress tests providedvaluable information to market participants, reduced uncertainty aboutthe financial condition of the participating bank holding companiesunder a scenario that was more adverse than that which was anticipatedto occur at the time, and had an overall stabilizing effect.Building on the SCAP and other supervisory work coming out of thecrisis, the Board initiated the annual Comprehensive Capital Analysis andReview (CCAR) in late 2010 to assess the capital adequacy and theinternal capital planning processes of large, complex bank holdingcompanies and to incorporate stress testing as part of the Board’s regularsupervisory program for assessing capital adequacy and capital planningpractices at large bank holding companies.The CCAR represents a substantial strengthening of previous approachesto assessing capital adequacy and promotes thorough and robustprocesses at large banking organizations for measuring capital needs andfor managing and allocating capital resources.The CCAR focuses on the risk measurement and management practicessupporting organizations’ capital adequacy assessments, including theirability to deliver credible inputs to their loss estimation techniques, aswell as the governance processes around capital planning practices.On November 22, 2011, the Board issued an amendment (capital planrule) to its Regulation Y to require all U.S bank holding companies withtotal consolidated assets of $50 billion or more to submit annual capitalplans to the Board to allow the Board to assess whether they have robust,forward-looking capital planning processes and have sufficient capital tocontinue operations throughout times of economic and financial stress.In the wake of the financial crisis, Congress enacted the Dodd-Frank Act,which requires the Board to implement enhanced prudential supervisorystandards, including requirements for stress tests, for covered companiesto mitigate the threat to financial stability posed by these institutions. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 82. 82Section 165(i)(1) of the Dodd-Frank Act requires the Board to conduct anannual stress test of each covered company to evaluate whether thecovered company has sufficient capital, on a total consolidated basis, toabsorb losses as a result of adverse economic conditions (supervisorystress tests).The Act requires that the supervisory stress test provide for at least threedifferent sets of conditions—baseline, adverse, and severely adverseconditions—under which the Board would conduct its evaluation.The Act also requires the Board to publish a summary of the supervisorystress test results.In addition, section 165(i)(2) of the Dodd-Frank Act requires the Board toissue regulations that require covered companies to conduct stress testssemi-annually and require financial companies with total consolidatedassets of more than $10 billion that are not covered companies and forwhich the Board is the primary federal financial regulatory agency toconduct stress tests on an annual basis (collectively, company-run stresstests).The Act requires that the Board issue regulations that:(i) Define the term “stress test”;(ii) Establish methodologies for the conduct of the company-run stresstests that provide for at least three different sets of conditions, includingbaseline, adverse, and severely adverse conditions;(iii) Establish the form and content of the report that companies subjectto the regulation must submit to the Board; and(iv) Require companies to publish a summary of the results of therequired stress tests. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 83. 83On January 5, 2012, the Board invited public comment on a notice ofproposed rulemaking (proposal or NPR) that would implement theenhanced prudential standards required to be established under section165 of the Dodd-Frank Act and the early remediation requirementsestablished under Section 166 of the Act, including proposed rulesregarding supervisory and company-run stress tests.Under the proposed rules, the Board would conduct an annualsupervisory stress test of covered companies under three sets of scenarios,using data as of September 30 of each year as reported by coveredcompanies, and publish a summary of the results of the supervisory stresstests in early April of the following year.In addition, the proposed rule required each covered company to conducttwo company-run stress tests each year: an “annual” company-run stresstest using data as-of September 30 of each year and the three scenariosprovided by the Board, and an additional company-run stress test usingdata as of March 31 of each year and three scenarios developed by thecompany.The proposed rule required each covered company to publish thesummary of the results of its company-run stress tests within 90 days ofsubmitting the results to the Board.Together, the supervisory stress tests and the company-run stress testsare intended to provide supervisors with forward-looking information tohelp identify downside risks and the potential effect of adverse conditionson capital adequacy at covered companies.The stress tests will estimate the covered company’s net income and otherfactors affecting capital and how each covered company’s capitalresources would be affected under the scenarios and will produce proforma projections of capital levels and regulatory capital ratios in eachquarter of the planning horizon, under each scenario. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 84. 84The publication of summary results from these stress tests will enhancepublic information about covered companies’ financial condition and theability of those companies to absorb losses as a result of adverseeconomic and financial conditions.The Board will use the results of the supervisory stress tests andcompany-run stress tests in its supervisory evaluation of a coveredcompany’s capital adequacy and capital planning practices.In addition, the stress tests will also provide a means to assess capitaladequacy across companies more fully and support the Board’s financialstability efforts.The Dodd-Frank Act mandates that the OCC and the FDIC adopt rulesimplementing stress testing requirements for the depository institutionsthat they supervise, and the OCC and FDIC invited public comment onproposed rules in January of 2012.The Board is finalizing the stress testing frameworks in two separaterules.First, the Board is issuing this final rule, which implements thesupervisory and company-run stress testing requirements for coveredcompanies (final rule).Second, the Board is concurrently issuing a final rule implementingannual company-run stress test requirements for bank holdingcompanies, savings and loan holding companies, and state memberbanks with consolidated assets greater than $10 billion that are nototherwise covered by this rule.The Board is issuing this final rule implementing the stress testingrequirements in advance of the other enhanced prudential standards andearly remediation requirements in order to address the timing of when thestress testing requirements will apply to various banking organizations Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 85. 85and to require large bank holding companies to publicly disclose theresults of their company-run stress tests conducted in the fall of 2012.Description of the Final RuleScope of ApplicationThis final rule applies to any bank holding company (other than a foreignbanking organization) that has $50 billion or more in average totalconsolidated assets and to any nonbank financial company that theCouncil has determined under section 113 of the Dodd-Frank Act must besupervised by the Board and for which such determination is in effect.Average total consolidated assets for bank holding companies is based onthe average of the total consolidated assets as reported on the bankholding company’s four most recent Consolidated Financial Statementfor Bank Holding Companies (FR Y–9C).If the bank holding company has not filed the FR Y-9C for each of thefour most recent consecutive quarters, average total consolidated assetswill be based the average of the company’s total consolidated assets, asreported on the company’s FR Y–9C, for the most recent quarter orconsecutive quarters.In either case, average total consolidated assets are measured on the as-ofdate of the relevant regulatory report.Once the average total consolidated assets of a bank holding companyexceed $50 billion, the company will remain subject to the final rule’srequirements unless and until the total consolidated assets of thecompany are less than $50 billion, as reported on four FR Y-9C reportsconsecutively filed.Average total consolidated assets are measured on the as-of date of theFR Y-9C. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 86. 86The final rule does not apply to foreign banking organizations.The Board expects to issue for public comment a separate rulemaking onthe application of enhanced prudential standards and early remediationrequirements established under the Dodd-Frank Act, including enhancedcapital and stress testing requirements, to foreign banking organizationsat a later date.AU.S.-domiciled bank holding company subsidiary of a foreign bankingorganization that has total consolidated assets of $50 billion or more issubject to the requirements of this final ruleScenariosThe proposal provided that the Board would publish a minimum of threedifferent sets of economic and financial conditions, including baseline,adverse, and severely adverse scenarios, under which the Board wouldconduct its annual analyses and companies would conduct their annualcompany-run stress tests.The Board would update, make additions to, or otherwise revise thesescenarios as appropriate, and would publish any such changes to thescenarios in advance of conducting each year’s stress test.Commenters suggested that significant changes in scenarios from year toyear could cause a banking organization’s stress testing results todramatically change.To ameliorate this volatility, commenters suggest that the federalbanking agencies have a uniform approach for identifying stressscenarios or establish a “quantitative severity limit” in the final rule toensure that scenarios do not drastically change from year to year.Commenters pointed out that consistency in annual scenariodevelopment will make comparability of stress test results betweeninstitutions and across time periods more accurate, increase market Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 87. 87confidence in the results of stress tests, and make for more dependablecapital planning by banking organizations.Commenters also requested the opportunity to provide input on thescenarios.The Board believes that it is important to have a consistent andtransparent framework to support scenario design.To further this goal, the final rule clarifies the definition of “scenarios”and includes definitions of baseline, adverse, and severely adversescenarios.Scenarios are defined as those sets of conditions that affect the U.S.economy or the financial condition of a covered company that the Board,or with respect to the mid-cycle stress test, the covered company,annually determines are appropriate for use in the company-run stresstests, including, but not limited to, baseline, adverse, and severely adversescenarios.The baseline scenario is defined as a set of conditions that affect the U.S.economy or the financial condition of a covered company and that reflectthe consensus views of the economic and financial outlook.The adverse scenario is defined as a set of conditions that affect the U.S.economy or the financial condition of a covered company that are moreadverse than those associated with the baseline scenario and may includetrading or other additional components.The severely adverse scenario is defined as a set of conditions that affectthe U.S. economy or the financial condition of a covered company andthat overall are more severe than those associated with the adversescenario and may include trading or other additional components.In general, the baseline scenario will reflect the consensus views of themacroeconomic outlook expressed by professional forecasters, Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 88. 88government agencies, and other public-sector organizations as of thebeginning of the annual stress-test cycle.The Board expects that the severely adverse scenario will, at a minimum,include the paths of economic variables that are generally consistent withthe paths observed during severe post-war U.S. recessions.Each year the Board expects to take into account of salient risks thataffect the U.S. economy or the financial condition of a covered companythat may not be observed in a typical severe recession.The Board expects that the adverse scenario will, at a minimum, includethe paths of economic variables that are generally consistent with mild tomoderate recessions.The Board may vary the approach it uses for the adverse scenario eachyear so that the results of the scenario provide the most value tosupervisors, given the current conditions of the economy and the bankingindustry.Some of the approaches the Board may consider using include, but arenot limited to, a less severe version of the severely adverse scenario orspecifically capturing, in the adverse scenario, risks that the Boardbelieves should be understood better or should be monitored.The scenarios will consist of a set of conditions that affect the U.S.economy or the financial condition of a covered company over the stresstest planning horizon.These conditions will include projections for a range of macroeconomicand financial indicators, such as real Gross Domestic Product (GDP), theunemployment rate, equity and property prices, and various other keyfinancial variables, and will be updated each year to reflect changes in theoutlook for economic and financial conditions. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 89. 89The paths of these economic variables could reflect risks to the economicand financial outlook that are especially salient but were not prevalent inrecessions of the past.Depending on the systemic footprint and scope of operations andactivities of a company, the Board may use, and require that company touse, additional components in the adverse and severely adverse scenariosor additional or more complex scenarios that are designed to capturesalient risks to specific lines of business.For example, the Board recognizes that certain trading positions andtrading-related exposures are highly sensitive to adverse market events,potentially leading to large short-term volatility in covered companies’earnings.To address this risk, the Board may require covered companies withsignificant trading activities to include market price and rate “shocks” intheir adverse and severely adverse scenarios as specified by the Board,that are consistent with historical or other adverse market events.In addition, the scenarios, in some cases, may also include stress factorsthat may not be directly correlated to macroeconomic or financialassumptions but nevertheless can materially affect covered companies’risks, such as factors that affect operational risks.The process by which the Board may require a covered company toinclude additional components in its adverse and severely adversescenarios or to use additional scenarios is described under section III.E.2of this Supplementary Information.The Board plans to publish for comment a policy statement thatdescribes its framework for developing scenarios.Some commenters suggested that the Board adopt a tailored approach toscenarios to better capture idiosyncratic characteristics of each company. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 90. 90For example, commenters representing the insurance industry suggestedthat any stress testing regime applicable to insurance companiesincorporate shocks relating to the exogenous factors that actually impacta particular company, such as a shock to the insurance companysinsurance policy portfolio arising from a natural disaster, andde-emphasize shocks arising from traditional banking activities.In the Board’s view, a generally uniform set of scenarios is necessary toprovide a basis for comparison across companies.However, the Board expects that each company’s stress testing practiceswill be tailored to its business model and lines of business, and that thecompany may not use all of the variables provided in the scenario, if thosevariables are not appropriate to the firm’s line of business, or may addadditional variables, as appropriate.In addition, the Board expects banking organizations to consider otherscenarios that are more idiosyncratic to their operations and associatedrisks as part of their ongoing internal analyses of capital adequacy andinclude company-specific vulnerabilities in their scenarios whencomplying with the Board’s requirements for mid-cycle company-runstress test. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 91. 91EBA publishes follow-upreview of banks’ transparencyin their 2011 Pillar 3 reportsThe European Banking Authority(EBA) published today a follow-up review aimed at assessing thedisclosures European banks’ made in response to the Pillar 3requirements set out in the Capital Requirements Directive (CRD).Overall, the EBA welcomes efforts made by banks to improve theirdisclosure practices and to comply with the new requirements introducedwith CRD 3.Nevertheless, the report notes that there is still room for improvements inBanks’ Pillar 3 disclosures, and the EBA intends to continue to press forsuch improvements.Main findingsWeaknesses remain in the areas of banks disclosures of credit risk – onInternal Ratings Based approaches (IRB) and securitisation activities –and market risk.The introduction of new disclosure requirements in CRD 3 in particularin the areas of securitisation and market risk may explain some of theweaknesses identified.But the EBA has also noted that weaknesses already identified in itsprevious assessments remain and calls for further action.Beyond assessing compliance with CRD disclosures requirements, theEBA has also performed an analysis of banks’ Basel III implementationdisclosures, in particular as regards the impact on own funds, and of the2011 EBA Capital Exercise related disclosures.Information provided by credit institutions in these two areas were foundto be of varying quality. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 92. 92In all disclosure areas, the EBA has identified some best practices whichcredit institutions are encouraged to follow, in order to enhance thegeneral quality of Pillar 3 information.With a view of both facilitating compliance with the requirements as wellas enhancing the quality and comparability of disclosures, the EBA willthis year supplement information on best practices with furtherexplanations on the objective and content of the disclosure requirements,which banks are also encouraged to consider while preparing their Pillar 3disclosures.Some improvements in the quality of disclosures were noted in the area ofremuneration and own funds.On the latter, credit institutions provided appropriate details of capitalitems and a meaningful breakdown of deductions.With regards to the timing, formats or verification of disclosures, nosignificant changes have been made in banks’ practices of reporting Pillar3 information.However, information was generally published nearer to the reportingdate of banks’ annual accounts and annual report but the EBA will stillpush for publication of these reports at the same time to allow investors tohave the complete set of publicly available information at once.Next stepsBased on the findings and content of this report, the EBA, throughout2012 and in 2013, plans to implement a strategy for enhanced transparencyand to that end willi) Keep on identifying best practices of public disclosures in thepublications as well as the CRD requirements for which compliance hasto be improved andii) Will work on these improvements, including in the area ofcomparability of disclosures. In this respect, the EBA will consult andengage with the industry and users where it is needed. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 93. 93BackgroundThe analysis, carried out in 2012 and covering a sample of nineteenEuropean banks, focussed mainly on those areas where the need forimprovement had already been identified in previous assessments as wellas on areas where new disclosure requirements have been introducedwith CRD3.The conclusions of this review will serve as essential input for definingand developing the EBA’s strategy in enhancing the area oftransparency.The European Banking Authority was established by Regulation (EC)No. 1093/2010 of the European Parliament and of the Council of 24November 2010.The EBA has officially come into being as of 1 January 2011 and has takenover all existing and ongoing tasks and responsibilities from theCommittee of European Banking Supervisors (CEBS).The EBA acts as a hub and spoke network of EU and national bodiessafeguarding public values such as the stability of the financial system,the transparency of markets and financial products and the protection ofdepositors and investors.Executive summaryOne of the EBA’s regular tasks is to assess Pillar 3 reports of Europeanbanks / credit institutions1 and monitor their compliance with therequirements of the Capital Requirements Directive (CRD).This analysis continues from Pillar 3 assessments that have been carriedout annually since 2008.It focuses particularly on areas where the need for improvement wasalready identified in previous assessments. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 94. 94It also covers areas where new disclosure requirements entered into forcein 2011.The current analysis was carried out in 2012 and covers the 2011 Pillar 3reports of nineteen European banks.No significant changes in banks’ practices were noted this year in thepractical aspects of the publication of Pillar 3 information (e.g. timing,formats or verification of disclosures), although the EBA noted that bankshave generally published their Pillar 3 information nearer to the reportingdate of their annual accounts and publication of their annual reports.The EBA would prefer the Pillar 3 information to be published at thesame time as these annual reports and accounts, and expects the situationto improve as a result of compliance with the new Capital RequirementsRegulation (CRR).As far as remuneration disclosures are concerned, if these are not actuallyincluded in the Pillar 3 reports or annual reports, the EBA would alsoprefer them to be published at the same time and provide cross-referencesbetween the reports.This would then ensure that Pillar 3 report users (investors and otherusers) have timely access to the complete set of publicly availableinformation that is essential for assessing credit institutions’ risk profiles.Disclosures on own funds were generally assessed as comprehensive,with credit institutions providing details of capital items and ameaningful breakdown of deductions.Cases of non-compliance were mostly related to disclosures on thegrandfathering of instruments, qualitative details about the capitalinstruments or breakdowns of capital items.The EBA also believes that comparability of disclosures on own-fundswill be significantly improved by the implementation of the CRR and ofthe related EBA‘s implementing technical standards on own fundsdisclosures, which will provide common definitions and templates fordisclosures. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 95. 95However, the analysis of information on credit risk – Internal RatingsBased (IRB) approach and securitisation risk – revealed certainweaknesses as well as the need for improvements and more explanationon the rationale for and the expected content of disclosure requirements.In particular, credit institutions are expected to increase the back-testingdisclosures.Half of the banks in the sample failed to comply with the relevant CRDrequirement, and many of the banks provided confusing informationabout the assumptions underlying internally developed models.In this context, the EBA also notes that to allow meaningful and reliableconclusions to be drawn on the functioning of the model, disclosures of acomparison between expected losses against actual losses should beprovided for a period of at least three years - a best practice that is notfollowed by the majority of the banks.As far as securitisation risk is concerned, the small number of disclosuresassessed as adequate was mainly due to the introduction of newqualitative and quantitative disclosures requirements with theimplementation of CRD III.Significant improvement is therefore needed for new disclosures on riskmanagement and exposures in the trading book or related to specialpurpose entities (SPEs).However, there were also failures to comply with disclosure requirementswhich were related to pre-CRD III requirements.Market risk was another area where many new disclosure requirementswere introduced and here the analysis also identified certain areas wheresignificant improvements were needed.These included disclosures on back-testing of internal models, stresstesting, valuation models, adequate breakdown of market risk capitalrequirements, stressed VaR measure, the new incremental risk charge aswell as the comprehensive risk measure. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 96. 96On the other hand, significant improvements were noted in the area ofremuneration disclosures with a total of 57% of the banks in the sampleassessed as providing adequate disclosures or disclosures that capturedthe spirit of the CRD requirements.In all these disclosure areas, the EBA identified some best practiceswhich credit institutions are encouraged to follow to enhance the qualityof Pillar 3 information.In addition to the assessment results and detailed findings as set forth inthis report, there are two other sections.The EBA decided to add further analysis that was not limited to acompliance exercise, but touched upon disclosure related issues, outsidethe Pillar 3 framework.The EBA therefore carried out a thematic study reviewing and comparingBasel III implementation disclosures, focusing on information providedby banks about the resulting impact on own funds, and on disclosures forthe EBA 2011 capital exercise.It was found that all credit institutions provided some disclosures, but thecontent and presentation of these greatly varied.Some institutions only disclosed qualitative elements while otherssupplemented these qualitative disclosures with some quantitative data.Data were however not comparable, due to differences in terms ofgranularity and of hypotheses used to estimate the impacts of regulatorychanges on own-funds.As last year, the EBA noticed that one of the main challenges of Pillar 3information, regardless the requirements considered, was comparabilityof disclosures between credit institutions.The EBA still believes greater comparability or some standardisationwould enhance the benefits of Pillar 3 information for users, including theESAs and the ESRB. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 97. 