Monday January 14 2013 Top 10 Risk Compliance News Events
Upcoming SlideShare
Loading in...5

Monday January 14 2013 Top 10 Risk Compliance News Events



Monday January 14 2013 Top 10 Risk Compliance News Events

Monday January 14 2013 Top 10 Risk Compliance News Events



Total Views
Views on SlideShare
Embed Views



0 Embeds 0

No embeds



Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

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

Monday January 14 2013 Top 10 Risk Compliance News Events Monday January 14 2013 Top 10 Risk Compliance News Events Document Transcript

  • Page |1 International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the weeks agenda, and what is nextDear Member,This was a difficult week. We had significantamendments to the Basel iii liquidity rules.And we needed 206 pages for this weeklynewsletter… Sorry, important thingshappen.1. The LCR will be introduced as planned on 1 January 2015, but theminimum requirement will begin at 60%, rising in equal annual steps of10 percentage points to reach 100% on 1 January 2019.This graduated approach is designed to ensure that the LCR can beintroduced without disruption to the orderly strengthening of bankingsystems or the ongoing financing of economic activity.2. During periods of stress it would be entirely appropriate for banks touse their stock of high quality liquid assets (HQLA), thereby fallingbelow the minimum. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |23. Banks will be able to count a much wider variety of liquid assetstowards their buffers, including some equities and high-qualitymortgage-backed securities.4. European and American banking stocks surged because they will incurmuch reduced costs due to the implementation of the relaxed rules.5. Banks in many other counties will have no benefit, as supervisors havealready asked for strict liquidity rules, and they are not willing to take itback.6. On the negative side, the main objective of Basel iii is to restoreinvestor confidence. The Basel Committee has developed the newframework as a response to the crisis, and has explained (time and timeagain, every month since November 2010) the need for these strict rules.Although it is true that Basel iii is an overreaction to the market crisis, it isway too late now to “ease” the rules and make (clever) investors happythe same time.This is simply a red flag for many investors, leading to the conclusion thatbanks could not comply with the rules.I agree with the Liquidity Coverage ratio (LCR) Basel iii amendment, butI cannot agree with the way it was presented.Welcome to the Top 10 list. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |3Basel III - Group of Governors and Heads ofSupervision endorses revised liquiditystandard for banksThe Group of Governors and Heads of Supervision(GHOS), the oversight body of the Basel Committeeon Banking Supervision, met today to consider theBasel Committees amendments to the LiquidityCoverage Ratio (LCR) as a minimum standard.It unanimously endorsed them.Commissioner Michel BarnierThe impact of the latest BaselCommittee liquidity developments forCapital Requirements (CRD 4) in theEUIn the light of the Group of Governors and Heads of Supervision meetingand the Basel Committee on Banking Supervision press release dated 6January 2013Basel III: The LiquidityCoverage Ratio and liquidity risk monitoringtools, January 2013 _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |4Summary ResponsesTo the Commissions’Green Paper on ShadowBankingThe European Commissions consultation on shadow banking attractedhigh interest from stakeholders.The comments provided cover a broad range of issues and responded toall the questions raised by the European Commission Green Paper.The Commission received in total 140 contributions, of which 24 fromPublic Authorities; 47 from registered organisations; and, 64 fromindividual organisations.European Union: Financial SectorAssessment, Preliminary Conclusionsby the IMF StaffA Financial Sector Assessment Program (FSAP) team led by theMonetary and Capital Markets Department of the International MonetaryFund (IMF) visited the European Union (EU) during November27–December 13, 2012, to conduct a first-ever overall EU-wide assessmentof the soundness and stability of the EU’s financial sector (EU FSAP).European CybercrimeCentre (EC3) opens on 11January _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |5As from 11 January the new European Cybercrime Centre (EC3) will beup and running to help protect European citizens and businesses fromcyber-crime.EU Commissioner for Home Affairs Cecilia Malmström will participatein the official opening of the Centre established at the European PoliceOffice, Europol in the Hague (the Netherlands).Sebastian von Dahlen and Goetz von PeterNatural catastrophes and global reinsurance –exploring the linkagesNatural disasters resulting in significant losses havebecome more frequent in recent decades,with 2011 being the costliest year in history.This feature explores how risk is transferred within and beyond the globalinsurance sector and assesses the financial linkages that arise in theprocess.Morten Bech, Todd KeisterOn the liquidity coverage ratio and monetarypolicy implementationBasel III introduces the first global framework for bankliquidity regulation.As monetary policy typically involves targeting the interest rateon interbank loans of the