97The conclusions of the report are the result of productive discussionsbetween the National Supervisory Authorities and the EBA, informed byinputs from preparers and users of Pillar 3 disclosures.These conclusions have highlighted topics where further discussionsshould be encouraged between those preparing and those using of Pillar 3information and the NSAs/EBA to enhance of quality of disclosures inthese areas.The EBA will use these conclusions as a basis for initiating discussionsand also as essential input for defining and developing its strategy inenhancing the area of transparency.Indeed, as a result to the findings from this report, the EBA will in 2012and 2013 :- Keep on identifying best practices of public disclosures in the publications- Keep on identifying the CRD requirements for which compliance has to be improved and those that should be improved, and work on these improvements, including in the area of comparability- Consult and work with industry and users to improve transparency in areas where it is needed Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 98. 98Twenty years of inflationtargetingSpeech given by Mervyn King,Governor of the Bank of EnglandThe Stamp Memorial Lecture, London School of EconomicsIntroductionI am delighted to be back at the School to deliverthe Stamp Memorial Lecture.Lord Stamp was eminent in the worlds of bothacademic and public life.Among other achievements, he was an alumnus and a governor of theSchool, and a Director of the Bank of England.Following his untimely death, in an air raid in 1941, he was succeeded atthe Bank by John Maynard Keynes.Keynes and Stamp often broadcast live discussions on the BBC whichwere published a week later in The Listener.Their conversations during the 1930s, at the height of the GreatDepression, are eerily reminiscent of the enormous challenges we facetoday, as you can see from the following exchange in 1930:KEYNES: Is not the mere existence of general unemployment for anylength of time an absurdity, a confession of failure, and a hopeless andinexcusable breakdown of the economic machine?STAMP: Your language is rather violent. You would not expect to put anearthquake tidy in a few minutes, would you? I object to the view that it is Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 99. 99a confession of failure if you cannot put a complicated machine right all atonce.KEYNES: In my opinion the return to the gold standard in the way wedid it set our currency system an almost impossible task ... If pricesoutside this country had been going up since 1925 that would have donesomething to balance the effect on this country of the return to the goldstandard.STAMP: Hush, Maynard; I cannot bear it. Remember, I am a Director ofthe Bank of England.In some respects our experience today is no different: putting right oureconomic machine is proving a slow and difficult task.But in the 1920s the Government made the task substantially harder byreinstating the gold standard at a rate that left sterling overvalued.Today, monetary policy is part of the solution, not part of the problem.That is thanks, in large part, to the monetary framework we have had inplace since 1992.Twenty years ago today, on 9 October 1992, the newspapers reported thatfor the first time monetary policy in Britain would be based on an explicittarget for inflation.Three weeks earlier, sterling had been forced out of the EuropeanExchange Rate Mechanism (ERM).A new framework for monetary policy was needed.After keen debates within the Treasury and the Bank of England, theanswer emerged – the inflation target. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 100. 100The essence of this new approach was the combination of a numericaltarget for inflation in the medium term and the flexibility to respond toshocks to the economy in the short run – and so the framework becameknown as flexible inflation targeting.It is time to reflect on twenty years’ experience of inflation targeting;fifteen years of stability and five years of turbulence – the Great Stabilityand the Great Recession, shown in Table 1 and Charts 1-3. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 101. 101Over that period, monetary policy around the world has changedradically. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 102. 102Inflation targeting has spread to more than 30 countries.And the results in terms of low and stable inflation have been impressive.There have been pronounced reductions in the mean, variance andpersistence of inflation in Britain and elsewhere.During the past twenty years, annual consumer price inflation in thiscountry has averaged 2.1%, remarkably close to the 2% target and wellbelow the averages of over 12% a year in the 1970s and nearly 6% a year inthe 1980s.But did we pay too high a price for this achievement in lowering inflation?After fifteen years of apparent success, the past five years of financialcrisis and turmoil in the world economy have raised serious questionsabout the adequacy of inflation targeting.We don’t have to look far to see that the costs of financial instability arehuge.In Britain, total output is today some 15% below an extrapolation of itspre-crisis trend, and that gap is likely to persist for some time yet.In the light of such costs, should monetary policy go beyond targetingprice stability and also target financial stability? And should the presentfinancial crisis lead us to question the intellectual basis of monetarypolicy as practised in most of the industrialised world today?Those questions are the subject of tonight’s lecture.The story of inflation targetingBut let us start at the beginning.Shortly after the adoption of inflation targeting, my predecessor but one, Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 103. 103Lord Kingsdown (Robin Leigh-Pemberton as he then was), gave animportant speech at the London School of Economics – indeed in thisroom – entitled “The Case for Price Stability”.I remember it vividly – for I had been involved in drafting it.It was an exciting time; we were reconstructing British monetary policyafter the trauma of forced exit from the ERM.In those days, of course, the Chancellor set monetary policy and theBank of England played only a behind the scenes role.But the role of the Bank was about to change – first with the InflationReport in February 1993, which gave the Bank its own public voice, andthen with independence for the Bank and the creation of the MonetaryPolicy Committee (MPC) in 1997.The inflation target was born out of the experience that high and variableinflation was very costly to reduce and that only a policy based ondomestic considerations would be credible.The objective of monetary policy in the medium term wouldunambiguously be price stability.As the then Chancellor of the Exchequer, Norman Lamont, put it “wewish to reduce inflation to the point where expected changes in theaverage price level are small enough and gradual enough that they do notmaterially affect business and household financial plans”.The idea that there is a long-run trade-off between price stability andemployment had long since been abandoned.That intellectual revolution, associated with the names of Friedman,Phelps and Lucas, had stood the test of time and formed the foundationsof inflation targeting. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 104. 104The initial reception of the inflation target among economists andcommentators alike was distinctly mixed.As the Financial Times put it in a leader published twenty years agotoday, “the Chancellors speech was as economically thin as it waspolitically disappointing”.The critics argued that the new framework was inadequate to controlinflation.They were to be proved wrong.Over the previous twenty years inflation had been the single biggestproblem facing the UK economy, peaking at 27% a year in 1975.Over the subsequent twenty years, inflation, as I mentioned earlier, wouldaverage only 2.1%.From the outset, inflation targeting was conceived as a means by whichcentral banks could improve the credibility and predictability of monetarypolicy.The overriding concern was not to eliminate fluctuations in consumerprice inflation from year to year, but to reduce the degree of uncertaintyover the price level in the long run because it is from that unpredictabilitythat the real costs of inflation stem.The improvement in credibility of policy is shown by the fact that whereasin 1992 expected inflation, as measured by the difference between yieldson conventional and index-linked gilts, was close to 6%, today the samemeasure is around 2½ %.Predictability of the price level is greater because over a long periodinflation has on average been close to the target. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 105. 105Even if inflation deviates from target – as will often be the case – it isexpected to return to target, and so inflation expectations are anchored.That is why since 2007 the UK has been able to absorb the largestdepreciation of sterling since the Second World War, as well as very largerises in oil and commodity prices, with an increase in inflation to anaverage of only 3.2% over the past five years and without dislodginglong-term inflation expectations.So the framework has been tested and has proved its worth.But the current crisis has demonstrated vividly that price stability is notsufficient for economic stability more generally.Low and stable inflation did not prevent a banking crisis.Did the single-minded pursuit of consumer price stability allow a disasterto unfold?Would it have been better to accept sustained periods of below or abovetarget inflation in order to prevent the build up of imbalances in thefinancial system?Is there, in other words, sometimes a trade-off between price stability andfinancial stability?The intellectual foundations of monetary policyThe experience of the past five years suggests that we reassess theintellectual framework underpinning monetary policy.The emergence of inflation targeting, and the successful results in theform of the Great Stability, coincided with the development of theso-called New Keynesian consensus on macroeconomic theory. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 106. 106This framework offered a theoretical foundation for flexible inflationtargeting.Central to the New Keynesian view is the assumption that some prices are“sticky” and adjust slowly.That assumption has two implications.First, high inflation produces inefficient changes in relative prices.As a result, there is a cost to inflation.Second, when central banks change nominal interest rates they also affectreal interest rates, and so encourage households and businesses to switchexpenditure from today to tomorrow or, as in present circumstances, theother way round.In this way, central banks can, in the model at least, offset shocks toaggregate demand.But there are shocks to supply as well as demand.External cost shocks sometimes drive inflation away from the target, aswe saw in recent years with rises in world energy and food prices.Because other prices are “sticky”, attempts to keep inflation at target allthe time would result in inefficient fluctuations in output.There is, therefore, a trade-off between stabilising inflation andstabilising output.Following a cost shock, it is sensible to bring inflation back to targetgradually.In this, by now conventional, framework, the proper objective ofmonetary policy is to minimise the variability of inflation around the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 107. 107target rate and the variability of output (or employment) around asustainable path consistent with stable inflation.Such an objective means that the central bank is effectively choosing atrade-off between the volatility of inflation and the volatility of output.This is sometimes described as choosing a point on the Taylor frontiershowing, as in Chart 4, the combinations of lowest volatility of inflationfor a given volatility of output.That optimal choice leads to a policy reaction function describing howthe central bank responds to shocks hitting the economy.The success of the New Keynesian framework was that it showed how thelong run objective of price stability could be implemented by anappropriate central bank policy reaction function.It stressed the importance of expectations and credibility, to which toolittle attention had been paid during the inflationary episodes of the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 108. 1081970s and 1980s.But inevitably, as with all models, the basic New Keynesian model omitsa number of key factors.The treatment of expectations is simplified, and neglects the possibilitythat expectations themselves may be a source of fluctuations, rather thansimply reflecting changes elsewhere in the economy.Sentiment can vary, misperceptions occur, and people can change theheuristics they use to cope with a complex world.And it lacks an account of financial intermediation, so money, credit andbanking play no meaningful role.Those omissions obviously limit the ability of the model to help usunderstand the trade-offs between monetary policy and financial stability.Although there is a, by now extensive, literature on financial frictions,including attempts to incorporate them in New Keynesian models, itturns out that such extensions make little difference to the propagation ofshocks, to optimal policy, or to the quantitative conclusion thatoverwhelmingly the most important objective remains inflationstabilisation.There is no doubt that financial frictions such as asymmetric information,credit constraints, and costly monitoring of borrowers, to name but a few,are an important part of the story of how crises happen and why theyimpact on output.But those models do not provide a convincing account of the gradualbuild-up of debt, leverage and fragility that characterises the run-up tofinancial crises.Existing models, then, do not tell us why stability today may come at theexpense of instability tomorrow. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 109. 109Perhaps we should heed the advice of Ricardo Caballero, who has writtenthat “macroeconomic research has been in ‘fine-tuning’ mode within thelocal maximum of the dynamic stochastic general equilibrium world,when we should be in ‘broad-exploration’ mode”.So let me now move into broad exploration mode and give three examplesin which a trade-off between monetary and financial stability might arise,and which could in theory justify a policy of aiming off the inflation targetin order to reduce the risk of future financial instability, before I turn towhether such a policy would have been appropriate before the crisis.The first is where misperceptions about future incomes persist and areembodied in key prices, such as the exchange rate and long-term interestrates.Households, businesses, and banks can all make big mistakes whenforming judgements about the future, and make spending decisionstoday which they will come to regret when their true lifetime budgetconstraints are revealed.There is no mechanism for ensuring that misperceptions about thesustainable level of spending are corrected quickly.It may take many years before those beliefs are invalidated by experience.So an equilibrium pattern of spending and saving can emerge that isstable temporarily but not sustainable indefinitely.And misaligned prices may reinforce mistaken beliefs if people are usingmarket prices to extract signals about future incomes and consumptionopportunities.Evidence of the persistence of misperceptions can be seen in theimbalances in the world, and especially the European, economies. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 110. 110I do not mean to imply that when economic agents make these mistakesthey are behaving irrationally.Rather that in a world of intrinsic uncertainty it is far from obvious how tomake decisions.The assumption of rational expectations is very helpful for economistswhen trying to understand the implications of their own models – it is adiscipline to prevent the drawing of arbitrary conclusions.In practice, however, households are on their own in a highly uncertainand complex world where they are learning from experience.When it comes to decisions about how much to spend and how much tosave, expectations of future incomes are crucial.In the absence of a complete set of markets for future consumption goods– and labour – there is no mechanism to ensure that decisions today, andso the implied plans for tomorrow, will be consistent with the possibilitiesavailable in the future.If revisions to expectations of future incomes are uncorrelated acrosshouseholds, then aggregate spending will be relatively stable.The problem comes when many households have similarlyover-optimistic views about the future.Aggregate spending and borrowing can then be unsustainably high andlead to an inevitable correction at an unpredictable date when realitydawns.Financial markets both reflect and propagate that common degree ofoptimism.Sentiment and animal spirits can change very quickly. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 111. 111Examples include the extrapolation of past growth rates of incomes orasset prices into the future when in fact they reflect an adjustment of thelevel of income or asset price to a new equilibrium.At the time, the MPC argued that the rise in the ratio of house prices toincomes in the years leading up to 2007 reflected a fall in long-term realinterest rates – in other words, an adjustment to a new equilibrium houseprice to income ratio.But if households extrapolated past increases in house prices into thefuture, then they may have mistakenly inferred that future incomes toowould be higher, and so spending and borrowing more than could besustained.Similar arguments could be made about the reaction of businesses andhouseholds to the rise in the sterling effective exchange rate in the late1990s, and I shall return to this later.Since long-term interest rates in financial markets are, if anything, evenlower today the question of sustainability has not yet been resolved.Misperceptions mean that unsustainable levels of spending, andassociated levels of debt, can build up over many years.When those misperceptions are eventually corrected, they lead to suddenlarge changes in asset values, a synchronised de-leveraging of balancesheets, a large downward correction to spending and output, anddefaults.Keynesian policies to smooth the path of adjustment by supportingaggregate demand can help in the short run, but their effectiveness islimited by the fact that a significant adjustment to spending – fromconsumption to investment – is required. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 112. 112If policymakers can, first, identify misperceptions, and, second, correctthem by changes in monetary policy – both highly uncertain empirically –then there is indeed a trade-off between hitting the inflation target andreducing the chance of a financial crisis down the road.But are central banks less prone to misperceptions than others?My second example concerns what Masaaki Shirakawa, Governor of theBank of Japan calls the ‘cycle of confidence’.He argues that success breeds confidence, and eventuallyover-confidence and complacency, leading to collapse.Such ideas are closely associated with the work of Hyman Minsky andothers.Minsky set out a ‘financial instability hypothesis’ in which a period ofstability encourages exuberance in credit markets and subsequentinstability.Perhaps the experience of unprecedented stability in the UK and worldeconomies before the crisis dulled the senses and bred complacencyabout future risks.I talked about this when I christened the period leading up to 2003 thenice (non-inflationary consistently expansionary) decade.The point of that speech was that the following decade was unlikely to beas nice. And, of course, it wasn’t.But the point didn’t get home, and the financial system became more andmore fragile as the leverage of our banking system rose to unprecedentedlevels.The experience of continuing stability may have sowed the seeds of itsown destruction. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 113. 113That idea has been explored recently in an interesting new book byNassim Taleb.He argues that the opposite of fragility is not resilience or robustness, but“antifragility”, that is a state in which people or institutions thrive onvolatility, shocks to the system and risk.We go to the gym to stress our muscles in order to strengthen them;occasional seismic activity may prevent a more damaging earthquake.Frequent exposure to shocks and surprises may improve the way peoplelearn about and manage risks.In a complex world, we are “better at doing than we are at thinking”, inTaleb’s words.Unless we train and practice at coping with bad outcomes we may fail torespond in the right way to adverse shocks when they come.“Antifragility” does not imply that it might be desirable to engineer smallrecessions in order to head off a deep depression.We know far too little about the economy to attempt any such strategy,and in a world of intrinsic uncertainty we rely on heuristics – simplifiedrules of thumb – to guide our behaviour.But it offers a warning of the dangers of believing that the role ofmonetary policy is to offset all shocks.Rather than pretend that we can forecast the future, a more intelligentresponse is to reinforce the resilience of those parts of the financial systemthat we cannot permit to fail and encourage entry and exit in a free marketin other parts.It is clear that we need to understand more about how stability affectsrisk-taking, leverage, and the ‘cycle of confidence’. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 114. 114My third example relates to the so-called ‘risk taking’ channel ofmonetary policy.Short-term policy rates, especially when they are, as now, exceptionallylow, may encourage investors to take on more risk than they wouldotherwise wish as they ‘search for yield’.Financial institutions with long-term commitments (pension funds andinsurance companies, for example) need to match the yield they promisedon their liabilities, with the yield on their assets.When interest rates are high, they can invest in safe assets to generate thenecessary revenue.When interest rates are low, however, they are forced to invest in riskierassets to continue to meet their target nominal rate of return.That tends to push down risk premia and lower the price of borrowing.Other investors too find it difficult to accept that in a world of lownominal and real interest rates equilibrium rates of return will not meettheir previous expectations.If these mechanisms are important, the financial cycle may be heavilyinfluenced by monetary policy, especially when interest rates are low.That also creates the possibility of a trade-off between monetary andfinancial stability.All three examples suggest that the conventional analysis of the trade-offbetween the volatility of inflation and the volatility of output is likely to befar too optimistic.Does this add up to a case for ‘leaning against the wind’ of rising assetprices rather than waiting to ‘mop’ up after the bust? Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 115. 115Certainly we have seen that monetary policy cannot fully offset the effectsof financial crises for two reasons.First, crises may impact output before the response of monetary policy isfelt.Second, crises typically reduce potential supply growth, for example bydisrupting the supply of credit to productive firms.A failure to take financial instability into account creates an undulyoptimistic view of where the Taylor frontier lies, especially when it isbased on data drawn from a period of stability.Relative to a Taylor frontier that reflects only aggregate demand andcost shocks, the addition of financial instability shocks generates what Icall the Minsky-Taylor frontier, shown in Chart 5.This reflects the influence of misperceptions, financial cycles and thesearch for yield. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 116. 116On the Minsky-Taylor curve, for a given degree of inflation variability,output is more volatile in the long run than on the simple Taylor curve.Ignoring financial instability might mean choosing a policy reactionfunction that is believed to imply a trade-off at point O in Chart 5.In fact, the true trade-off is given by point P.Once that is understood then the optimal policy reaction function mightwell change and correspond to a trade-off at point Q.The examples I have given suggest the possibility that there is a trade-offbetween meeting the inflation target in the short run and reducing therisk of a financial crisis in the long run.To shed light on whether that possibility warrants a change to the way weimplement inflation targeting, I want now to conduct a counter-factualthought experiment and ask whether monetary policy before 2007 mighthave moderated the crisis if it had not simply pursued a target forinflation.A Counter-Factual Monetary Policy 1997-2007I want to ask whether, with the benefit of hindsight, monetary policyshould have been set differently during the period of the so-called GreatStability.Should interest rates have been higher during that period in order tomitigate some of the growth of credit, rise in asset prices, and increase inthe leverage of the banking system?Many commentators today seem to think that the answer is clearly yes –though I seem to remember that fewer said so at the time – and most ofthe pressure on the MPC, both from without and within, was for lowerrather than higher levels of Bank Rate. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 117. 117Before trying to answer the question, let me remind you of two key factsabout the Great Stability.First, the growth rate of GDP over the period prior to the onset of thecrisis in 2007 was 2.9%, very close to its previous long-run average of 2.8%(see Table 2).Second, the policy rate set by the MPC was higher than that in any otherG7 country for almost the whole of the ten years prior to the crisis (seeChart 6). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 118. 118But if the rate of growth was sustainable, its pattern was not.In the late 1990s, there had been a substantial, and not entirely explicable,rise in sterling of around 25% against most other currencies, leading tothe emergence of imbalances in the UK economy.These took the form of a shift in the composition of output away frommanufacturing and towards services, and a shift in demand away fromexports towards domestic demand.National saving fell to unsustainably low levels.In the early years of the MPC there was an intense debate about theseimbalances, and how they should affect monetary policy.In a speech in April 2000, I argued that “it is important not to let domesticdemand grow too rapidly for too long.The longer the correction is left, the sharper the required adjustment willbe”.The question was how much to stimulate domestic demand, at the cost ofexacerbating the imbalances, in order to compensate for weak external Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 119. 119demand, and the minutes of the MPC in 2001 and 2002 explicitlydiscussed the case for accepting inflation below target over the two-yearhorizon.The Committee rejected the case, and during that period most of thedissenting votes on the MPC were for lower rates (see Table 3).The dilemma, and the MPC’s resolution of it, was summed up by mypredecessor Eddie George in 2002 when he said “So in effect we havetaken the view that unbalanced growth in our present situation is betterthan no growth – or as some commentators have put it, a two-speedeconomy is better than a no-speed economy.”Was that the right choice?As in some other industrialised countries, asset prices, including houseprices, had been pushed up by falls in long-term real interest rates (seeChart 7). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 120. 120Since those long rates were set in world capital markets by the interactionbetween the demand for investment and the (very large) supply of saving,only a strategy of persistently higher interest rates at home than overseas– which to some extent we did follow – would have prevented a significantrise in asset prices, thus reducing some of the upward pressure on creditgrowth.Such a strategy might have brought some benefits for financial stability.It is possible that without rising asset prices we might have keptexpectations of future incomes on a more modest path that did not laterrequire a correction.Higher rates and the resulting recession and unemployment might havereminded firms, households and financial markets that the economy wasnot guaranteed to experience continual steady growth, and thereby havedisrupted the dynamic I described earlier in which stability leads tooverconfidence and eventual instability – by stressing the economy inorder to promote its “antifragility”, in Taleb’s phrase.And higher domestic interest rates might have alleviated some of the‘search for yield’ that probably followed a period of low rates.But leverage and the growth rate of credit may be relatively insensitive tointerest rates, especially once a self-reinforcing cycle of optimism andcredit expansion is underway.And this financial crisis was a global one; the United Kingdom could notalone have stopped it happening.We would still have suffered greatly from the very sudden and sharp fall inworld output and trade in 2008-09.We might still have experienced a banking crisis and a domestic ‘creditcrunch’ because, as my colleague Ben Broadbent has described, lendingto the UK real economy contributed only a small share of the rise in Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 121. 121leverage of the largest UK banks which reflected more an expansion oflending within the financial sector and overseas (see Table 4).Three quarters of UK banks’ losses to date have been on their foreignassets.The search for yield that prompted excessive risk-taking was the result oflow long-term interest rates around the world, not simply rates in theUK.So what would have happened had we adopted the counter-factual policyof higher levels of Bank rate?Of course, it is impossible to know with certainty.And much depends on what would have happened to the exchange rate.On the MPC, two views were discussed.One was that by setting interest rates at a much higher level, sodampening domestic demand and output growth, expectations of thelong-run exchange rate consistent with a sustainable path of domesticdemand might be dislodged and ‘jolted’ down to a lower equilibrium level– from A to B in Chart 8. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 122. 122Certainly, there seemed good reason at the time to imagine that slowergrowth at home might mean that hot money would return to countriesexperiencing stronger growth.As a result, the current exchange rate would have fallen from O to P inChart 8 and then been expected to follow the path PB consistent withuncovered interest rate parity.The result would have been higher external demand to offset weakerdomestic demand.After a time, we might have attained ‘one-speed’ growth, so avoiding theunpalatable choice between ‘two-speed’ and no growth.The other view was that higher interest rates would not have altered theexpected long-run equilibrium value of sterling, but would have led to animmediate upwards jump in the exchange rate, as the greater interest ratedifferential with other countries would have shifted up the uncoveredinterest rate parity path from OA to QA in Chart 8.That would have meant even weaker external demand, and a moredepressed domestic economy. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 123. 123Higher interest rates would have moderated domestic credit growth andasset prices, but only at the expense of slower output growth, risingunemployment and a prolonged undershoot of the inflation target.Everything would have hinged on the success of the strategy in bringingdown the expected equilibrium level of sterling in the long run to avoid afurther rise in sterling in the short run and a damaging recession.At best, persistently higher interest rates would have implied an initialslowing of growth, a deliberate attempt to weaken sterling, and anunder-shooting of the inflation for a period.At worst, we would have seen the exchange rate appreciate further.The decade would have been characterised by rising unemployment andvery low inflation.To have deviated from our statutory remit in a direction that would haveimposed real costs to output and employment would have been a biggamble.But the costs of the ensuing crisis have been so great that we cannot stopthere and say that nothing could have been done.Was there a better alternative to a strategy of higher interest rates?The natural first line of defence against financial crises ismacro-prudential policy.In principle, such policies can shift the Minsky-Taylor curve closerto the original Taylor curve.With hindsight, before 2007 there should have been a cap on the leverageof banks (see Chart 9). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 124. 124And the cap should have tightened as asset prices increased and the likelyexposure to losses increased.That is why we now have a macro-prudential policy regime in the UK.It will be overseen by the Bank of England’s Financial Policy Committee,which will have the power to direct, and make recommendations to,regulators about capital and leverage in the UK financial system.In my judgement, the big challenge to monetary policy before the crisiswas a serious mis-pricing in long-term interest and exchange rates, andthe imbalances that resulted.Much of this was outside the control of UK policy-makers and reflecteddevelopments in the world economy. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 125. 125It is arguable, though not certain, that in the absence of amacro-prudential regime or tighter fiscal policy, persistently higherinterest rates might have been a second-best strategy.It would, though, have been a big gamble.As the Chairman of the Federal Reserve, Ben Bernanke has remarked,“the issue is not whether central bankers should ignore possible financialimbalances – they should not – but, rather, what is ‘the right tool for thejob’ to respond to such imbalances”.So it is vital that macro-prudential tools and micro-prudential regulationare part of the armoury of a central bank to mitigate, if not prevent, thebuild up of excessive leverage and risk-taking in the banking and widerfinancial sector.From next year, the Bank of England will have those responsibilities, andthe new Financial Policy Committee is already up and running.But macro-prudential tools deal with symptoms rather than theunderlying problems of misperceptions and mispricing.Although we think the new tools given to the Bank would have helped toalleviate the last crisis, it would be optimistic to rely solely on such toolsto prevent all future crises.It would be sensible to recognize that there may be circumstances inwhich it is justified to aim off the inflation target for a while in order tomoderate the risk of financial crises.Monetary policy cannot just ‘mop up’ after a crisis.Risks must be dealt with beforehand. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 126. 126I do not see this as inconsistent with inflation targeting because it is thestability of inflation over long periods, not year to year changes, which iscrucial to economic success.The key principles underlying flexible inflation targeting are credibility,predictability and transparency of decision-taking, and they will remainthe cornerstone of successful monetary policy in the future.ConclusionsGovernor Leigh Pemberton’s 1992 lecture concluded with a message forthe LSE: “in a world of price stability you might not think of inviting theGovernor of the Bank of England to address you”.Had price stability guaranteed financial stability, and had I achieved mylong-held ambition of being boring, that might have been true.Unfortunately, it is not how things have worked out!What I have tried to show tonight is that the case for price stability is asstrong today as it was twenty years ago – both in theory and in practice.The clarity and simplicity of the inflation target helps to anchor inflationexpectations on the target.We forget the lessons of the 1970s and 1980s at our peril.In the end, the essence of central banking is to maintain confidence in,and the value of, paper money.It is far too soon to bury inflation targeting.Together with central bank independence, it played a key role inbringingprice stability to the UK. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 127. 127As the Times reported 20 years ago, “the pounds firmer tone, and softerGerman money market rates, could tempt the Chancellor to shave half apoint off base rates to coincide with the Prime Ministers speech atBrighton today”.The party conference season is no longer a time for speculation aboutchanges in interest rates.No doubt we shall learn a great deal about the appropriate allocation ofresponsibilities to monetary policy, on the one hand, andmacro-prudential policy, on the other, over the next twenty years.But we should not throw out the baby with the bathwater.Low and stable inflation is a pre-requisite for economic success.Much of what I have said is, I hope, a call to arms for economists, andespecially younger economists, to rethink the foundations of ourmacroeconomic theories.Not to abandon rigorous modelling – after all, in the words of last year’sNobel Prize winner Tom Sargent “it takes a model to beat a model” – butto recognize that in our present models the way we think of humanbehaviour in the face of irreducible uncertainty is seriously incomplete.Ideas matter far more than is usually recognised in the public discussionof monetary policy which concentrates too much on personalities.Keynes and Stamp both knew that.In February 1929, Josiah Stamp went to Paris as a member of the YoungCommittee to assess whether the reparations debts run up by Germanycould be repaid – the similarities with the present situation in Europe aretoo poignant to dwell on.In a letter to Keynes, Stamp compared these international meetings to aconjuror trying to pull a rabbit out of the hat: Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 128. 128“It is still a madhouse, in a way – but all are mad in a very genteel way, themain occupation being elaborate proofs, from different angles, of sanity.One half sit round a hat saying with Coué reiteration: there is a rabbit– there is.The other half try to make a noise like a succulent lettuce.There is a general conviction that the more eminent the conjurorsconvened, the more certainty is there of the existence of the rabbit”.The only escape from madness is the power of ideas.Today, we understand less than we would wish about how the economyworks.The challenge of trying to understand more, and of developing those newideas, belongs to you – the next generation of students and academics atthe LSE and elsewhere.Go to it! Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 129. 129Solvency II – monitoring the ongoingappropriateness of internal modelsJulian Adams, Director, InsuranceIn June 2012 I wrote to all firms in our internalmodel approval process to share our thinkingon the way we will monitor the ongoingappropriateness of internal models after approval.This letter gives an update on the development of early warningindicators and reiterates the purpose and intended use of the indicators.Our underlying concern is that, if not adequately monitored and updated,the solvency standard delivered by internal models can deteriorate overtime.The implementation of internal models inherently rests on a greatnumber of judgements and assumptions, both explicit and implicit.Our experience suggests that, over time, if models are not appropriatelyupdated, these assumptions and judgements can become lessappropriate, leading to an overall reduction in solvency standards.We therefore continue to develop early warning indicators to ensure thatthe Solvency Capital Requirement (SCR) will meet the Solvency IIcalibration on an ongoing basis.To achieve this objective, we believe that early warning indicators:a. should be based on metrics that are independent from the internalmodel calculations, i.e. not based on the firm’s modelled SCR;b. should be simple in their construction, calibration and application,avoiding complexity; and Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 130. 130c. will, if breached, trigger an immediate supervisory response; a capitaladd-on is, in all but exceptional cases, likely to be the most effective wayto restore compliance with the Solvency II calibration requirement (i.e.99.5% over a one-year period).We consider that the use of early warning indicators is consistent with thesupervisory powers set out in the Solvency II Directive and as such willform part of the supervisory review process for internal model firms.The early warning indicators would supplement information collectedfrom firms during the supervisory review process, including in particularthe results of model validation as well as any approval of changes to themodel.Further, the calibration of the indicators will aim to identify significantdeviations in firm risk profile with respect to the assumptions underlyingthe calculation of the SCR.Industry responsesWe received ten responses to our June 2012 letter. Overall, they focussedon how we will monitor the ongoing appropriateness of an internal modelat the individual firm level.These are useful suggestions which we will take into account as part ofour supervisory review process.We also received some suggestions of an alternative indicator to theproposed ratio between the pre-corridor Minimum Capital Requirement(pMCR) and modelled SCR and we are investigating crediblealternatives.We did not receive any comments on the proposed industry sub-sectorsegmentation set out in the letter. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 131. 131Some respondents noted that the construction should also allow for thecapture of the underwriting cycle, and be mindful of the potential forpro-cyclicality and we will take this feedback into consideration in furtherwork.A number of respondents expressed support for a European approach andwe have shared our thinking with EIOPA.I would like to confirm that we do not intend to use a multiple of thepMCR indicator, or any other early warning indicator, as a condition tothe approval of a firm’s use of an internal model.Our work with firms in the run up to implementation will inform thecalibration for the indicators at day one.As I said in my letter in June, we expect that, in the vast majority of cases,firms submitting a model that properly reflects the firm’s risk profile tothe standard required by the Solvency II Directive, and which is approvedby us, will fall within the ratio or range of the indicator.So this should not be an issue for approved models on day one.Fundamentally, the purpose of the indicator is to limit subsequentdownward SCR drift relative to risk profile.We have set out our intention to review the indicators periodically, bothfrom our experience of their use and their calibration.In response to comments received that the early warning indicators wouldnot allow for the reflection of the nature of and risks run by individualinsurers - we will not be providing calibration for indicators at anindividual firm level as this runs counter to the policy approach to have asimple, easy-to-apply indicator. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 132. 132Next stepsThere is still an opportunity for further engagement from the industry bycob Friday 26 October on early warning indicators that deliver the policyapproach set out above.We also welcome suggestions for the segmentation set out in the Juneletter.You can send your response to your usual supervisory contact or to medirectly.In the meantime we will be using data from firms to inform thedevelopment and calibration of early warning indicators.Yours sincerelyJulian AdamsDirector, Insurance Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 133. 13318 June 2012Solvency II: monitoring the ongoing appropriateness of internalmodelsAs part of our commitment to share developments in our approach to theimplementation of the Solvency II Directive, we wanted to set out ourthinking on the way in which we would monitor the ongoingappropriateness of internal models after approval.Model approval and beyondAs required by the Solvency II Directive, we will only approve an internalmodel for the calculation of the Solvency Capital Requirement (SCR) ifwe are satisfied that the systems for identifying, measuring, monitoring,managing and reporting risks are adequate and in particular if the modelfulfils the tests and standards set out in the Solvency II framework.While our focus is on the work we need to do to be able to give firms adecision on their internal model application in time for the first day of theregime, we are also looking ahead to how we use our knowledge andlearning to monitor the ongoing appropriateness of a firm’s internalmodel in the new regime.Following approval, firms are responsible for ensuring the ongoingappropriateness of the internal model, by ensuring that the internal modelmeets the tests and standards and reflects the firm’s risk profile.Firms should also ensure that the SCR is calibrated and corresponds tothe value at risk of their basic own funds of the firm, subject to aconfidence level of 99.5% over a one-year period.This means that we need to be assured that firms have put in placesystems which ensure that the internal model operates properly on acontinuous basis. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 134. 134We also need to be confident that the controls put in place are adequateand effective at all times, including stressed market conditions or crises.At a market level, we will monitor the movement of insurance sectorcapital over time.Our experience of internal models to date tells us that significant effort isput into an approval process, without adequate attention given toongoing appropriateness.This leads to a risk that standards of solvency deteriorate over time.Based on the requirements of the Solvency II Directive, it is ourexpectation that models will be monitored and updated regularly toreflect the firm’s risk profile and to ensure compliance with modelrequirements.Early warning indicatorsTo this end, we are developing a number of early warning indicatorsaimed at helping us and firms ensure that, after approval, internal modelsand the SCR calculation remain appropriate on an ongoing basis, at bothfirm and system level and that firms’ internal models continue to deliveroutputs that are consistent with the requirements of Solvency II.We will use the information provided by firms in their Solvency IIregulatory reporting to assess their position relative to these indicators(which may take the form of ratios or ranges) and so, the development ofthese indicators will not in itself create an additional reportingrequirement.However, firms will be required to notify us immediately in the event theirposition falls outside these pre-determined ranges.In all but exceptional cases, we will take immediate supervisory action. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 135. 135This could include seeking a revision of the parameters and/orimposing a capital add-on.The aim of this action will be to increase the SCR so as to bring it onceagain above the indicator level with a view to ensuring that it complieswith the Solvency II calibration requirement (i.e. 99.5% over a one-yearperiod).In the meantime (and in any event), the firm and the FSA will worktogether to understand the issues better, which may result inimprovements to the firm’s model.We propose to use a number of early warning indicators to assist us withour monitoring of capital on a firm-specific and industry-wide basis.The indicators will be tailored to specific sectors of the insurance market.We will periodically review the indicators, both from our experience oftheir use and their calibration.Ratio between the pMCR and modelled SCROne of the indicators that we are currently developing is a ratio betweenthe pre-corridor minimum capital requirement (pMCR) and the modelledSCR.Separate pMCR indicators would be set at the level of an industrysub-sector to give us a high degree of assurance that the model isdelivering a calibration at 99.5% over a one-year period.We intend to have indicators for firms which undertake:• life business, excluding with-profits business;• with-profits business; Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 136. 136• general insurance business, excluding London market business; and• London market business.Our preliminary analysis indicates that the pMCR indicator could rangebetween:• 175-200% for life business; and• 175-200% for general insurance business.We have used data from the fifth quantitative impact study, and applied itto the latest version of the MCR specification set out in the November2011 draft Level 2 text to derive these preliminary ranges.However, to refine the calibration we will need information from UKfirms and we will issue a template and instructions in September 2012.Our intention is to calibrate the indicator so that, in the vast majority ofcases, firms submitting a model which properly reflects the firm’s riskprofile to the standard required by the Solvency II Directive and which isapproved by us will fall within the ratio or range of the indicator and sothis should not be an issue for approved models on day one.Fundamentally, the purpose of the indicator is to limit subsequentdownward SCR drift relative to risk profile.Since there is no MCR for groups, the ratio set out in this letter wouldapply to the UK solo entities.Next stepsIn addition to the request for data to refine the calibrations in September2012, we will also provide an update on the other early warning indicatorswe are considering to prompt supervisory intervention, including the use Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 137. 137of stress tests and scenarios for economy-wide variables for with-profitsbusiness and groups.Yours sincerelyJulian AdamsDirector, Insurance Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 138. 138Final Basel III Rules inAustraliaAustralian PrudentialRegulation Authority(APRA)To: All locally incorporated authorised deposit-taking institutionsBasel III capital: interim arrangements for Additional Tier 1 and Tier 2capital instrumentsAPRA has released final prudential standards implementing the Basel IIImeasures to raise the quality, consistency and transparency of the capitalbase, including Prudential Standard APS 111 Capital Adequacy:Measurement of Capital (APS 111).This letter sets out APRA’s treatment of new Additional Tier 1 and Tier 2capital instruments issued before the new standard comes into effect on +To be eligible for inclusion in regulatory capital, all capital instrumentsthat have not been submitted to APRA for review before close of businesstoday must comply with the final version of APS 111 issued today.Instruments that have been submitted to APRA up to and includingtoday’s date and that were intended to be issued under the currenttransitional arrangements (including APRA’s letters to industry dated 27May 2011 and 30 March 2012), will be assessed against these criteria.To be counted as eligible regulatory capital, instruments approved byAPRA under these criteria must be issued before close of business on 31December 2012. Any questions in relation to this letter should in the firstinstance be directed to your Responsible Supervisor.Yours sincerelyCharles LittrellExecutive General Manager Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 139. 139NotesIn December 2010, the Basel Committee on Banking Supervision (BaselCommittee) released a package of reforms to raise the level and quality ofregulatory capital in the global banking system (Basel III).APRA is a member of the Basel Committee and fully supports theimplementation of these reforms.In September 2011, APRA released a discussion paper outlining itsproposals to implement these Basel III capital reforms in Australia.APRA subsequently released, in March and June 2012, draft prudentialand reporting standards on which submissions were invited.In June 2012, APRA also invited submissions on its proposal that certaincapital instruments be subject to Australian law and on its proposedregulatory capital treatment of joint arrangements.Fifteen submissions were received on the March and June 2012consultation packages.APRA’s capital adequacy prudential and reporting standardsSubmissions were broadly supportive of the content of the draftprudential and reporting standards and mostly sought clarification ofparticular provisions.In response, APRA has:• clarified its expectations for an ADI’s Internal Capital AdequacyAssessment Process (ICAAP), which are included in the draft PrudentialPractice Guide CPG 110 Internal Capital Adequacy AssessmentProcess and supervisory review (CPG 110) recently released for publicconsultation; Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 140. 140• revised its proposed treatment of an ADI’s funding of purchases of itsown capital instruments, including margin loans;• removed the ‘profits test’ from Additional Tier 1 and Tier 2 Capitalinstruments;• clarified the operation of the countercyclical capital buffer;• simplified transitional arrangements for capital issued by consolidatedsubsidiaries and held by third parties; and• made minor changes to the prudential and reporting standards toimprove ease of use.Submissions raised concerns about APRA’s proposal that certain capitalinstruments should be subject to Australian law.APRA acknowledges these concerns.In response, it has clarified areas of uncertainty about the loss absorptionand non-viability requirements and has refined its approach to thequestion of governing law for capital instruments, such that only thoseprovisions of capital instrument documentation dealing with lossabsorption and non-viability must be governed by Australian law.In June 2012, the Basel Committee finalised its proposals to improveconsistency and ease of use of disclosures on capital positions and capitalcomposition.These measures, which are to come into effect for reporting periodsending on or after 30 June 2013, include a common template anddisclosure provisions that, if implemented, would facilitate comparisonbetween the capital position of banking institutions across jurisdictions.APRA will consult in early 2013 on these requirements. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 141. 141Consultation with industry and other interested stakeholdersThe Basel III reforms also implement measures relating to external creditassessment institutions (ECAIs) and to minimise cliff effects arising fromguarantees and derivatives.Objectives and key requirements of this Prudential StandardThis Prudential Standard requires an authorised deposit-takinginstitution (ADI) to maintain adequate capital, on both a Level 1 andLevel 2 basis, to act as a buffer against the risk associated with itsactivities.The ultimate responsibility for the prudent management of capital ofan ADI rests with its Board of directors.The Board must ensure the ADI maintains an appropriate level andquality of capital commensurate with the type, amount andconcentration of risks to which the ADI is exposed.The key requirements of this Prudential Standard are that an ADIand any Level 2 group must:- have an Internal Capital Adequacy Assessment Process;- maintain required levels of regulatory capital;- operate a capital conservation buffer and, if required, a countercyclical capital buffer;- inform APRA of any adverse change in actual or anticipated capital adequacy; and- seek APRA’s approval for any planned capital reductions.Interesting: Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 142. 142An ADI that is part of a group may rely on the ICAAP of the groupprovided that the Board of the ADI is satisfied that the group ICAAPmeets the criteria in respect of the ADI.Group risk management8. Paragraphs 9 to 13 of this Prudential Standard apply to an ADI thatheads a conglomerate group.Where an ADI is part of a conglomerate group headed by an authorisednon-operating holding company (authorised NOHC), the requirementsset out in paragraphs 9 to 13 of this Prudential Standard apply to the ADIand its subsidiaries.9. For conglomerate groups headed by an ADI, the Board of the ADI isresponsible for ensuring that comprehensive policies and procedures arein place to measure, manage, monitor and report overall risk at a grouplevel.To ensure that existing Board-approved policies and the relevant controlsremain adequate and appropriate for managing and monitoring overallgroup risk, the Board or a board committee must review them regularly(at least annually) to take account of changing risk profiles of groupentities.Any material changes to group risk management policies must beapproved by the Board.10. The Board of an ADI must ensure that the ADI establishesappropriate policies, systems and procedures to monitor compliance withAPRA’s prudential requirements on a group basis.To facilitate conglomerate group supervision by APRA, an ADI must:(a) provide APRA with the following group information: Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 143. 143(i) details of group members (e.g. name, place of incorporation, boardcomposition, nature of business and any other additional informationrequired by APRA for a better understanding of the risk profiles ofindividual group members);(ii) management structure of the group (including key risk managementreporting lines);(iii) intra-group support arrangements (e.g. a specific guarantee of theobligations of an entity in the group);(iv) intra-group exposures; and(v) other information as required by APRA from time to time for theeffective supervision of the group;(b) notify APRA in accordance with section 62A of the Banking Act of anybreach of a requirement in a prudential standard or a condition of abanking authority (whether by an ADI in the group or by the group) andof any circumstances that might reasonably be seen as having a materialimpact and potentially adverse consequences for an ADI in the group orfor the overall group;(c) advise APRA in advance of any proposed changes to the compositionor operations of the group with the potential to materially alter the group’soverall risk profile (this must include any proposed changes to the ADI’sstand-alone operations); and(d) obtain APRA’s prior written approval for the establishment oracquisition of a regulated presence domestically or overseas.11. An ADI must provide APRA with descriptions of its group riskmanagement policies and the procedures used to measure and controloverall group risk (including any material changes thereto). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 144. 144The ADI should, as best practice, disclose in the group’s full publishedannual report each year an outline of its group risk management policies,including the policies governing dealings between the ADI and othergroup members.12. An ADI must submit a declaration signed by its chief executive officer,approved by the Board, covering the Level 2 groups risk managementsystems within three months of the ADIs annual balance date inaccordance with the declaration requirements in Prudential Standard APS310 Audit and Related Matters (APS 310).13. If an ADI qualifies the declaration in paragraph 12, the ADI mustexplain the reasons for the qualifications in accordance with therequirements in APS 310 and provide plans for corrective action. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 145. 145Five Questions about the Federal Reserve andMonetary PolicyChairman Ben S. Bernanke, at the Economic Club ofIndiana, Indianapolis, IndianaGood afternoon. I am pleased to be able to join theEconomic Club of Indiana for lunch today.I note that the mission of the club is "to promote an interest in, andenlighten its membership on, important governmental, economic andsocial issues." I hope my remarks today will meet that standard.Before diving in, Id like to thank my former colleague at the WhiteHouse, Al Hubbard, for helping to make this event possible.As the head of the National Economic Council under President Bush, Alhad the difficult task of making sure that diverse perspectives oneconomic policy issues were given a fair hearing before recommendationswent to the President.Al had to be a combination of economist, political guru, diplomat, andtraffic cop, and he handled it with great skill.My topic today is "Five Questions about the Federal Reserve andMonetary Policy."I have used a question-and-answer format in talks before, and I knowfrom much experience that people are eager to know more about theFederal Reserve, what we do, and why we do it.And that interest is even broader than one might think.Im a baseball fan, and I was excited to be invited to a recent battingpractice of the playoff-bound Washington Nationals.I was introduced to one of the teams star players, but before I could pressmy questions on some fine points of baseball strategy, he asked, "So,whats the scoop on quantitative easing?" Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 146. 146So, for that player, for club members and guests here today, and foranyone else curious about the Federal Reserve and monetary policy, I willask and answer these five questions:What are the Feds objectives, and how is it trying to meet them?Whats the relationship between the Feds monetary policy and the fiscaldecisions of the Administration and the Congress? What is the risk that the Feds accommodative monetary policy will leadto inflation?How does the Feds monetary policy affect savers and investors?How is the Federal Reserve held accountable in our democratic society?What Are the Feds Objectives, and How Is It Trying to MeetThem? The first question on my list concerns the Federal Reserves objectivesand the tools it has to try to meet them. As the nations central bank, the Federal Reserve is charged withpromoting a healthy economy--broadly speaking, an economy with lowunemployment, low and stable inflation, and a financial system thatmeets the economys needs for credit and other services and that is notitself a source of instability.We pursue these goals through a variety of means. Together with otherfederal supervisory agencies, we oversee banks and other financialinstitutions.We monitor the financial system as a whole for possible risks to itsstability.We encourage financial and economic literacy, promote equal access tocredit, and advance local economic development by working withcommunities, nonprofit organizations, and others around the country. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 147. 147We also provide some basic services to the financial sector--for example,by processing payments and distributing currency and coin to banks.But today I want to focus on a role that is particularly identified with theFederal Reserve--the making of monetary policy.The goals of monetary policy--maximum employment and pricestability--are given to us by the Congress.These goals mean, basically, that we would like to see as many Americansas possible who want jobs to have jobs, and that we aim to keep the rate ofincrease in consumer prices low and stable.In normal circumstances, the Federal Reserve implements monetarypolicy through its influence on short-term interest rates, which in turnaffect other interest rates and asset prices.Generally, if economic weakness is the primary concern, the Fed acts toreduce interest rates, which supports the economy by inducingbusinesses to invest more in new capital goods and by leadinghouseholds to spend more on houses, autos, and other goods andservices.Likewise, if the economy is overheating, the Fed can raise interest rates tohelp cool total demand and constrain inflationary pressures.Following this standard approach, the Fed cut short-term interest ratesrapidly during the financial crisis, reducing them to nearly zero by the endof 2008--a time when the economy was contracting sharply.At that point, however, we faced a real challenge: Once at zero, theshort-term interest rate could not be cut further, so our traditional policytool for dealing with economic weakness was no longer available.Yet, with unemployment soaring, the economy and job market clearlyneeded more support.Central banks around the world found themselves in a similarpredicament. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 148. 148We asked ourselves, "What do we do now?"To answer this question, we could draw on the experience of Japan,where short-term interest rates have been near zero for many years, aswell as a good deal of academic work.Unable to reduce short-term interest rates further, we looked instead forways to influence longer-term interest rates, which remained well abovezero.We reasoned that, as with traditional monetary policy, bringing downlonger-term rates should support economic growth and employment bylowering the cost of borrowing to buy homes and cars or to finance capitalinvestments.Since 2008, weve used two types of less-traditional monetary policy toolsto bring down longer-term rates. The first of these less-traditional tools involves the Fed purchasinglonger-term securities on the open market--principally Treasurysecurities and mortgage-backed securities guaranteed bygovernment-sponsored enterprises such as Fannie Mae and Freddie Mac.The Feds purchases reduce the amount of longer-term securities held byinvestors and put downward pressure on the interest rates on thosesecurities.That downward pressure transmits to a wide range of interest rates thatindividuals and businesses pay.For example, when the Fed first announced purchases ofmortgage-backed securities in late 2008, 30-year mortgage interest ratesaveraged a little above 6percent; today they average about 3-1/2 percent.Lower mortgage rates are one reason for the improvement we have beenseeing in the housing market, which in turn is benefiting the economymore broadly.Other important interest rates, such as corporate bond rates and rates onauto loans, have also come down. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 149. 149Lower interest rates also put upward pressure on the prices of assets, suchas stocks and homes, providing further impetus to household andbusiness spending.The second monetary policy tool we have been using involvescommunicating our expectations for how long the short-term interest ratewill remain exceptionally low.Because the yield on, say, a five-year security embeds marketexpectations for the course of short-term rates over the next five years,convincing investors that we will keep the short-term rate low for a longertime can help to pull down market-determined longer-term rates.In sum, the Feds basic strategy for strengthening the economy--reducinginterest rates and easing financial conditions more generally--is the sameas it has always been.The difference is that, with the short-term interest rate nearly at zero, wehave shifted to tools aimed at reducing longer-term interest rates moredirectly.Last month, my colleagues and I used both tools--securities purchasesand communications about our future actions--in a coordinated way tofurther support the recovery and the job market.Why did we act? Though the economy has been growing since mid-2009and we expect it to continue to expand, it simply has not been growingfast enough recently to make significant progress in bringing downunemployment.At 8.1 percent, the unemployment rate is nearly unchanged since thebeginning of the year and is well above normal levels.While unemployment has been stubbornly high, our economy hasenjoyed broad price stability for some time, and we expect inflation toremain low for the foreseeable future. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 150. 150So the case seemed clear to most of my colleagues that we could do moreto assist economic growth and the job market without compromising ourgoal of price stability.Specifically, what did we do? On securities purchases, we announced thatwe would buy mortgage-backed securities guaranteed by thegovernment-sponsored enterprises at a rate of $40 billion per month.Those purchases, along with the continuation of a previous programinvolving Treasury securities, mean we are buying $85 billion oflonger-term securities per month through the end of the year.We expect these purchases to put further downward pressure onlonger-term interest rates, including mortgage rates.To underline the Federal Reserves commitment to fostering asustainable economic recovery, we said that we would continue securitiespurchases and employ other policy tools until the outlook for the jobmarket improves substantially in a context of price stability.In the category of communications policy, we also extended our estimateof how long we expect to keep the short-term interest rate at exceptionallylow levels to at least mid-2015.That doesnt mean that we expect the economy to be weak through 2015.Rather, our message was that, so long as price stability is preserved, wewill take care not to raise rates prematurely.Specifically, we expect that a highly accommodative stance of monetarypolicy will remain appropriate for a considerable time after the economystrengthens.We hope that, by clarifying our expectations about future policy, we canprovide individuals, families, businesses, and financial markets greaterconfidence about the Federal Reserves commitment to promoting asustainable recovery and that, as a result, they will become more willingto invest, hire and spend.Now, as I have said many times, monetary policy is no panacea. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 151. 151It can be used to support stronger economic growth in situations inwhich, as today, the economy is not making full use of its resources, and itcan foster a healthier economy in the longer term by maintaining low andstable inflation.However, many other steps could be taken to strengthen our economyover time, such as putting the federal budget on a sustainable path,reforming the tax code, improving our educational system, supportingtechnological innovation, and expanding international trade.Although monetary policy cannot cure the economys ills, particularly intodays challenging circumstances, we do think it can provide meaningfulhelp.So we at the Federal Reserve are going to do what we can do and trust thatothers, in both the public and private sectors, will do what they can aswell.Whats the Relationship between Monetary Policy and FiscalPolicy?That brings me to the second question: Whats the relationship betweenmonetary policy and fiscal policy?To answer this question, it may help to begin with the more basicquestion of how monetary and fiscal policy differ. In short, monetary policy and fiscal policy involve quite different sets ofactors, decisions, and tools.Fiscal policy involves decisions about how much the government shouldspend, how much it should tax, and how much it should borrow.At the federal level, those decisions are made by the Administration andthe Congress.Fiscal policy determines the size of the federal budget deficit, which is thedifference between federal spending and revenues in a year. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 152. 152Borrowing to finance budget deficits increases the governments totaloutstanding debt.As I have discussed, monetary policy is the responsibility of the FederalReserve--or, more specifically, the Federal Open Market Committee,which includes members of the Federal Reserves Board of Governorsand presidents of Federal Reserve Banks.Unlike fiscal policy, monetary policy does not involve any taxation,transfer payments, or purchases of goods and services. Instead, as Imentioned, monetary policy mainly involves the purchase and sale ofsecurities.The securities that the Fed purchases in the conduct of monetary policyare held in our portfolio and earn interest.The great bulk of these interest earnings is sent to the Treasury, therebyhelping reduce the government deficit.In the past three years, the Fed remitted $200 billion to the federalgovernment.Ultimately, the securities held by the Fed will mature or will be sold backinto the market. So the odds are high that the purchase programs that theFed has undertaken in support of the recovery will end up reducing, notincreasing, the federal debt, both through the interest earnings we sendthe Treasury and because a stronger economy tends to lead to higher taxrevenues and reduced government spending (on unemployment benefits,for example).Even though our activities are likely to result in a lower national debt overthe long term, I sometimes hear the complaint that the Federal Reserve isenabling bad fiscal policy by keeping interest rates very low and therebymaking it cheaper for the federal government to borrow.I find this argument unpersuasive.The responsibility for fiscal policy lies squarely with the Administrationand the Congress. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 153. 153At the Federal Reserve, we implement policy to promote maximumemployment and price stability, as the law under which we operaterequires.Using monetary policy to try to influence the political debate on thebudget would be highly inappropriate.For what its worth, I think the strategy would also likely be ineffective:Suppose, notwithstanding our legal mandate, the Federal Reserve were toraise interest rates for the purpose of making it more expensive for thegovernment to borrow.Such an action would substantially increase the deficit, not only becauseof higher interest rates, but also because the weaker recovery that wouldresult from premature monetary tightening would further widen the gapbetween spending and revenues.Would such a step lead to better fiscal outcomes? It seems likely that asignificant widening of the deficit--which would make the needed fiscalactions even more difficult and painful--would worsen rather thanimprove the prospects for a comprehensive fiscal solution.I certainly dont underestimate the challenges that fiscal policymakersface.They must find ways to put the federal budget on a sustainable path, butnot so abruptly as to endanger the economic recovery in the near term.In particular, the Congress and the Administration will soon have toaddress the so-called fiscal cliff, a combination of sharply higher taxesand reduced spending that is set to happen at the beginning of the year.According to the Congressional Budget Office and virtually all otherexperts, if that were allowed to occur, it would likely throw the economyback into recession.The Congress and the Administration will also have to raise the debtceiling to prevent the Treasury from defaulting on its obligations, an Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 154. 154outcome that would have extremely negative consequences for thecountry for years to come.Achieving these fiscal goals would be even more difficult if monetarypolicy were not helping support the economic recovery.What Is the Risk that the Federal Reserves Monetary PolicyWill Lead to Inflation?A third question, and an important one, is whether the Federal Reservesmonetary policy will lead to higher inflation down the road.In response, I will start by pointing out that the Federal Reserves pricestability record is excellent, and we are fully committed to maintaining it.Inflation has averaged close to 2 percent per year for several decades, andthats about where it is today.In particular, the low interest rate policies the Fed has been following forabout five years now have not led to increased inflation.Moreover, according to a variety of measures, the publics expectations ofinflation over the long run remain quite stable within the range that theyhave been for many years.With monetary policy being so accommodative now, though, it is notunreasonable to ask whether we are sowing the seeds of future inflation.A related question I sometimes hear--which bears also on the relationshipbetween monetary and fiscal policy, is this: By buying securities, are you"monetizing the debt"--printing money for the government to use--andwill that inevitably lead to higher inflation?No, thats not what is happening, and that will not happen.Monetizing the debt means using money creation as a permanent sourceof financing for government spending.In contrast, we are acquiring Treasury securities on the open market andonly on a temporary basis, with the goal of supporting the economicrecovery through lower interest rates. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 155. 155At the appropriate time, the Federal Reserve will gradually sell thesesecurities or let them mature, as needed, to return its balance sheet to amore normal size.Moreover, the way the Fed finances its securities purchases is by creatingreserves in the banking system.Increased bank reserves held at the Fed dont necessarily translate intomore money or cash in circulation, and, indeed, broad measures of thesupply of money have not grown especially quickly, on balance, over thepast few years. For controlling inflation, the key question is whether the Federal Reservehas the policy tools to tighten monetary conditions at the appropriatetime so as to prevent the emergence of inflationary pressures down theroad.Im confident that we have the necessary tools to withdraw policyaccommodation when needed, and that we can do so in a way that allowsus to shrink our balance sheet in a deliberate and orderly way.For example, the Fed can tighten policy, even if our balance sheetremains large, by increasing the interest rate we pay banks on reservebalances they deposit at the Fed.Because banks will not lend at rates lower than what they can earn at theFed, such an action should serve to raise rates and tighten creditconditions more generally, preventing any tendency toward overheatingin the economy.Of course, having effective tools is one thing; using them in a timely way,neither too early nor too late, is another.Determining precisely the right time to "take away the punch bowl" isalways a challenge for central bankers, but that is true whether they areusing traditional or nontraditional policy tools. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 156. 156I can assure you that my colleagues and I will carefully consider how bestto foster both of our mandated objectives, maximum employment andprice stability, when the time comes to make these decisions.How Does the Feds Monetary Policy Affect Savers andInvestors? The concern about possible inflation is a concern about the future. Oneconcern in the here and now is about the effect of low interest rates onsavers and investors.My colleagues and I know that people who rely on investments that pay afixed interest rate, such as certificates of deposit, are receiving very lowreturns, a situation that has involved significant hardship for some.However, I would encourage you to remember that the current low levelsof interest rates, while in the first instance a reflection of the FederalReserves monetary policy, are in a larger sense the result of the recentfinancial crisis, the worst shock to this nations financial system since the1930s.Interest rates are low throughout the developed world, except in countriesexperiencing fiscal crises, as central banks and other policymakers try tocope with continuing financial strains and weak economic conditions.A second observation is that savers often wear many economic hats.Many savers are also homeowners; indeed, a familys home may be itsmost important financial asset.Many savers are working, or would like to be. Some savers ownbusinesses, and--through pension funds and 401(k) accounts--they oftenown stocks and other assets.The crisis and recession have led to very low interest rates, it is true, butthese events have also destroyed jobs, hamstrung economic growth, andled to sharp declines in the values of many homes and businesses.What can be done to address all of these concerns simultaneously? Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 157. 157The best and most comprehensive solution is to find ways to a strongereconomy.Only a strong economy can create higher asset values and sustainablygood returns for savers.And only a strong economy will allow people who need jobs to find them.Without a job, it is difficult to save for retirement or to buy a home or topay for an education, irrespective of the current level of interest rates.The way for the Fed to support a return to a strong economy is bymaintaining monetary accommodation, which requires low interest ratesfor a time.If, in contrast, the Fed were to raise rates now, before the economicrecovery is fully entrenched, house prices might resume declines, thevalues of businesses large and small would drop, and, critically,unemployment would likely start to rise again. Such outcomes wouldultimately not be good for savers or anyone else.How Is the Federal Reserve Held Accountable in a DemocraticSociety? I will turn, finally, to the question of how the Federal Reserve is heldaccountable in a democratic society.The Federal Reserve was created by the Congress, now almost a centuryago.In the Federal Reserve Act and subsequent legislation, the Congress laidout the central banks goals and powers, and the Fed is responsible to theCongress for meeting its mandated objectives, including fosteringmaximum employment and price stability.At the same time, the Congress wisely designed the Federal Reserve to beinsulated from short-term political pressures. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 158. 