most liquid asset – central _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |6bank reserves – it is important tounderstand how this newrequirement will impact theefficacy of current operationalframeworks.EIOPA – Risk DashboardSovereign risk – a world withoutrisk-free assetsPanel comments by Mr Patrick Honohan,Governor of the Central Bank of Ireland, atthe BIS Conference on “Sovereign risk – aworld without risk-free assets”, Basel, 8January 2013.What’s new about sovereign risk since thecrisis began?Conceptually, not so much, I would suggest – and nothing that cannot befully explained within standard models of finance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |7Basel III - Group of Governors and Headsof Supervision endorses revised liquiditystandard for banks6 January 2013The Group of Governors and Heads ofSupervision (GHOS), the oversight body of theBasel Committee on Banking Supervision, mettoday to consider the Basel Committeesamendments to the Liquidity Coverage Ratio (LCR) as a minimumstandard.It unanimously endorsed them.Todays agreement is a clear commitment to ensure that banks holdsufficient liquid assets to prevent central banks becoming the "lender offirst resort".The GHOS also endorsed a new Charter for the Committee, anddiscussed the Committees medium-term work agenda.The GHOS reaffirmed the LCR as an essential component of the BaselIII reforms.It endorsed a package of amendments to the formulation of the LCRannounced in 2010.The package has four elements:1. Revisions to the definition of high quality liquid assets (HQLA) and netcash outflows2. A timetable for phase-in of the standard _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |83. A reaffirmation of the usability of the stock of liquid assets in periods ofstress, including during the transition period4. An agreement for the Basel Committee to conduct further work on theinteraction between the LCR and the provision of central bank facilities.A summary description of the agreed LCR is in Annex 1.The changes to the definition of the LCR, developed and agreed by theBasel Committee over the past two years, include an expansion in therange of assets eligible as HQLA and some refinements to the assumedinflow and outflow rates to better reflect actual experience in times ofstress.These changes are set out in Annex 2.The GHOS agreed that the LCR should be subject to phase-inarrangements which align with those that apply to the Basel III capitaladequacy requirements.Specifically, the LCR will be introduced as planned on 1 January 2015, butthe minimum requirement will begin at 60%, rising in equal annual stepsof 10 percentage points to reach 100% on 1 January 2019.This graduated approach is designed to ensure that the LCR can beintroduced without disruption to the orderly strengthening of bankingsystems or the ongoing financing of economic activity.The GHOS agreed that, during periods of stress it would be entirelyappropriate for banks to use their stock of HQLA, thereby falling belowthe minimum.Moreover, it is the responsibility of bank supervisors to give guidance onusability according to circumstances.The GHOS also agreed today that, since deposits with central banks arethe most - indeed, in some cases, the only - reliable form of liquidity, the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • Page |9interaction between the LCR and the provision of central bank facilities iscritically important.The Committee will therefore continue to work on this issue over the nextyear.GHOS members endorsed two other areas of further analysis.First, the Committee will continue to develop disclosure requirements forbank liquidity and funding profiles.Second, the Committee will continue to explore the use of market-basedindicators of liquidity to supplement the existing measures based on assetclasses and credit ratings.The GHOS discussed and endorsed the Basel Committees medium-termwork agenda.Following the successful agreement of the LCR, the Committee will nowpress ahead with the review of the Net Stable Funding Ratio.This is a crucial component in the new framework, extending the scope ofinternational agreement to the structure of banks debt liabilities.This will be a priority for the Basel Committee over the next two years.Over the next few years, the Basel Committee will also:1. Complete the overhaul of the policy framework currently under way2. Continue to strengthen the peer review programme established in 2012to monitor the implementation of reforms in individual jurisdictions3. Monitor the impact of, and industry response to, recent and proposedregulatory reforms.During 2012 the Committee has been examining the comparability ofmodel-based internal risk weightings and considering the appropriate _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 10balance between the simplicity, comparability and risk sensitivity of theregulatory framework.The GHOS encouraged continuation of this work in 2013 as a matter ofpriority.Furthermore, the GHOS supported the Committees intention to promoteeffective macro- and microprudential supervision.The GHOS also endorsed a new Charter for the Basel Committee.The new Charter sets out the Committees objectives and key operatingmodalities, and is designed to improve understanding of the Committeesactivities and decision-making processes.Finally, the GHOS reiterated the importance of full, timely and consistentimplementation