158For example, members of the Federal Reserve Board are appointed tostaggered, 14-year terms, with the result that some members may servethrough several Administrations.Research and practical experience have established that freeing thecentral bank from short-term political pressures leads to better monetarypolicy because it allows policymakers to focus on what is best for theeconomy in the longer run, independently of near-term electoral orpartisan concerns.All of the members of the Federal Open Market Committee take thisprinciple very seriously and strive always to make monetary policydecisions based solely on factual evidence and careful analysis.It is important to keep politics out of monetary policy decisions, but it isequally important, in a democracy, for those decisions--and, indeed, all ofthe Federal Reserves decisions and actions--to be undertaken in a strongframework of accountability and transparency.The American people have a right to know how the Federal Reserve iscarrying out its responsibilities and how we are using taxpayer resources.One of my principal objectives as Chairman has been to make monetarypolicy at the Federal Reserve as transparent as possible.We promote policy transparency in many ways.For example, the Federal Open Market Committee explains the reasonsfor its policy decisions in a statement released after each regularlyscheduled meeting, and three weeks later we publish minutes with adetailed summary of the meeting discussion.The Committee also publishes quarterly economic projections withinformation about where we anticipate both policy and the economy willbe headed over the next several years.I hold news conferences four times a year and testify often beforecongressional committees, including twice-yearly appearances that are Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 159. 159specifically designated for the purpose of my presenting a comprehensivemonetary policy report to the Congress.My colleagues and I frequently deliver speeches, such as this one, intowns and cities across the country.The Federal Reserve is also very open about its finances and operations.The Federal Reserve Act requires the Federal Reserve to report annuallyon its operations and to publish its balance sheet weekly.Similarly, under the financial reform law enacted after the financial crisis,we publicly report in detail on our lending programs and securitiespurchases, including the identities of borrowers and counterparties,amounts lent or purchased, and other information, such as collateralaccepted.In late 2010, we posted detailed information on our public website aboutmore than 21,000 individual credit and other transactions conducted tostabilize markets during the financial crisis.And, just last Friday, we posted the first in an ongoing series of quarterlyreports providing a great deal of information on individual discountwindow loans and securities transactions.The Federal Reserves financial statement is audited by an independent,outside accounting firm, and an independent Inspector General has widepowers to review actions taken by the Board.Importantly, the Government Accountability Office (GAO) has the abilityto--and does--oversee the efficiency and integrity of all of our operations,including our financial controls and governance.While the GAO has access to all aspects of the Feds operations and is freeto criticize or make recommendations, there is one important exception:monetary policymaking.In the 1970s, the Congress deliberately excluded monetary policydeliberations, decisions, and actions from the scope of GAO reviews. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 160. 160In doing so, the Congress carefully balanced the need for democraticaccountability with the benefits that flow from keeping monetary policyfree from short-term political pressures.However, there have been recent proposals to expand the authority of theGAO over the Federal Reserve to include reviews of monetary policydecisions.Because the GAO is the investigative arm of the Congress and GAOreviews may be initiated at the request of members of the Congress, thesereviews (or the prospect of reviews) of individual policy decisions couldbe seen, with good reason, as efforts to bring political pressure to bear onmonetary policymakers.A perceived politicization of monetary policy would reduce publicconfidence in the ability of the Federal Reserve to make its policydecisions based strictly on what is good for the economy in the longerterm.Balancing the need for accountability against the goal of insulatingmonetary policy from short-term political pressure is very important, andI believe that the Congress had it right in the 1970s when it explicitlychose to protect monetary policy decisionmaking from the possibility ofpolitically motivated reviews.ConclusionIn conclusion, I will simply note that these past few years have been adifficult time for the nation and the economy.For its part, the Federal Reserve has also been tested by unprecedentedchallenges.As we approach next years 100th anniversary of the signing of the FederalReserve Act, however, I have great confidence in the institution.In particular, I would like to recognize the skill, professionalism, anddedication of the employees of the Federal Reserve System. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 161. 161They work tirelessly to serve the public interest and to promote prosperityfor people and businesses across America.The Feds policy choices can always be debated, but the quality andcommitment of the Federal Reserve as a public institution is second tonone, and I am proud to lead it.Now that Ive answered questions that Ive posed to myself, Id be happyto respond to yours. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 162. 162BIS, Results of the Basel III monitoringexercise as of 31 December 2011Important partsThis report presents the results of the BaselCommittees Basel III monitoring exercise.The study is based on rigorous reportingprocesses set up by the Committee toperiodically review the implications of theBasel III standards for financial markets; thefirst results of the exercise based on June 2011data had been published in April 2012.A total of 209 banks participated in the study, including 102 Group 1banks (ie those that have Tier 1 capital in excess of €3 billion and areinternationally active) and 107 Group 2 banks (ie all other banks).While the Basel III framework sets out transitional arrangements toimplement the new standards, the monitoring exercise results assume fullimplementation of the final Basel III package based on data as of 31December 2011 (ie they do not take account of the transitionalarrangements such as the phase in of deductions).No assumptions were made about bank profitability or behaviouralresponses, such as changes in bank capital or balance sheet composition.For that reason the results of the study are not comparable to industryestimates.The study finds that based on data as of 31 December 2011 and applyingthe changes to the definition of capital and risk-weighted assets, theaverage common equity Tier 1 capital ratio (CET1) of Group 1 banks was7.7%, as compared with the Basel III minimum requirement of 4.5%. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 163. 163In order for all Group 1 banks to reach the 4.5% minimum, an increase of€11.9 billion CET1 would be required.The overall shortfall increases to €374.1 billion to achieve a CET1 targetlevel of 7.0% (ie including the capital conservation buffer); this amountincludes the surcharge for global systemically important banks whereapplicable.As a point of reference, the sum of profits after tax and prior todistributions across the same sample of Group 1 banks in 2011 was €356billion.Compared to the June 2011 exercise, the aggregate CET1 shortfall withrespect to the 4.5% minimum for Group 1 banks has reduced by €26.9billion.At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1banks has reduced by €111.5 billion.For Group 2 banks, the average CET1 ratio stood at 8.8%.In order for all Group 2 banks in the sample to meet the new 4.5% CET1ratio, the additional capital needed is estimated to be €7.6 billion.They would have required an additional €21.7 billion to reach a CET1target 7.0%; the sum of these banks profits after tax and prior todistributions in 2011 was €24 billion.Executive summaryIn 2010, the Basel Committee on Banking Supervision1 conducted acomprehensive quantitative impact study (C-QIS) using data as of 31December 2009 to ascertain the impact on banks of the Basel IIIframework that was published in December 2010 and revised inJune 2011. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 164. 164The Committee intends to continue monitoring the impact of the BaselIII framework in order to gather full evidence on its dynamics.For this purpose, a semi-annual monitoring framework has been set upon the risk-based capital ratio, the leverage ratio, and the liquidity metricsusing data collected by national supervisors on a representative sample ofinstitutions in each jurisdiction.This report is the second publication of results of the Basel III monitoringexercise and summarises the aggregate results using data as of 31December 2011.The Committee believes that the information contained in the report willprovide the relevant stakeholders with a useful benchmark for analysis.Information considered for this report was obtained by data submissionsof individual banks to their national supervisors on a voluntary andconfidential basis.A total of 209 banks participated in the study, including 102 Group 1banks and 107 Group 2 banks.Members’ coverage of their banking sector is very high for Group 1 banks,reaching 100% coverage for some jurisdictions, while coverage iscomparatively lower for Group 2 banks and varied across jurisdictions.The Committee appreciates the significant efforts contributed by bothbanks and national supervisors to this ongoing data collection exercise.The report focuses on the following items:- Changes to bank capital ratios under the new requirements, and estimates of any capital deficiencies relative to fully phased-in minimum and target capital requirements (to include capital charges for global systemically important banks – G-SIBs); Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 165. 165- Changes to the definition of capital that result from the new capital standard, referred to as common equity Tier 1 (CET1), including a reallocation of deductions to CET1, and changes to the eligibility criteria for Additional Tier 1 and Tier 2 capital;- Increases in risk-weighted assets resulting from changes to the definition of capital, securitisation, trading book, and counterparty credit risk requirements;- The Basel III leverage ratio; and- Two Basel III liquidity standards – the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).With the exception of the transitional arrangements for non-correlationtrading securitization positions in the trading book, this report does nottake into account any transitional arrangements such as phase-in ofdeductions and grandfathering arrangements.Rather, the estimates presented assume full implementation of the finalBasel III requirements based on data as of 31 December 2011.No assumptions have been made about banks’ profitability orbehavioural responses, such as changes in bank capital or balance sheetcomposition, since this date or in the future.For this reason, the results are not comparable to current industryestimates, which tend to be based on forecasts and consider managementactions to mitigate the impact, and incorporate estimates whereinformation is not publicly available.The results presented in this report are also not comparable to the C-QISthat was prepared using end-December 2009 data because that reportevaluated the impact of policy questions that differ in certain key respectsfrom the finalised Basel III framework. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 166. 166As one significant example, the C-QIS did not consider the impact ofcapital surcharges for global systemically important banks.Key resultsCapital shortfallsAssuming full implementation of the Basel III requirements as of 31December 2011, including changes to the definition of capital andrisk-weighted assets, and ignoring phase-in arrangements, Group 1 bankswould have an overall shortfall of €11.9 billion for the CET1 minimumcapital requirement of 4.5%, which rises to €374.1 billion for a CET1 targetlevel of 7.0% (ie including the capital conservation buffer); the lattershortfall also includes the G-SIB surcharge where applicable.As a point of reference, the sum of profits after tax prior to distributionsacross the same sample of Group 1 banks in 2011 was €356 billion.Compared to the June 2011 exercise, the aggregate CET1 shortfall withrespect to the 4.5% minimum for Group 1 banks has improved by €26.9billion or 69.3%.At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1banks has improved by €111.5 billion or 23.0%.Under the same assumptions, the capital shortfall for Group 2 banksincluded in the Basel III monitoring sample is estimated at €7.6 billion forthe CET1 minimum of 4.5% and €21.7 billion for a CET1 target level of7.0%.The sum of Group 2 bank profits after tax prior to distributions in 2011was €24 billion.Further details on additional capital needs to meet the Basel IIIrequirements are included in Section 2. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 167. 167Capital ratiosThe average CET1 ratio under the Basel III framework would declinefrom 10.4% to 7.7% for Group 1 banks and from 10.4% to 8.8% for Group 2banks.The Tier 1 capital ratios of Group 1 banks would decline, on average from11.7% to 8.0% and total capital ratios would decline from 14.2% to 9.2%.As with the CET1 ratios, the decline in other capital ratios iscomparatively less pronounced for Group 2 banks; Tier 1 capital ratioswould decline on average from 11.0% to 9.2% and total capital ratioswould decline on average from 14.3% to 11.0%.Changes in risk-weighted assetsAs compared to current risk-weighted assets, total risk-weighted assetsincrease on average by 18.1% for Group 1 banks under the Basel IIIframework.This increase is driven largely by charges against counterparty credit risk,trading book exposures, and securitization exposures (principally thoserisk-weighted at 1250% under the Basel III framework that werepreviously 50/50 deductions under Basel II).Banks that have significant exposures in these areas influence the averageincrease in risk-weighted assets heavily.As Group 2 banks are less affected by the revised counterparty credit riskand trading book rules, these banks experience a comparatively smallerincrease in risk-weighted assets of only 7.5%.Even within this sample, higher risk-weighted assets are attributedlargely to Group 2 banks with counterparty and securitisation exposures(ie those subject to a 1250% risk weighting). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 168. 168As discussed in Section 4.1, the increase in risk-weighted assets containscertain estimates pertaining to trading book exposures for banks thathave already adopted the Basel 2.5 enhancements.Leverage ratioThe average Basel III Tier 1 leverage ratio for all banks is 3.6%. The BaselIII average for Group 1 banks is 3.5%, and the average for Group 2 banksis 4.2%.Liquidity standardsBoth liquidity standards are currently subject to an observation periodwhich includes a review clause to address any unintended consequencesprior to their respective implementation dates of 1 January 2015 for theLCR and 1 January 2018 for the NSFR.Basel III monitoring results for the end-December 2011 reporting periodgive an indication of the impact of the calibration of the standards basedon the December 2010 rules text and highlight several key observations:- A total of 102 Group 1 and 107 Group 2 banks participated in the liquidity monitoring exercise for the end-December 2011 reference period.- The weighted average LCR for Group 1 banks is 91%, compared to 90% for 30 June 2011, while the weighted average LCR for Group 2 banks is 98%. The aggregate LCR shortfall is €1.8 trillion which represents approximately 3% of the €61.4 trillion total assets of the aggregate sample. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 169. 169- The weighted average NSFR is 98% for Group 1 banks and 95% for Group 2 banks, compared to 94% for each of the Group 1 and Group 2 samples as at 30 June 2011. The aggregate shortfall of required stable funding is €2.5 trillion.Sample of participating banksA total of 209 banks participated in the study, including 102 Group 1banks and 107 Group 2 banks.Group 1 banks are those that have Tier 1 capital in excess of €3 billion andare internationally active.All other banks are considered Group 2 banks.Banks were asked to provide data as of 31 December 2011 at theconsolidated level.Subsidiaries are not included in the analyses to avoid double counting.Table 1 shows the distribution of participation by jurisdiction.For Group 1 banks members’ coverage of their banking sector was veryhigh reaching 100% coverage for some jurisdictions.Coverage for Group 2 banks was comparatively lower and varied acrossjurisdictions.Not all banks provided data relating to all parts of the Basel IIIframework.Accordingly, a small number of banks are excluded from individualsections of the Basel III monitoring analysis due to incomplete data. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 170. 170In certain sections, data are based on a consistent sample of banks.This consistent sample represents only those banks that reportednecessary data at both the June 2011 and December 2011 reporting dates,in order to make more meaningful period-to-period comparisons. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 171. 171Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 172. 172Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 173. 173Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 174. 174Capital shortfallsChart 5 and Table 2 provide estimates of the amount of capital that Group1 and Group 2 banks would need based on data as of 31 December 2011 inaddition to capital already held at the reporting date, in order to meet thetarget CET1, Tier 1, and total capital ratios under Basel III assuming fullyphased-in target requirements and deductions.Under these assumptions, the CET1 capital shortfall for Group 1 bankswith respect to the 4.5% CET1 minimum requirement is €11.9 billion.The CET1 shortfall with respect to the 4.5% requirement for Group 2banks, where coverage of the sector is considerably smaller, is estimatedat €7.6 billion.For a CET1 target of 7.0% (ie the 4.5% CET1 minimum plus the 2.5%capital conservation buffer, plus any capital surcharge for Group 1 G-SIBsas applicable), Group 1 banks’ shortfall is €374.1 billion and Group 2banks’ shortfall is €21.7 billion. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 175. 175The surcharges for G-SIBs are a binding constraint on 21 of the 27 G-SIBsincluded in this Basel III monitoring exercise.As a point of reference, the aggregate sum of after-tax profits prior todistributions for Group 1 and Group 2 banks in the same sample was €356billion and €24 billion, respectively in 2011.Compared to the June 2011 exercise, the aggregate CET1 shortfall withrespect to the 4.5% minimum for Group 1 banks has improved by €26.9billion or 69.3% (see Chart 5).At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1banks has improved by €111.5 billion or 23.0%.Assuming the 4.5% CET1 minimum capital requirements were fully met(ie, there were no CET1 shortfalls), Group 1 banks would need anadditional €32.5 billion of additional Tier 1 or CET1 capital to meet theminimum Tier 1 capital ratio requirement of 6.0%.Assuming banks already hold 7.0% CET1 capital, Group 1 banks wouldneed an additional €219.3 billion of additional Tier 1 or CET1 capital tomeet the Tier 1 capital target ratio of 8.5% (ie the 6.0% Tier 1 minimumplus the 2.5% CET1 capital conservation buffer), respectively.Group 2 banks would need an additional €2.1 billion and an additional€11.9 billion to meet these respective Tier 1 capital minimum and targetratio requirements.Assuming CET1 and Tier 1 capital requirements were fully met (ie, therewere no shortfalls in either CET1 or Tier 1 capital), Group 1 banks wouldneed an additional €100.2 billion of Tier 2 or higher quality capital to meetthe minimum total capital ratio requirement of 8.0% and an additional€224.3 billion of Tier 2 or higher quality capital to meet the total capitaltarget ratio of 10.5% (ie the 8.0% Tier 1 minimum plus the 2.5% CET1capital conservation buffer). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 176. 176Group 2 banks would need an additional €4.1 billion and an additional€8.6 billion to meet these respective total capital minimum and targetratio requirements.As indicated above, no assumptions have been made about bank profitsor behavioural responses, such as changes balance sheet composition,that will serve to ameliorate the impact of capital shortfalls over time.Impact of the definition of capital on Common Equity Tier 1capitalAs noted above, reductions in capital ratios under the Basel IIIframework are attributed in part to capital deductions not previouslyapplied at the common equity level of Tier 1 capital in most jurisdictions.Table 3 shows the impact of various regulatory adjustment categories Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 177. 177on the gross CET1 capital (ie, CET1 before adjustments) of Group 1 andGroup 2 banks.In the aggregate, regulatory adjustments reduce the gross CET1 of Group1 banks under the Basel III framework by 29.0%.The largest driver of Group 1 bank deductions is goodwill, followed bycombined deferred tax assets (DTAs) deductions, and intangibles otherthan mortgage servicing rights.These deductions reduce Group 1 bank gross CET1 by 14.0%, 4.3%, and3.5%, respectively.The category described as other adjustments reduces Group 1 bank grossCET1 by 3.8% and pertain mainly to deductions for provision shortfallsrelative to expected credit losses and deductions related to defined benefitpension fund schemes.Holdings of capital of other financial companies reduce the CET1 ofGroup 1 banks by 1.9%.The category “Excess above 15%” refers to the deduction of the amountby which the aggregate of the three items subject to the 10% limit forinclusion in CET1 capital exceeds 15% of a bank’s CET1, calculated afterall deductions from CET1.These 15% threshold bucket deductions reduce Group 1 bank gross CET1by 1.6%.Deductions for MSRs exceeding the 10% limit have no impact on Group 1CET1 in the aggregate.Table 3 also compares regulatory adjustments for Group 1 banks with theresults of the previous period for those banks which participated in bothexercises. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 178. 178Overall, deductions have been reduced by 2.6 percentage points, mainlydriven by lower deductions for goodwill and financials.Regulatory adjustments reduce the CET1 of Group 2 banks by 20.4%.Goodwill is the largest driver of deductions for Group 2 banks, followedby holdings of the capital of other financial companies, deductions forintangibles other than mortgage servicing rights, and combined DTAsdeductions.These deductions reduce Group 2 bank CET1 by 7.5%, 2.3%, 2.3% and1.9%, respectively.Other adjustments, which are driven significantly by deductions forprovision shortfalls relative to expected credit losses, result in a 3.1%reduction in Group 2 bank gross CET1.Deductions for items in excess of the aggregate 15% threshold basketreduce Group 2 bank gross CET1 by 1.2%.Deductions for mortgage servicing rights above the 10% limit have noimpact on Group 2 banks. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 179. 179Changes in risk-weighted assets4.1 Overall resultsReductions in capital ratios under the Basel III framework are alsoattributed to increases in risk-weighted assets.Table 4 provides additional detail on the contributors to these increases,to include the following categories:Definition of capital:These columns measure the change in risk-weighted assets as a result ofproposed changes to the definition of capital.The column heading “other” includes the effects of lower risk-weightedassets for exposures that are currently included in risk-weighted assetsbut receive a deduction treatment under Basel III.The column heading “50/50” measures the increase in risk-weightedassets applied to securitisation exposures currently deducted under theBasel II framework that are risk-weighted at 1250% under Basel III.The column heading “threshold” measures the increase in risk-weightedassets for exposures that fall below the 10% and 15% limits for CET1deduction;Counterparty credit risk (CCR):This column measures the new capital charge for credit valuationadjustments (CVA risk) and the higher capital charge that results fromapplying a higher asset value correlation parameter against exposures tofinancial institutions under the IRB approaches to credit risk.Banks have not been asked to provide data on the risk-weighted asseteffects of capital charges for exposures to central counterparties (CCPs) Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 180. 180or on any impact of incorporating stressed parameters for effectiveexpected positive exposure (EEPE);Trading book:As data from most countries already include the RWA impact of theBasel 2.5 market risk rules, the incremental impact for changes in marketRWA shown in these tables has been estimated using the sum of thefollowing elements relative to elements in place under Basel II: theproportion of internally modeled general and specific risk that isattributable to stress value-at-risk, the incremental risk capital charge(IRC), capital charges for the correlation trading portfolio, and capitalcharges under the standardised measurement method (SMM) for othersecuritisation exposures and nth-to-default credit derivatives.The effect of higher capital charges for re-securitisation exposures in thebanking book and increased conversion factors for short-term liquidityfacilities to off-balance sheet conduits are not considered in these tablesgiven the data are no longer available for all countries.However, prior reports have shown the impact of these charges to begenerally small for both Group 1 and Group 2 banks.Risk-weighted assets for Group 1 banks increase overall by 18.1% forGroup 1 banks.This increase is to a large extent attributed to higher risk-weighted assetsfor counterparty credit risk exposures, which result in an overall increasein total Group 1 bank risk-weighted assets of 7.9%.The predominant drivers behind this figure are capital charges for CVArisk and the higher asset value correlation parameter, which is included inthe column labelled “CCR”. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 181. 181Trading book exposures and securitisation exposures currently subject todeduction under Basel II, also contribute significantly to higherrisk-weighted assets at Group 1 banks at 4.9% and 4.2%, respectively.Risk-weighted assets of Group 2 banks increase overall by 7.5%.Banks in this group tend to have smaller counterparty credit risk andtrading book exposures, which explains the lower increase risk-weightedassets for Group 2 banks as compared to Group 1 banks.Securitisation exposures currently subject to deduction, CCR exposures,and exposures that fall below the 10% and 15% CET1 eligibility limits aresignificant contributors to changes in risk-weighted assets for Group 2banks.Changes in risk-weighted assets show significant variation across banksas shown in Chart 6.Again, these differences are explained in large part by the extent of banks’counterparty credit risk and trading book exposures, which attractsignificantly higher capital charges under Basel III as compared tocurrent rules. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 182. 182Liquidity6.1 Liquidity coverage ratioOne of the two standards introduced by the Committee is a 30-dayliquidity coverage ratio (LCR) which is intended to promote short-termresilience to potential liquidity disruptions.The LCR has been designed to require global banks to have sufficienthigh-quality liquid assets to withstand a stressed 30-day funding scenariospecified by supervisors. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 183. 183The LCR numerator consists of a stock of unencumbered, high-qualityliquid assets that must be available to cover any net outflow, while thedenominator is comprised of cash outflows less cash inflows (subject to acap at 75% of outflows) that are expected to occur in a severe stressscenario.102 Group 1 and 107 Group 2 banks provided sufficient data in the 31December 2011 Basel III monitoring exercise to calculate the LCRaccording to the Basel III liquidity framework.The weighted average LCR was 91% for Group 1 banks, compared to 90%for 30 June 2011, and 98% for Group 2 banks.These aggregate numbers do not speak to the range of results across thebanks.Chart 8 below gives an indication of the distribution of bank results; thethick red line indicates the 100% minimum requirement, the thin redhorizontal lines indicate the median for the respective bank group.47% of the banks in the Basel III monitoring sample already meet orexceed the minimum LCR requirement, an increase from 45% at the endof June 2011, and 62% have LCRs that are at or above 75%. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 184. 184For the banks in the sample, Basel III monitoring results show a shortfall(ie the difference between high-quality liquid assets and net cashoutflows) of €1.8 trillion (which represents approximately 3% of the €61.4trillion total assets of the aggregate sample) as of 31 December 2011, ifbanks were to make no changes whatsoever to their liquidity risk profile. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 185. 185This number is only reflective of the aggregate shortfall for banks that arebelow the 100% requirement and does not reflect surplus liquid assets atbanks above the 100% requirement.Banks that are below the 100% required minimum have until 2015 to meetthe standard by scaling back business activities which are mostvulnerable to a significant short term liquidity shock or by lengtheningthe term of their funding beyond 30 days.Banks may also increase their holdings of liquid assets.The key components of outflows and inflows are shown in Table 7.Group 1 banks show a notably larger percentage of total outflows, whencompared to balance sheet liabilities, than Group 2 banks.This can be explained by the relatively greater contribution of wholesalefunding activities and commitments within the Group 1 sample, whereasGroup 2 banks, as a whole, are less reliant on these types of activities. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 186. 18675% cap on total inflowsAs at 31 December 2011, no Group 1 and 16 Group 2 banks reportedinflows that exceeded the cap, compared to 19 Group 2 banks as at 30June 2011.Of the 16 Group 2 banks, three fail to meet the LCR, so the cap is bindingon them.Of the banks impacted by the cap on inflows, 12 have inflows from otherfinancial institutions that are in excess of the excluded portion of inflows. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 187. 187Composition of high-quality liquid assetsThe composition of high-quality liquid assets currently held at banks isdepicted in Chart 9.The majority of Group 1 and Group 2 banks’ holdings, in aggregate, arecomprised of Level 1 assets; however the sample, on whole, showsdiversity in their holdings of eligible liquid assets.Within Level 1 assets, 0% risk-weighted securities issued or guaranteedby sovereigns, central banks and PSEs, and cash and central bankreserves comprise the most significant portions of the qualifying pool,with the latter increasing its contribution to the overall composition to31.4% as at the end of December 2011 from 27.6% as at the end ofJune 2011.Comparatively, within the Level 2 asset class, the majority of holdings arecomprised of 20% risk-weighted securities issued or guaranteed bysovereigns, central banks or PSEs, and qualifying covered bonds. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 188. 188Cap on Level 2 assets€117 billion of Level 2 liquid assets were excluded because reported Level2 assets were in excess of the 40% cap as currently operationalised.23 banks currently reported assets excluded, of which 16 (8% of the totalsample) had LCRs below 100%.These results compare to €121 billion of Level 2 liquid assets excluded by34 banks as at 30 June 2011, of which 24% (11% of the sample) had LCRsbelow 100%.Chart 10 combines the above LCR components by comparing liquidityresources (buffer assets and inflows) to outflows.Note that the €710 billion difference between the amount of liquid assetsand inflows and the amount of outflows and impact of the cap displayedin the chart is smaller than the €1.8 trillion gross shortfall noted above as itis assumed here that surpluses at one bank can offset shortfalls at otherbanks.In practice the aggregate shortfall in the industry is likely to liesomewhere between these two numbers depending on how efficientlybanks redistribute liquidity around the system. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 189. 189Net stable funding ratioThe second standard is the net stable funding ratio (NSFR), alonger-term structural ratio to address liquidity mismatches and provideincentives for banks to use stable sources to fund their activities.102 Group 1 and 107 Group 2 banks provided sufficient data in the 31December 2011 Basel III monitoring exercise to calculate the NSFRaccording to the Basel III liquidity framework.51% of these banks already meet or exceed the minimum NSFRrequirement, compared to 46% at the end of June 2011, with 92% at anNSFR of 75% or higher as at 31 December 2011. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 190. 190The weighted average NSFR for the Group 1 bank sample is 98% while itis 95% for the Group 2 sample, compared to 94% for each of the Group 1and Group 2 samples as at 30 June 2011.Chart 11 shows the distribution of results for Group 1 and Group 2 banks;the thick red line indicates the 100% minimum requirement, the thin redhorizontal lines indicate the median for the respective bank group. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 191. 191The results show that banks in the sample had a shortfall of stablefunding of €2.5 trillion at the end of December 2011, a decrease from €2.8trillion at the end of June 2011, if banks were to make no changeswhatsoever to their funding structure.This number is only reflective of the aggregate shortfall for banks that arebelow the 100% NSFR requirement and does not reflect any surplus stablefunding at banks above the 100% requirement.Banks that are below the 100% required minimum have until 2018 to meetthe standard and can take a number of measures to do so, including bylengthening the term of their funding or reducing maturity mismatch.It should be noted that the shortfalls in the LCR and the NSFR are notnecessarily additive, as decreasing the shortfall in one standard may resultin a similar decrease in the shortfall of the other standard, depending onthe steps taken to decrease the shortfall. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 192. 192Benoît Coeuré: Challenges to the singlemonetary policy and theEuropean Central Bank’s responseSpeech by Mr Benoît Coeuré, Member of theExecutive Board of the European CentralBank, at the Institut d’études politiques, Paris,20 September 2012.Ladies and gentlemen, It is a great pleasure forme to speak here today at Sciences Po Paris.9 August this year was the fifth anniversary ofthe start of the financial crisis.The past few years have been times of hardship, financial turbulence andrisks.At the same time, the crisis has exposed weaknesses in the framework ofthe economic and monetary union and provided an impetus to strengthenits foundations and to begin the process of bringing all euro areacountries back to a more sustainable fiscal and macroeconomic path.The crisis has also brought challenges and opportunities for monetarypolicy, which is going to be the focus of my remarks today.Let me elaborate on two of them.The first challenge I will describe is that after Lehman’s collapse centralbanks had to combat exceptional threats to price stability arising fromfinancial instability and recessionary forces.At that time their standard tool of monetary policy – changes to theshort-term interest rate – was losing traction due to the dislocation in thefinancial system. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 193. 193Central banks had to quickly learn that this situation required switchingfrom normal operating mode, based simply on setting short-term interestrates, to crisis mode, aimed at sidestepping the obstacles to the standardchannels of monetary policy transmission.This experience has given us an opportunity to deepen our understandingof monetary policy and, in particular, to reject the textbook dichotomythat either the central bank is able to rely on the “interest rate channel” forthe transmission of its intentions, or else the economy is condemned tolasting instability.It is now clear that additional channels and conduits are available.The second challenge I want to discuss is the sovereign debt crisis andthe associated fragmentation of credit markets across national borders.Starting in 2010, the financial crisis began to unfold in the euro area byturning into a debt crisis for some sovereign issuers.This quickly spilled across markets and countries.And more recently, it was exacerbated by investors’ fears of thereversibility of the euro.The challenge faced by monetary policy in this environment is enormousand is testing the ability of the ECB to act as the central bank of a singlemonetary area with 17 fiscal jurisdictions.It has been increasingly challenging to preserve the singleness of themonetary policy and to ensure the proper transmission of the policystance to the real economy throughout the currency area.To address this situation, the ECB has taken a number of non-standardmeasures, and two weeks ago it announced the modalities forundertaking Outright Monetary Transactions in secondary markets forsovereign bonds in the euro area. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 194. 194I will describe the rationale for this decision and argue that it is a keyelement to ensure a lasting “monetary dominance” in the euro area,compliant with the Treaties.Channels of monetary policy in normal times and crisis timesIn normal times, monetary policy works primarily through inter-temporalfinancial arbitrage.In the Eurosystem, this arbitrage covers two different time dimensions.There is the weekly arbitrage cycle, through which the volume of centralbank liquidity is reallocated across banks trading in the money market inthe period between two consecutive weekly Eurosystem main refinancingoperations (MROs).The reason for this reallocation is that – as a matter of routine, at least –the Eurosystem provides reserves at weekly intervals.While the banking sector’s need for reserves in the aggregate may notchange significantly within a week, the cash needs of individual banks dofluctuate at higher frequencies, probably daily.So banks with liquidity deficits in the infra-weekly period need to borrowfrom banks with liquidity surpluses.The price at which these trades of liquid reserves between banks occur,i.e. the overnight interest rate (of which a euro area average, the EONIA,is computed and published every day by the ECB), is influenced byexpectations of the cost of Eurosystem credit – the so-called MRO rate –at the next weekly monetary policy operation.A short-term inter-temporal arbitrage calculus anchors the overnightinterest rate applied on the credit transaction between banks that needliquidity and banks that have a liquidity surplus. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 195. 195The second dimension of the inter-temporal calculus has a longer horizonand a wider scope of application across asset classes.Banks can borrow short in the money market or from the Eurosystem anddecide to engage in term lending to other banks or to their customers.Bank customers, in turn, can use bank liquidity to finance consumptionor the acquisition of capital.It is important to note that all of these money transactions in the broadereconomy involve traders weighing the costs of their borrowing against thereturn opportunities on their asset acquisition at different points in time,where the horizon is typically longer than a week.But, again, as banks borrowing from the Eurosystem are the source ofthis liquidity propagation pattern, and banks’ financial calculus is basedon their anticipations of the interest rate settings by the Eurosystem in thefuture, such anticipations anchor the pricing of credit in the broadereconomy.We call this “the interest rate channel” of monetary policy decisions.In normal times, when risk factors are contained and can be diversifiedaway, the interest rate channel, working through inter-temporal arbitrage,is the prime conduit of monetary policy (see slide 2).It sets the floor for term borrowing costs.Parsing longer-term yields into two components – the average level of theshort-term policy interest rate expected over the term to maturity of theasset, and the risk premia – expectations of monetary policy pin down thefirst component.The mechanism through which this occurs is the inter-temporal financialarbitrage I just described. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 196. 196Term and liquidity premia are the additional returns that investorsdemand as a compensation for their reluctance to bear interest rate riskover long-duration assets, and for their decision to forgo liquidity services– I am abstracting here from credit risk, to which I will return later.When markets are properly functioning, non-depository institutions –dealers, hedge funds, investment banks – provide immediacy by offeringlenders and borrowers their capacity to take positions on both sides of themarket.Their ready availability to take positions as lenders and borrowerssupports market liquidity, namely the ease with which a lender canliquidate a position before maturity.When market liquidity is secure, lenders are willing to engage in finance,trades in long-duration assets are active and the liquidity premia arecontained. And, most importantly, they are steady.With a steady premium, the expectations of the short-term rates becomethe driving factor in the pricing of long-dated securities, and monetarypolicy acquires a potent handle on the economy.In August 2007, a sudden re-pricing in the US sub-prime mortgagemarket changed this world.The close and predictable relationship between the expected path ofpolicy rates and market rates broke down because the liquidity premiawidened and became volatile.The elevation of market premia was especially pronounced in the spreadbetween the three-month EURIBOR and the expected three-month pathof the overnight rate (see slide 3).Banks recognised a substantial counterparty risk in lending to each other,given that interbank lending was generally unsecured. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 197. 197But, even if collateral was taken, the ability to liquidate it at a reasonableprice was severely impaired in an environment of widespread fear anduncertainty.Bank positions in the interbank market can be highly persistent.Large diversified banks tend to be borrowers and smaller, regional bankslenders.When the financial turmoil erupted, persistent borrowers endured a sharpand sustained jump in their funding costs and many of them had noaccess to markets at all.When Lehman Brothers finally filed for bankruptcy in mid-September2008, widespread financial panic broke out.The paralysis of transactions spread beyond the money markets, where ithad been more or less confined for a year.Outside the money market, dealers play a critical role guaranteeingmarket liquidity.But in order to be able to take positions on both sides of the market, theyneed to finance their securities positions via collateralised funding.For that, they need their own capital, which they can use to pay for themargins required by those who lend them securities.When confidence evaporates, margins increase and dealers’ capital iseroded, so that their ability to trade as buyers is restricted.Markets lose a critical actor, assets become less liquid, and the value ofassets declines further.Having tasted the forbidden fruit of excess risk-taking, financialinstitutions were cast out of the paradise of seamless financial markets. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 198. 198In a financial crisis of these proportions, “outside money” – an asset thatis not a liability for anybody else than a central bank – becomes the soletrustworthy store of value.Only a central bank, the monopoly provider of outside money, canrespond to the scrambles for liquidity.The ECB injected its funding capacity into a market vacuum left wideopen by bank retrenchment, dealer defaults and investor panic.In these conditions, inter-temporal financial arbitrage – of the type Idescribed above – becomes impaired.The power of banks and dealers to engage in or finance inter-temporaltrades of liquidity balances is degraded.So the main conduit of monetary policy – which depends on those trades– is lost.The ECB had to open a new channel, the “liquidity channel”, to getround the roadblocks facing the interest rate channel (see slide 4).More precisely, the ECB acted in two dimensions.It sought to alleviate the difficulties experienced by banks in gettingliquidity from the interbank market, which was putting pressure on theassets side of banks’ balance sheets and increasing the risks of hinderingcredit supply.At the same time, it sought to restore the normal pass-through fromshort-term money market (lending) rates to other market and bankinterest rates.As far as impairments to banks’ funding are concerned, the ECBaddressed banks’ funding uncertainty by fully accommodating liquidity Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 199. 199needs at a fixed interest rate (the ECB main refinancing rate), whilesimultaneously lengthening the maturity of refinancing operations:from three to six months and twelve months, and more recently twooperations with a three-year maturity.This has allowed an alleviation of the funding constraints of the bankingsystem.In this way, a substantial change in the term structure of liquidity hastaken place.While before the crisis about three-quarters of outstanding liquidity had amaturity of one week and the rest three months (i.e. an average maturityof 15–20 days), the current average maturity is 28 months (see slide 5).The expansion of the ECB collateralised monetary policy operations,together with the more widespread collateralisation of financialtransactions, has raised the fear of encumbrance of bank assets.This risk has not materialised as the list of eligible collateral has beenexpanded to enable banks to take full advantage of the ECB full-allotmentpolicy, while rigorously applying risk control measures to mitigateliquidity, market and credit risk.But as higher haircuts erode the refinancing power of encumbered assets,there must be an asymptotic limit to the ability of the central bank toprovide outside money without endangering its creditworthiness, onwhich confidence in the currency rests.The notion that central banks have an unlimited capacity to create moneyis an illusion and thus cannot be used as an excuse not to reform theeconomy.Overall, the policy measures taken on several fronts were able to stem therisk of a credit flow fallout with related adverse implications for pricestability. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 200. 200In particular, the role of bank credit in financing the private sector hasbeen preserved, supported by an increased recourse to debt marketsespecially by large firms (see slide 6).The sovereign debt crisis and fragmentation of credit marketsacross national bordersMy discussion so far has focused on term and liquidity premia, whichhave taken centre stage since the very beginning of the financial crisis.Starting in May 2010, the crisis was marked by a new phenomenon, untilthen little known in euro area: the emergence of large and variable creditrisk premia in the pricing of supposedly risk-free securities issued by euroarea governments.This has led to questions about the creditworthiness of some sovereignissuers and to a fully-fledged sovereign debt crisis.This new phase of the crisis has taken on several dimensions.The first and most noticeable one has been the large sell-off ofgovernment debt issued by sovereigns in precarious fiscal positions (seeslide 7).Markets have increased their scrutiny of the fiscal and structuralconditions of Member States (the “fundamentals”) and assessed themwith an increasing degree of risk aversion.At times, markets have also overreacted to national news and to thepolitical debate at euro area level, with yields subsequently displayinglittle mean reversion.Fragmentation of credit market across national bordersThe second dimension of the debt crisis has been a fragmentation ofcredit markets across national borders, affecting both banks and the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 201. 201private non-financial sector – in addition to the fragmentationexperienced in government debt markets.The tight link between sovereign and bank creditworthiness is clearlyvisible in the high degree of correlation between sovereign CDS premiaand bank CDS premia within the same jurisdiction (see slide 8).Causality runs both ways: banks’ rising funding costs reflect the riskassociated with banks’ holdings of bonds issued by their own sovereign;and sovereign risk is exacerbated by the contingent liabilities comingfrom the perception that the government will have to intervene torescue the domestic financial system.This creates a self-reinforcing loop between bank and sovereign risks,with doubts about the solvency of the sovereigns feeding doubts aboutthe solvency of the banks, and vice versa.Such dynamics are much weaker in euro area countries considered bymarkets as financially solid.In the US – an example of a well-integrated fiscal and financial union,with a shock-absorbing capacity at the federal level, credible discipline atstate level and a centralised mechanism to supervise and resolve banks– there is no correlation between bank and sovereign CDS premia.With hindsight, the “original sins” of Economic and Monetary Union, anotherwise carefully thought-through and consistent project, were weakfiscal institutions, tolerance of economic imbalances and the lack of anintegrated mechanism to supervise and resolve banks.As a matter of fact, financial fragmentation has led to a “two-gear”monetary union, in which the marginal cost of borrowing for banks variesaccording to the jurisdiction.1. Banks belonging to jurisdictions considered by markets as financiallysound can generally access the interbank money market and get Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 202. 202overnight financing at the EONIA rate, which is currently as low as0.10%.2. Banks in jurisdictions where risks and uncertainty are elevatedgenerally have limited access to the interbank money market and rely to alarge extent on central bank liquidity, charged at the MRO rate, currently0.75%.The distressed funding conditions faced by banks in some parts of theeuro area, compounded by expectations of a worsening macroeconomicoutlook, have in turn resulted in fragmented credit conditions forhouseholds and firms, again along national borders.For one thing, credit supply standards applied by banks in their lendingto the real economy have diverged across euro area countries.A similar message comes from the cross-country comparison of banklending rates.The 75 basis point cut in the ECB main policy rate implemented in late2011 has been accompanied by little reaction or even an increase oflending rates in countries under stress, whereas there has been acomplete pass-through in euro area countries considered by the marketsas financially solid (see slide 9).Self-fulfilling equilibria driven by break-up fearsThe third, and most recent, dimension of the debt crisis has taken theform of investor fears of a break-up of the currency union.Whereas exchange rate risk across euro area countries should havedisappeared permanently with the creation of the single currency in 1999,there have been signs, especially over the summer, that investors havestarted pricing in redenomination risk.Investors require a compensation for the risk that the euro might not Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 203. 203remain the irreversible currency of the euro area – at least in its currentcomposition.Although it is difficult to disentangle redenomination premia from othersources of risks – and it requires econometric analysis – the inversion ofthe slope of the term structure of sovereign bond spreads observed inearly summer 2012, for instance, for Spain and Italy was consistent withexpectations of imminent break-up risks.Market fears of a high probability of not paying back in full, or ofequivalently to repaying in a different, lower-valued currency, commandhigh spreads.If the probability of this event concentrates over the short horizon, thenthe cumulative default probability for longer horizons (bounded overallby 100%) cannot rise much further, and inversion of the spread curvenecessarily follows.Redenomination premia share some similarities with exchange ratepremia that were driven out of control in the early 1990s by speculativeattacks against the legacy currencies.The early symptoms – inverted sovereign yield curves, at least for somecontries – were the same.And the potential of such attacks is known to generate self-fulfillingprophecies.In early summer 2012 this situation had two main implications.One was for fiscal policy: it needs to deliver sound fundamentals as theonly way to lastingly overcome the crisis; but, at the same time, there canbe no viable fiscal adjustment that can ensure sustainability if the interestrate faced by the fiscal authority keeps rising and there are severedistortions in government bond markets. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 204. 