of Basel III standards.Mervyn King, Chairman of the GHOS and Governor of the Bank ofEngland, said,"The Liquidity Coverage Ratio is a key component of the Basel IIIframework.The agreement reached today is a very significant achievement.For the first time in regulatory history, we have a truly global minimumstandard for bank liquidity.Importantly, introducing a phased timetable for the introduction of theLCR, and reaffirming that a banks stock of liquid assets are usable intimes of stress, will ensure that the new liquidity standard will in no wayhinder the ability of the global banking system to finance a recovery."Stefan Ingves, Chairman of the Basel Committee and Governor of theSveriges Riksbank, noted: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 11"The amendments to the LCR are designed to ensure that it provides asound minimum standard for bank liquidity - a standard that reflectsactual experience during times of stress.The completion of this work will allow the Basel Committee to turn itsattention to refining the other component of the new global liquiditystandards, the Net Stable Funding Ratio, which remains subject to anobservation period ahead of its implementation in 2018."Annex 1Summary description of the LCRTo promote short-term resilience of a bank’s liquidity risk profile, theBasel Committee developed the Liquidity Coverage Ratio (LCR).This standard aims to ensure that a bank has an adequate stock ofunencumbered high quality liquid assets (HQLA) which consists of cashor assets that can be converted into cash at little or no loss of value inprivate markets to meet its liquidity needs for a 30 calendar day liquiditystress scenario.The LCR has two components:(a) The value of the stock of HQLA(b) Total net cash outflowsand is expressed as: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 12High Quality Liquid AssetsThe numerator of the LCR is the stock of HQLA.Under the standard, banks must hold a stock of unencumbered HQLA tocover the total net cash outflows over a 30-day period under theprescribed stress scenario.In order to qualify as HQLA, assets should be liquid in markets during atime of stress and, in most cases, be eligible for use in central bankoperations.Certain types of assets within HQLA are subject to a range of haircuts.HQLA are comprised of Level 1 and Level 2 assets.Level 1 assets generally include cash, central bank reserves, and certainmarketable securities backed by sovereigns and central banks, amongothers.These assets are typically of the highest quality and the most liquid, andthere is no limit on the extent to which a bank can hold these assets tomeet the LCR.Level 2 assets are comprised of Level 2A and Level 2B assets and includecertain marketable government securities as well as corporate debtsecurities, residential mortgage backed securities and equities that meetcertain conditions.Level 2 assets (comprising Level 2A and Level 2B assets) are typically ofslightly lesser quality and may not in aggregate account for more than40% of a bank’s stock of HQLA.Level 2B assets may not account for more than 15% of a bank’s total stockof HQLA. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 13Total net cash outflowsThe denominator of the LCR is the total net cash outflows.It is defined as total expected cash outflows, minus total expected cashinflows, in the specified stress scenario for the subsequent 30 calendardays.Total expected cash outflows are calculated by multiplying theoutstanding balances of various categories or types of liabilities andoff-balance sheet commitments by the rates at which they are expected torun off or be drawn down.Total expected cash inflows are calculated by multiplying the outstandingbalances of various categories of contractual receivables by the rates atwhich they are expected to flow in.Total cash inflows are subject to an aggregate cap of 75% of totalexpected cash outflows, thereby ensuring a minimum level of HQLAholdings at all times.Liquidity Coverage RatioThe standard requires that, absent a situation of financial stress, the valueof the ratio be no lower than 100% (ie the stock of HQLA should at leastequal total net cash outflows).Banks are expected to meet this requirement continuously and hold astock of unencumbered HQLA as a defence against the potential onset ofliquidity stress.During a period of financial stress, however, banks may use their stock ofHQLA, thereby falling below 100%.Important - The 100% threshold is the minimum requirement absent aperiod of financial stress, and after the phase-in arrangements arecomplete. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 14References to 100% may be adjusted for any phase-in arrangements inforce at a particular time.Annex 2Complete set of agreed changes to the Liquidity Coverage RatioHIGH QUALITY LIQUID ASSETS (HQLA)Expand the definition of HQLA subject to a higher haircut and limit- Corporate debt securities rated A+ to BBB– with a 50% haircut- Certain unencumbered equities subject to a 50% haircut- Certain residential mortgage-backed securities rated AA or higher with a25% haircutAggregate of additional assets, after haircuts, subject to a 15% limit of theHQLARating requirement on qualifying Level 2 assets- Use of local rating scales and inclusion of qualifying commercial paperUsability of the liquidity pool- Incorporate language related to the expectation that banks will use theirpool