204The second implication was for monetary policy: the central bank cannotfulfil its mandate to maintain price stability if its policy intentions are nottransmitted correctly to the real economy through the chain which formsthe basis for monetary policy transmission; but, at the same time, thecentral bank cannot fulfil its mandate to maintain price stability if thefiscal authority does not fully honour its obligation to pay back itsliabilities under all circumstances.How to make these apparently conflicting instances compatible? Andhow to overcome the deadlock?The ECB policy response: Outright Monetary TransactionsGuidance to answer these questions can be derived from the MaastrichtTreaty and the conceptual apparatus developed in the context of theeconomic literature on monetary vs. fiscal dominance.These insights have made clear that, from an institutional designperspective, central bank independence and a clear focus on pricestability are necessary but not sufficient to ensure that the central bankcan provide a regime of low and stable inflation under all circumstances –in the economic jargon, ensuring “monetary dominance”.Maintaining price stability also requires appropriate fiscal policy.To borrow from Leeper’s terminology, this means that an “active”monetary policy – namely a monetary policy that actively engages in thesetting of its policy interest rate instrument independently and in theexclusive pursuit of its objective of price stability – must be accompaniedby “passive” fiscal policy.A passive fiscal policy means that the fiscal authority must be ready andwilling to adjust its policy stance (revenues and primary spending) insuch a way as to stabilise its debt at any level of the interest rate that thecentral bank may choose. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 205. 205Or, to put it another way, borrowing from Woodford’s terminology, fiscalpolicy needs to be “Ricardian”.Although the Treaty shows an awareness of the need for consistencybetween monetary and fiscal policy, in the sense described above, toensure lasting stability, it did not foresee that fiscal policy could go offtrack to an extent that requires dedicated institutions and policies able toprovide financial assistance, against conditionality, in order to restoresustainability and preserve financial stability in the euro area.The creation of the EFSF/ESM in charge of providing support to euroarea Member States in difficulties and enforcing appropriateconditionality has filled this gap.It provides the euro area with a means to restore “Ricardianess”, therebyminimising the risk of “fiscal dominance”.Against this background, it is easy to understand the ECB’s decision on 6September to undertake Outright Monetary Transactions (OMTs) insecondary markets for sovereign bonds in the euro area, and tounderstand the specific framework within which they will beimplemented.The aim of OMTs is to preserve the singleness of monetary policy and toensure the proper transmission of the monetary policy stance to the realeconomy throughout the euro area. OMTs are intended to provide theECB with a tool to address severe distortions in government bondmarkets which originate from, in particular, unfounded fears on the partof investors of the reversibility of the euro.Effectively, OMTs represent a means to rule out destructive self-fulfillingprophecies that would force the economy into a sub-optimal equilibrium(with elevated interest rates, adjustments made impossible, ultimatelyleading to default and currency redenomination). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 206. 206Meanwhile, OMTs preserve the incentives for governments to enforce theeconomic and fiscal adjustments which will prove necessary to steer theeconomy towards the “good” equilibrium.As a consequence, OMTs can succeed only if action is taken bygovernments, at national and at euro area level, to restore long-termgrowth and bridge fiscal and economic imbalances.The framework for OMTs is based on six main elements (see slide 10).First, strict and effective conditionality.A necessary condition for initiating OMTs is that a Member Stateactivates an appropriate EFSF/ESM programme, which envisages strictand effective conditionality spanning the fiscal, macroeconomic,structural and financial spheres.And the design of conditionality and the monitoring of such a programmecan largely benefit from the involvement of the IMF.This is however not sufficient.The country also needs to maintain (at least some) market access.And this is signalled by the reference the ECB has made to the need forthe EFSF/ESM programme to include the possibility of primary marketpurchases.In addition, and most importantly, the Governing Council maintains fulldiscretion to initiate OMTs, focusing its assessment exclusively onmonetary policy considerations.The second main element on which the framework for OMTs is based is abuilt-in exit strategy. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 207. 207OMTs will be terminated when one of the following conditionsmaterialises.OMTs are no longer warranted due to threats to price stability; the aim ofOMTs has been achieved; there is non-compliance with theconditionality established in the EFSF/ESM programme.This announced rules-based approach represents a way to address timeinconsistency.Third, OMTs will focus on the shorter part of the yield curve, and inparticular on sovereign bonds with a maturity of between one and threeyears.This underscores the monetary policy nature of such outrighttransactions, the principle of which was foreseen in the ECB Statute.And it buttresses the OMTs’ aim to address reversibility premia which, asI argued above, have tended to manifest themselves at the short end of theterm structure, while addressing the fact that credit risk embedded inlonger-term yields should reflect the credibility of countries’ economicand financial adjustment programmes.Fourth, there are no ex ante quantitative limits on the size of OMTs.This makes clear that the ECB is committed to do whatever it takes,within its mandate, to preserve the solidity and irreversibility of thecurrency.Fifth, the ECB accepts the same (pari passu) treatment as private or othercreditors with respect to bonds purchased in the context of OMTs.Finally, the liquidity created through OMTs will be fully sterilised.This reflects the role of OMTs in counteracting destructive self-fulfillingequilibria rather than altering the aggregate liquidity stance. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 208. 208The main features of the framework for OMTs outlined here address bydesign also three concerns or questions sometimes voiced in relation tooutright purchases of government bonds by a central bank.The first concern can be summed up in two questions:Are OMTs a form of monetary financing of governments and will inflationbe unleashed?The answer to both questions is: No. In fact, quite the opposite.OMTs will be conducive to the monetary authority restoring itspower to control credit conditions in the euro area and, through thatchannel, inflation in the medium term.It thus creates the conditions for a transition from a regime ofundisciplined fiscal policies – from a “non-Ricardian” or “active” fiscalpolicy, using the terminology of the economic literature referred to above– to a regime where fiscal policy respects its inter-temporal obligations –it becomes “Ricardian”, or “passive”.This means that monetary policy has regained its pre-eminence indetermining credit conditions and inflation.This renewed assignment of tasks pushes back fiscal dominance andaffirms monetary dominance.The second concern can be formulated in terms of the question: willOMTs bring large risks to the central bank’s balance sheet?The answer again is: no. OMTs establish a second type of interaction:between the central bank, real money investors and households and firms,which save and borrow to finance real economic activity. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 209. 209To the extent that break-up and reversibility premia are squeezed out ofbond pricing, real money investors will return to the euro area securitiesmarket, and the prices of securities will again better reflect thefundamentals.Households and firms will benefit from restored credit conditions.And the associated widespread reassessment of risks will make marketportfolios and the central bank portfolios grow in value.Ultimately, strict and effective conditionality could be seen as acting as acredit enhancement of all euro area portfolios.The third question is whether OMTs are a form of quantitative easing(QE).The answer is: no.First of all, QE is meant to ease the general credit conditions which areconsidered by the central bank to have become tight in a situation inwhich the short-term interest rate cannot be reduced further.OMTs are meant instead to restore homogeneous credit conditionsthroughout the euro area, but not necessarily to ease credit conditions inthe aggregate.In the euro area as a region, there are currently no clear signs of deflationfears (see slide 11) that would justify QE.In addition, the channels of transmission are different.QE is expected to act on risk premia (primarily term premia) bysubtracting long-duration securities from the market and replacing themwith base money, which has a very short duration.This would reduce term premia and bid up the price of long-datedsecurities. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 210. 210The aim of OMTs however is not to create an excess demand for durationin the market, but to counteract redenomination risk and squeezeredenomination premia out of bond prices.In fact, OMTs focus on relatively short maturities, where premiaassociated with break-up risk are most evident.Finally, QE would need to be tailored to the specificities of the euro area,where two-thirds of the external financing of non-financial corporations isextended by banks and which does not have access to actively tradedcredit markets.ConclusionsLet me conclude. The effectiveness of monetary policy relies on thecontrol of monetary and credit conditions.This ability has been severely tested by the crisis.Some of the challenges faced by the ECB have been common to othercentral banks.The threat to the viability of the interest rate channel, and the consequentneed to devise alternative (“non-standard”) measures exploiting otherchannels of transmission, is a prominent example.The crisis has taught us that the liquidity channel exploited by monetarypolicy in the euro area can be very powerful.It has allowed the ECB to maintain the flow of credit to the real economyand ensure price stability even in face of the soaring liquidity and fundingrisks experienced by banks during the crisis. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 211. 211Other challenges faced by the ECB have taken a specific form in the euroarea and thus been somewhat different from those experienced by centralbanks elsewhere.The most obvious one is the sovereign debt crisis, with the associatedfragmentation of credit markets across national borders and morerecently the break-up fears.The destructive potential of these developments is enormous.This has led the ECB to recently announce its Outright MonetaryTransactions in secondary markets for sovereign bonds as a means tosafeguard the monetary policy transmission mechanism in all countries ofthe euro area and to counteract self-fulfilling prophecies.The design of OMTs has been inspired by the desire to affirm in a lastingmanner “monetary dominance”, in compliance with the principlesenshrined in the Maastricht Treaty.Going forward, the ECB remains committed to do whatever it takes tocomply with its mandate of maintaining price stability in the euro area. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
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  • 219. 219Joint Forum, Principles for thesupervision of financial conglomeratesCorporate GovernanceBroadly, corporate governance describes theprocesses, policies and laws that govern how acompany or group is directed, administered orcontrolled.It defines the set of relationships between acompany’s management, its board, itsshareholders, and other recognisedstakeholders.Corporate governance also provides the structure through which theobjectives of the company are set, and the means of attaining thoseobjectives and monitoring performance are determined.Good corporate governance should provide proper incentives for theboard and management to pursue objectives that are in the interests ofthe company and its shareholders and should facilitate effectivemonitoring.The presence of an effective corporate governance system, within anindividual company or group and across an economy as a whole, helps toprovide a degree of confidence that is necessary for the properfunctioning of a market economy.Financial conglomerates are often complex groups with multipleregulated and unregulated financial and other entities.Given this inherent complexity, corporate governance must carefullyconsider and balance the combination of interests of recognisedstakeholders of the ultimate parent, and the regulated financial and otherentities of the group. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 220. 220Ensuring that a common strategy supports the desired balance and thatregulated entities are compliant with regulation on an individual and onan aggregate basis should be a goal of the governance system.This governance system is the fiduciary responsibility of the board ofdirectors.When assessing corporate governance across a financial conglomerate,supervisors should apply these principles in a manner that is appropriateto the relevant sectors and the supervisory objectives of those sectors.This section describes the elements of the governance system mostrelevant to financial conglomerates, and how they should be assessed bysupervisors.Corporate governance in financial conglomerates10. Supervisors should seek to ensure that the financial conglomerateestablishes a comprehensive and consistent governance frameworkacross the group that addresses the sound governance of the financialconglomerate, including unregulated entities, without prejudice to thegovernance of individual entities in the group.Implementation criteria10(a) Supervisors should require that the corporate governanceframework of the financial conglomerate has minimum requirements forgood governance of the entities of the financial conglomerate which allowfor the prudential and legal obligations of its constituent entities to beeffectively met.The ultimate responsibility for the sound and prudent management of afinancial conglomerate rests with the board of the head of the financialconglomerate. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 221. 22110(b) Supervisors should require that the financial conglomerateemphasises a high degree of integrity in the conduct of its affairs.10(c) Supervisors should seek to ensure that the corporate governanceframework appropriately balances the diverging interests of constituententities and the financial conglomerate as a whole.10(d) Supervisors should require that the governance framework respectsthe interests of policy holders and depositors (where relevant), and shouldseek to ensure that it respects the interests of other recognisedstakeholders of the financial conglomerate and the financial soundness ofentities in the financial conglomerate.10(e) Supervisors should require that the governance framework includesadequate policies and processes that enable potential intra-groupconflicts of interest to be avoided, and actual conflicts of interest to beidentified and managed.Explanatory comments10.1 The corporate governance framework should address whereappropriate:• Alignment to the structure of the financial conglomerate;• Financial soundness of the significant owners;• Suitability of board members, senior management and key persons incontrol functions including their ability to make reasonable and impartialbusiness judgments;• Fiduciary responsibilities of the boards of directors and seniormanagement of the head company and material subsidiaries; Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 222. 222• Management of conflicts of interest, in particular at the intra-group leveland remuneration policies and practices within the financialconglomerate; and• Internal control and risk management systems and internal audit andcompliance functions for the financial conglomerate.10.2 The group’s corporate governance framework should notably includea strong risk management framework (refer to the Risk Managementsection), a robust internal control system, effective internal audit andcompliance functions, and ensure that the group conducts its affairs withappropriate independence and a high degree of integrity.10.3 Group-wide governance not only involves the governance of the headof the financial conglomerate, but also applies group-wide to all materialactivities and entities of the financial conglomerate.10.4 In the event the local corporate governance requirements applicableto any particular material entity in the financial conglomerate are belowthe group standards, the more stringent group corporate governancestandards should apply, except where this would lead to a violation oflocal law.10.5 Supervisors should require that the corporate governance frameworkof the financial conglomerate includes a code of ethical conduct.10.6 Supervisors should require that the financial conglomerate have inplace policies focused on identifying and managing potential intra-groupconflicts of interest, including those that may result from intra-grouptransactions, charges, up streaming dividends, and risk-shifting.The policies should be approved by the board of the head of the financialconglomerate and be effectively implemented throughout the group.The policies should recognise the long-term interest of the financialconglomerate as a whole, the long term interest of the significant entities Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 223. 223of the financial conglomerate, the stakeholders within the financialconglomerate, and all applicable laws and regulations.Structure of the financial conglomerate11. Supervisors should seek to ensure that the financial conglomerate hasa transparent organisational and managerial structure, which isconsistent with its overall strategy and risk profile and is well understoodby the board and senior management of the head company.Implementation criteria11(a) Supervisors should understand the financial conglomerate’s groupstructure and the impact of any proposed changes to this structure.11(b) Supervisors should assess the ownership structure of the financialconglomerate, including the financial soundness and integrity of itssignificant owners.11(c) Supervisors should seek to ensure that the structure of the financialconglomerate does not impede effective supervision. Supervisors mayseek restructuring under appropriate circumstances to achieve this, ifnecessary.11(d) Supervisors should seek to ensure that the board and seniormanagement of the head of the financial conglomerate are capable ofdescribing and understanding the purpose, structure, strategy, materialoperations, and material risks of the financial conglomerate, includingthose of unregulated entities that are part of the financial conglomeratestructure.11(e) Supervisors should assess and monitor the financial conglomeratesprocess for approving and controlling structural changes, including thecreation of new legal entities.11(f) Where the financial conglomerate is part of a wider group,supervisors should require that the board and senior management of the Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 224. 224head of the financial conglomerate have governance arrangements thatenable material risks stemming from the wider group structure to beidentified and appropriately assessed by relevant supervisory authorities.11(g) Supervisors should seek to ensure that there is a frameworkgoverning information flows within the financial conglomerate andbetween the financial conglomerate and entities of the wider group (egreporting procedures).Explanatory comments11.1 A financial conglomerate may freely set its functional, hierarchical,business and/or regional organisation, provided all entities within thefinancial conglomerate comply with their relevant sectoral and legalframeworks.11.2 Elements to be considered for assessing the significant ownershipstructure of the financial conglomerate may include the identification ofsignificant owners, including the ultimate beneficial owners, thetransparency of their ownership structure, their financial information, andthe sources of their initial capital and all other requirements of nationalauthorities.At a minimum, the necessary qualities of significant owners relate to theintegrity demonstrated in personal behaviour and business conduct, aswell as to the ability to provide additional support when needed.11.3 Supervisors should seek to ensure that a financial conglomerate hasan organisational and managerial structure that promotes and enablesprudent management, and if necessary, orderly resolution aligned withcorresponding sectoral requirements.Reporting lines within the financial conglomerate should be clear andshould facilitate information flows within the financial conglomerate,both bottom-up and top-down. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 225. 22511.4 Supervisors should be satisfied that the board and seniormanagement of the head of the financial conglomerate understand andinfluence the evolution of an appropriate group legal structure inalignment with the approved business strategy and risk profile of thefinancial conglomerate, and understand how the various elements of thestructure relate to one another.Where a financial conglomerate creates many legal entities, their numberand, particularly, the interconnections and transactions between them,may pose challenges for the design of effective corporate governancearrangements.This risk should be recognised and managed.This is particularly the case where the organisational and managerialstructure of the financial conglomerate deviates from the legal entitystructure of the financial conglomerate.11.5 Supervisors should assess changes to the group structure and howthese changes impact its soundness, especially where such changes causethe financial conglomerate to engage in activities and/or operate injurisdictions that impede transparency or do not meet internationalstandards stemming from sectoral regulation.Suitability of board members, senior managers and key personsin control functions12. Supervisors should seek to ensure that the board members, seniormanagers and key persons in control functions in the various entities in afinancial conglomerate possess integrity, competence, experience andqualifications to fulfil their role and exercise sound objective judgment.Implementation criteria12(a) Supervisors should be satisfied of the suitability of board members,senior managers and key persons in control functions. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 226. 22612(b) Supervisors should require financial conglomerates to havesatisfactory processes for periodically assessing suitability.12(c) Supervisors should require that the members of the boards of thehead of the financial conglomerate and of its significant subsidiaries actindependently of parties and interests external to the wider group; andthat the board of the head of the financial conglomerate include a numberof members acting independently of the wider group (including owners,board members, executives, and staff of the wider group).12(d) Supervisors should communicate with the supervisors of otherregulated entities within the conglomerate when board members, seniormanagement and key persons in control functions are deemed not tomeet their suitability tests.Explanatory comments12.1 Board members, senior managers and key persons in controlfunctions need to have appropriate skills, experience and knowledge, andact with care, honesty and integrity, in order to to make reasonable andimpartial business judgments and strengthen the protection afforded torecognised stakeholders.To this end, institutions need to prudently manage the risk that personsin positions of responsibility may not be suitable.Suitability criteria may vary depending on the degree of influence on orthe responsibilities for the financial conglomerate.12.2 Supervisors of regulated entities of the financial conglomerate aresubject to statutory and other requirements in applying suitability tests tothese entities in their jurisdiction.The organisational and managerial structure of financial conglomeratesadds elements of complexity for supervisors seeking to ensure thesuitability of persons. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 227. 227For instance, the management of regulated entities within the financialconglomerate can be extensively influenced by persons who are notdirectly responsible for such functions.A group-wide perspective regarding suitability of persons is intended toclose any loopholes in this respect.Supervisors may rely on assessments made by other relevant supervisorsin this area regarding suitability.Alternatively they may decide on concerted supervisory actions regardingsuitability if required.12.3 In order to meet suitability requirements, board members, seniormanagers and key persons in control functions, both individually andcollectively, should have and demonstrate the ability to perform the dutiesor to carry out the responsibilities required in their position.Competence can generally be judged from the level of professionalism (egpertinent experience within financial industries or other businesses)and/or formal qualifications.12.4 Serving as a board member or senior manager of a company (fromthe wider group) that competes or does business with the regulatedentities in the financial conglomerate can compromise independentjudgment and create conflicts of interest, as can cross-membership onboards.A board’s ability to exercise objective judgment independent of the viewsof executives and of inappropriate political or personal interests can beenhanced by recruiting members from a sufficiently broad population ofcandidates.The key characteristic of independence is the ability to exercise objective,independent judgment after fair consideration of all relevant informationand views without undue influence from executives or from inappropriate Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 228. 228external parties and interests and while taking into account therequirements of applicable law.Responsibility of the board of the head of the financialconglomerate13. Supervisors should require that the board of the head of the financialconglomerate appropriately defines the strategy and risk appetite of thefinancial conglomerate, and ensures this strategy is implemented andexecuted in the various entities, both regulated and unregulated.Implementation criteria13(a) Supervisors should require that the board of the head of the financialconglomerate has in place a framework for monitoring compliance withthe strategy and risk appetite across the financial conglomerate.13(b) Supervisors should require that the board of the head of the financialconglomerate regularly assesses the strategy and risk appetite of thefinancial conglomerate to ensure it remains appropriate as theconglomerate evolved.13(c) Where the financial conglomerate is part of a wider group,supervisors should assess whether the head is managing its relationshipwith the wider group and ultimate parent in a manner that is consistentwith the governance framework of the financial conglomerate.13(d) Supervisors should require that a framework is in place which seeksto ensure resources are available across the financial conglomerate forconstituent entities to meet both the group and their own entity’sgovernance standards.Explanatory comments Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 229. 22913.1 Supervisors should assess if the board of directors exercises adequateoversight over the management of the head of the financial conglomerate.This includes assessing the actions taken by the board of the head todefine the strategy for the financial conglomerate and ensure theconsistency of the operations of the various entities in the financialconglomerate with such strategy.To this end, the head company should set up an adequate corporategovernance framework in line with the structure, business and risks of thefinancial conglomerate and its entities and applicable laws.This framework should ensure that the strategy is implemented andmonitored throughout the financial conglomerate and reviewed on aregular basis and following material change including due to growth,increased complexity, geographic expansion, etc.13.2 The head company should exercise adequate oversight ofsubsidiaries, both regulated and unregulated, while respectingindependent legal and governance responsibilities.Supervisors should satisfy themselves that entities within a financialconglomerate adhere to the same group-wide corporate governanceprinciples or at least apply policies that remain consistent with theseprinciples.The board of a regulated subsidiary of a financial conglomerate will retainand set its own corporate governance responsibilities and practices in linewith its own legal requirements or in proportion to its size or business.These should not, however, conflict with the broader financialconglomerate corporate governance framework.Appropriate governance arrangements will address arrangements suchthat legal or regulatory provisions or prudential rules of regulatedsubsidiaries will be known and taken into account by the head company. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 230. 23013.3 Where the financial conglomerate is part of a wider group structure,the head of the financial conglomerate is responsible for managing therelationship with its wider group.This includes ensuring there are appropriate arrangements for capital andliquidity management, assessing any material risk impact that may comefrom decisions made at its ownership level, service level agreements,reporting lines and regular top-level consultations with related companiesin the wider group and the ultimate parent.13.4 For smaller institutions within a larger conglomerate, it may beunnecessary to duplicate systems and controls.Such smaller institutions can rely on the systems and controls of the headif they have assessed that this is suitable to address group risks.13.5 Supervisors should be satisfied with the amount and quality ofinformation they receive from the head company of the financialconglomerate on its strategy, risk appetite and corporate governanceframework.Remuneration in a financial conglomerate14. Supervisors should require that the financial conglomerate has andimplements an appropriate remuneration policy that is consistent with itsrisk profile. The policy should take into account the material risks thatorganisation is exposed to, including those from its employees’ activities.Implementation criteria14(a) Supervisors should require that an appropriate remuneration policyconsistent with established international standards is in place andobserved at all levels and across jurisdictions in the financialconglomerate. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 231. 231An appropriate policy aligns risk-takers’ variable remuneration withprudent risk taking, promotes sound and effective risk management, andtakes into account any other appropriate factors.The overarching objective of the policy should be consistent across thegroup but can allow for reasonable differences based on the nature of theconstituent entities/units and local legal requirements.14 (b) Supervisors should require that ultimate oversight of theremuneration policy rest with the financial conglomerate’s headcompany.14(c) Supervisors should require that the remuneration of board members,senior managers and key persons in control functions be determined in amanner that does not incentivise them to disregard the obligations theyowe to the financial conglomerate or any of its entities, nor to otherwiseact in a manner contrary to any legal or regulatory obligations.14(d) Supervisors should require that the risks associated withremuneration are reflected in the financial conglomerate’s broader riskmanagement framework.For example, staff engaged in financial and risk control at the group-widelevel should be compensated in a manner that is consistent with theircontrol role and should be involved in designing incentive arrangements,and assessing whether such arrangements encourage imprudentrisk-taking.14(e) Supervisors should require that the variable remuneration receivedby risk management and control personnel is not based substantially onthe financial performance of the business units that they review but ratheron the achievement of the objectives of their functions (eg adherence tointernal controls). Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 232. 232Explanatory comments14.1 Remuneration is a key aspect of any governance framework andneeds to be properly considered in order to mitigate the risks that mayarise from poorly designed remuneration arrangements.The risks associated with remuneration should be reflected in thefinancial conglomerate’s broader risk management framework.14.2 Remuneration may serve important objectives, including attractingskilled staff, promoting better organisation-wide and employeeperformance, promoting retention, providing retirement security andallowing personnel costs to vary with revenues.It is also clear, however, that ill-designed compensation arrangementscan provide incentives to take risks that are not consistent with the longterm health of the organisation. Such risks and misaligned incentives areof particular supervisory interest.14.3 Ultimately a financial conglomerate’s remuneration policy shouldaim to ensure effective governance of remuneration, alignment ofremuneration with prudent risk-taking, and engagement of recognisedstakeholders.14.4 Supervisors should ensure that the governance system identifies andcloses loopholes that allow the circumvention of conglomerate, sectoral orentity-level remuneration requirements.14.5 Board members, senior managers and key persons in controlfunctions should be measured against performance criteria tied not onlyto the short-term, but also to the long-term interest of the financialconglomerate as a whole. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 233. 233V. Risk ManagementSince financial conglomerates are in the business of risk-taking, good riskmanagement is a crucial focus of supervision.This section provides principles for the sound and comprehensivesupervision of risk management frameworks in financial conglomerates.It covers factors ranging from risk culture and tolerance, to the use ofstress and scenario testing and the monitoring of risk concentrations.Risk management framework21. Supervisors should require that an independent, comprehensive andeffective risk management framework, accompanied by a robust systemof internal controls, effective internal audit and compliance functions, isin place for the financial conglomerate.Implementation criteria21(a) Supervisors should ensure that the risk management framework iscomprehensive, consistent across entities supervised in all sectors andcovers the risk management function, risk management processes andgovernance, and systems and controls.Risk management function21(b) Supervisors should require that the risk management function isindependent from the business units and has a sufficient level of authorityand adequately skilled resources to carry out its functions.21(c) Supervisors should require that the risk management functiongenerally has a direct reporting line to the board and senior managementof the financial conglomerate.21(d) Supervisors should, where they consider it appropriate, require that Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 234. 234a separate risk management committee at the board of directors level isestablished by the financial conglomerate.Risk management governance21(e) Supervisors should require that the board of the head of the financialconglomerate has overall responsibility for the financial conglomerate’sgroup-wide risk management, internal control mechanism, internal auditand compliance functions to ensure that the group conducts its affairswith a high degree of integrity.21(f) Supervisors should require that the financial conglomerate has anestablished enterprise-wide risk management process for, among others,periodically reviewing the effectiveness of the group-wide riskmanagement framework and for ensuring appropriate aggregation ofrisks.21(g) Supervisors should require that the risk management process coveridentification, measurement, monitoring and controlling of risk types (egcredit risk, operational risk, strategic risk, liquidity risk) and these belinked where appropriate to specific capital requirements.Systems and controls21(h) Supervisors should require that financial conglomerates have inplace adequate, sound and effective risk management processes andinternal control mechanisms at the level of the financial conglomerate,including sound administrative and accounting procedures.21(i) Supervisors should require that risk management processes andinternal control mechanisms of a financial conglomerate areappropriately documented and, at a minimum, take into account the:• nature, scale and complexity of its business;• diversity of its operations, including geographical reach ; Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 235. 235• volume, frequency and size of its transactions;• degree of risk associated with each area of its operation;• interconnectedness of the entities within the financial conglomerate(using intra-group transactions and exposures reporting as one measure);and• sophistication and functionality of information and reporting systems.Explanatory comments21.1 Financial conglomerates, irrespective of their particular mix ofbusiness lines or financial sectors, are in the business of risk taking.Therefore, strong risk management is of paramount importance.21.2 The comprehensive risk management framework and process shouldinclude board and senior management oversight.21.3 In identifying, evaluating, monitoring, controlling and mitigatingmaterial risks (from regulated and unregulated activities), financialconglomerates should consider the prospect for these to change over timeand prepare themselves accordingly.21.4 The risk management processes and internal control mechanisms ofa financial conglomerate should include clear arrangements fordelegating authority and responsibility; segregation of the functions thatinvolve committing the financial conglomerate’s funds and accountingfor assets and liabilities; reconciliation of these processes; safeguarding ofthe financial conglomerate’s assets; and appropriate independent internalaudit and compliance functions to test adherence to these controls as wellas applicable laws and regulations.Risk tolerance levels and risk appetite policy23. Supervisors should require that the financial conglomerate establishes Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 236. 236appropriate board approved, group-wide risk tolerance levels and a riskappetite policy.Implementation criteria23(a) Supervisors should require that key staff, senior management andthe board of the head of the financial conglomerate be aware of andunderstand the financial conglomerate’s risk tolerance levels and riskappetite policy.23(b) Supervisors should require that the financial conglomerate identifyand measure against risk tolerance limits (and in line with its risk appetitepolicy) the risk exposure of the financial conglomerate on an on-goingbasis in order to identify potential risks as early as possible.This may include looking at risks by territory, by line of business, or byfinancial sector.Explanatory comments23.1 Financial conglomerates should establish risk tolerance levels and arisk appetite policy which set the tone for acceptable and unacceptablerisk taking.This should be aligned with the financial conglomerate’s businessstrategy, risk profile and capital plan.23.2 A financial conglomerate’s risk tolerance should be kept underperiodic review so as to ensure that it remains relevant and takes accountof the changing dynamics of the financial conglomerate.The financial conglomerate’s risk appetite policy is re-assessed regularlywith respect to new business opportunities, changes in risk capacity andtolerance, and operating environment. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 237. 237New business24. Supervisors should require that the financial conglomerate carries outa robust risk assessment when entering into new business areas.Implementation criteria24(a) Supervisors should, where they consider it appropriate, review therisk assessment carried out by a financial conglomerate in the context ofentering into new business.24(b) Supervisors should require that financial conglomerates not expandinto new products unless they have put in place adequate processes,controls and systems (such as IT) to manage them.24(c) Supervisors should make sure that a financial conglomerate carriesout the ongoing risk assessment after entering into new business areas.Explanatory comments24.1 At the time of assessing whether or not to enter into a new businessarea or product line, it is imperative that financial conglomeratesundertake risk assessments and analyses to identify potential risksinherent in the new activity.24.2 They should seek to understand the potential interaction between therisks of the new activity and the existing risk profile of the financialconglomerate.This should include a consideration of whether the new activity couldadversely affect the risk appetite or risk tolerance of the financialconglomerate. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 238. 238Outsourcing25. Supervisors should require that, when considering whether tooutsource a particular function, the financial conglomerate carries out anassessment of the risks of outsourcing, including the appropriateness ofoutsourcing a particular function.Implementation criteria25(a) Supervisors should require that financial conglomerates haveprocesses and criteria in place to review decisions to outsource a functionin order to ensure that such outsourcing does not imply delegation ofresponsibility for that function.25(b) Supervisors should be satisfied that the decision to outsource afunction does not impede effective group-wide supervision of thefinancial conglomerate.Explanatory comments25.1 It is important that supervisors be satisfied that, when consideringwhether to outsource a particular function, financial conglomerates haveconsidered the risks involved and the appropriateness of outsourcing aparticular function.This includes considering the appropriateness of outsourcing to aparticular provider and the cumulative risks of all outsourced functions.The supervisor should require the financial conglomerate to review theprovider in advance to ensure it is in a position to provide the services,comply with the contractual terms, and observe all applicable laws andregulations. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 239. 23925.2 Supervisors should periodically assess the outsourced function withregard to policy compliance, risk management measures and controlprocedures.25.3 Outsourcing should never result in a delegation of responsibility for agiven function.There may be certain functions within financial conglomerates whichshould not be outsourced under any circumstances, while there may besome that may only be outsourced if certain safeguards are put in place.Stress and scenario testing26. Supervisors should require, where appropriate, that the financialconglomerate periodically carries out group-wide stress tests andscenario analyses for its major sources of risk.Implementation criteria26(a) Supervisors should require that stress tests are sufficiently severe,forward looking and flexible.They should cover an appropriate set of business activities and include avariety of different types of tests such as sensitivity analyses, scenarioanalyses and reverse stress testing.26(b) Supervisors should require the financial conglomerate to documentits stress and scenario tests, including reverse stress tests.Stress tests should be conducted under a robust governance frameworkthat encompasses policies, procedures, and adequate documentation ofprocedures as well as validation of results.26(c) Supervisors should require that the group-wide stress tests andscenario analyses conducted by the financial conglomerate are Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 240. 240appropriate to the nature, scale and complexity of those major sources ofrisk and to the nature, scale and complexity of the financialconglomerate’s business.26(d) Supervisors should require that group-wide stress tests and scenarioanalyses include a group-wide approach (which takes account of theinteraction between different parts of the group and different risk types)and consider the results of sectoral stress tests.26(e) Supervisors should require that, when carrying out reverse stresstests, a financial conglomerate identifies a range of adversecircumstances which would cause its business to fail and assess thelikelihood of such events crystallising.Explanatory comments26.1 A financial conglomerate should have a good understanding ofcorrelation between its respective sectors and the heterogeneity of suchrisks when conducting its stress tests.Stress tests should be robust and should consider sufficiently adversecircumstances.The group-wide stress test analysis should measure and evaluate thepotential impact on individual entities.26.2 Attention should be paid to covering all risks, including off-balancesheet items.For example, a financial conglomerate’s stress tests and scenario analysesshould take into account the risk that the financial conglomerate mayhave to bring back on to its consolidated balance sheet the assets andliabilities of off-balance sheet entities as a result of reputationalcontagion, notwithstanding the appearance of legal risk transfer. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 241. 24126.3 Where reverse stress tests reveal a risk of business failure that isunacceptably high relative to the financial conglomerate’s risk appetite orrisk tolerance, the financial conglomerate should evaluate and adopt,where appropriate, effective arrangements, processes, systems or othermeasures to prevent or mitigate that risk.Risk aggregation27. Supervisors should require that the financial conglomerate aggregatethe risks to which it is exposed in a prudent manner.Implementation criteria27(a) Supervisors should require that financial conglomerates ***notmake overly ambitious diversification assumptions*** or imprudentcorrelation claims, particularly for capital adequacy and solvencypurposes.27(b) Supervisors should require financial conglomerates to haveadequate resources and systems (including IT) for the purpose ofaggregating risks.Explanatory comments27.1 Risk aggregation should include a clear understanding ofassumptions and be robust enough to support a comprehensiveassessment of risk.27.2 While it is possible that the spread of activities within a financialconglomerate may create diversification effects and reduce correlation, itis also true that membership of a financial conglomerate group maycreate “group risks” in the form of financial contagion, reputationalcontagion, ratings contagion (where a subsidiary accesses capitalthrough a parent’s credit rating and then suffers stress following theutilisation of the capital), double/multiple-gearing (use of same capital Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 242. 242more than once within a group), excessive leveraging (upgrade in thequality of capital as it moves through a group), and regulatory arbitrage(it is important that risks are assessed at the financial conglomerate levelas well as at the level of its constituent parts).Risk concentrations and intra-group transactions and exposures28. Supervisors should require that the financial conglomerate has inplace effective systems and processes to manage and report group-widerisk concentrations and intra-group transactions and exposures.Implementation criteria28(a) Supervisors should require that the financial conglomerate has inplace effective systems and processes to identify, assess and reportgroup-wide risk concentrations (including for the purposes of monitoringand controlling those concentrations).28(b) Supervisors should require that the financial conglomerate has inplace effective systems and processes to identify, assess and reportsignificant intra-group transactions and exposures.28(c) Supervisors should require the financial conglomerate to reportsignificant risk concentrations and intra-group transactions andexposures at the level of the financial conglomerate on a regular basis.28(d) Supervisors should consider setting quantitative limits andadequate reporting requirements.Explanatory comments28.1 Supervisors should ensure that financial conglomerates aremanaging their risk concentrations and intra-group transactions andexposures satisfactorily. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 243. 24328.2 Supervisors should encourage adequate public disclosure of riskconcentrations and intra-group transactions and exposures.28.3 Supervisors should liaise closely with one another to ascertain eachother’s concerns and coordinate as deemed appropriate any supervisoryaction relative to risk concentrations and intra-group transactions andexposures within the financial conglomerate.28.4 Supervisors should deal effectively with material risk concentrationsand intra-group transactions and exposures that are considered to have adetrimental effect on the regulated entities or the financial conglomerateas a whole.Off-balance sheet activities29. Supervisors should require that off-balance sheet activities, includingspecial purpose entities, are brought within the scope of group-widesupervision of the financial conglomerate, where appropriate.Implementation criteria29(a) Supervisors should require that there is a process for determiningwhether the nature of the relationship between the financial conglomerateand a special purpose entity (SPE) requires the SPE to be fully orproportionally consolidated into the financial conglomerate for regulatorypurposes.29(b) Supervisors should require that the financial conglomerate’s stresstests and scenario analyses take into account the risk associated with offbalance sheet activities.29(c) Supervisors should require that the overall nature of the relationshipbetween the financial conglomerate and the SPE is considered includingthe risk of contagion from the SPE. This assessment should go beyondtraditional control and influence relationships.Explanatory comments29.1 A financial conglomerate’s risk management framework andprocesses should cover the full spectrum of risks to the financial Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 244. 244conglomerate. This includes risks from regulated and unregulatedentities, including SPEs and off-balance sheet activities.29.2 The fact that a financial conglomerate does not own or control theSPE in the traditional sense should not mean that it should not beconsolidated.Other channels of contagion should be considered, such as the provisionof (actual or contingent) liquidity support, reputational risk, and whetherthe assets of the SPE previously belonged to the financial conglomerateor were third-party assets.29.3 It is important that financial conglomerates assess all economic risksand business purposes of an SPE throughout the life of a transaction,distinguishing between risk transfer and risk transformation.Financial conglomerates should be particularly aware that, over time, thenature of these risks can change.Supervisors should require such assessment to be ongoing and thatmanagement has sufficient understanding of the risks.29.4 Financial conglomerates should have the capability to aggregate,assess and report all their SPE exposure risks in conjunction with all otherfirm-wide risks.29.5 Supervisors should regularly oversee and monitor the use of all SPEactivity and assess the implications for the financial conglomerate of theactivities of SPEs, in order to identify developments that can lead tosystemic weakness and contagion or that can exacerbate pro-cyclicality. Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 245. 245The Basel iii Compliance Professionals Association (BiiiCPA) is thelargest association of Basel iii Professionals in the world. It is a businessunit of the Basel ii Compliance Professionals Association (BCPA), whichis also the largest association of Basel ii Professionals in the world. Basel III Speakers BureauThe Basel iii Compliance Professionals Association (BiiiCPA) hasestablished the Basel III Speakers Bureau for firms and organizationsthat want to access the Basel iii expertise of Certified Basel iiiProfessionals (CBiiiPros).The BiiiCPA will be the liaison between our certified professionals andthese organizations, at no cost. We strongly believe that this can be agreat opportunity for both, our certified professionals and the organizers.To learn more:www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 246. 246 Certified Basel iii Professional (CBiiiPro) Distance Learning and Online Certification ProgramThe all-inclusive cost is $297What is included in this price:A. The official presentations we use in our instructor-led classes(1426 slides)You can find the course synopsis at:www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Professional.htmlB. Up to 3 Online ExamsThere is only one exam you need to pass, in order to become a CertifiedBasel iii Professional (CBiiiPro). If you fail, you must study again theofficial presentations, but you do not need to spend money to try again.Up to 3 exams are included in the price.To learn more 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, printing and posting to your office or home.To become a Certified Basel iii Professional (CBiiiPro) you must followthe steps described at:www.basel-iii-association.com/Basel_III_Distance_Learning_Online_Certification.html Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
  • 247. 247Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

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