of HQLA during periods of stressOperational requirements- Refine and clarify the operational requirements for HQLAOperation of the cap on Level 2 HQLA- Revise and improve the operation of the cap _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 15Alternative liquid asset (ALA) framework- Develop the alternative treatments and include a fourth option forsharia-compliant banksCentral bank reserves- Clarify language to confirm that supervisors have national discretion toinclude or exclude required central bank reserves (as well as overnightand certain term deposits) as HQLA as they consider appropriateINFLOWS AND OUTFLOWSInsured deposits- Reduce outflow on certain fully insured retail deposits from 5% to 3%- Reduce outflow on fully insured non-operational deposits fromnon-financial corporates, sovereigns, central banks and public sectorentities (PSEs) from 40% to 20%Non-financial corporate deposits- Reduce the outflow rate for “non-operational” deposits provided bynon-financial corporates, sovereigns, central banks and PSEs from 75% to40%Committed liquidity facilities to non-financial corporates- Clarify the definition of liquidity facilities and reduce the drawdown rateon the unused portion of committed liquidity facilities to non-financialcorporates, sovereigns, central banks and PSEs from 100% to 30%Committed but unfunded inter-financial liquidity and credit facilities- Distinguish between interbank and inter-financial credit and liquidityfacilities and reduce the outflow rate on the former from 100% to 40%Derivatives _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 16- Additional derivatives risks included in the LCR with a 100% outflow(relates to collateral substitution, and excess collateral that the bank iscontractually obligated to return/provide if required by a counterparty)- Introduce a standardised approach for liquidity risk related to marketvalue changes in derivatives positions- Assume net outflow of 0% for derivatives (and commitments) that arecontractually secured/collateralised by HQLATrade finance- Include guidance to indicate that a low outflow rate (0–5%) is expectedto applyEquivalence of central bank operations- Reduce the outflow rate on maturing secured funding transactions withcentral banks from 25% to 0%Client servicing brokerage- Clarify the treatment of activities related to client servicing brokerage(which generally lead to an increase in net outflows)OTHERRules text clarifications- Clearer guidance on the usability of HQLA, and the appropriatesupervisory response, has been developed to ensure that the stock ofliquid assets is available to be used when needed- A number of clarifications to the rules text to promote consistentapplication and reduce arbitrage opportunities (eg operational depositsfrom wholesale clients, derivatives cash flows, open maturity loans). Alsoincorporation of previously agreed FAQ _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 17Internationally agreed phase-in of the LCR- The minimum LCR in 2015 would be 60% and increase by 10 percentagepoints per year to reach 100% in 2019 _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 18Basel Committee on Banking Supervision (BCBS) CharterJanuary 2013I. Purpose and role1. MandateThe BCBS is the primary global standard-setter for the prudentialregulation of banks and provides a forum for cooperation on bankingsupervisory matters.Its mandate is to strengthen the regulation, supervision and practices ofbanks worldwide with the purpose of enhancing financial stability.2. ActivitiesThe BCBS seeks to achieve its mandate through the following activities:(a) Exchanging information on developments in the banking sector andfinancial markets, to help identify current or emerging risks for the globalfinancial system;(b) Sharing supervisory issues, approaches and techniques to promotecommon understanding and to improve cross-border cooperation;(c) Establishing and promoting global standards for the regulation andsupervision of banks as well as guidelines and sound practices;(d) Addressing regulatory and supervisory gaps that pose risks tofinancial stability;(e) Monitoring the implementation of BCBS standards in membercountriesand beyond with the purpose of ensuring their timely, consistentand effective implementation and contributing to a "level playing field"among internationally-active banks;(f) Consulting with central banks and bank supervisory authorities whichare not members of the BCBS to benefit from their input into the BCBSpolicy formulation process and to promote the implementation of BCBS _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 19standards, guidelines and sound practices beyond BCBS membercountries; and(g) Coordinating and cooperating with other financial sector standardsetters and international bodies, particularly those involved in promotingfinancial stability.3. Legal statusThe BCBS does not possess any formal supranational authority. Itsdecisions do not have legal force.Rather, the BCBS relies on its members commitments, as described inSection 5, to achieve its mandate.II. Membership4. BCBS membersBCBS members include organisations with direct banking supervisoryauthority and central banks.After consulting the Committee, the BCBS Chairman may invite otherorganisations to become BCBS observers.BCBS membership and observer status will be reviewed periodically.In accepting new members, due regard will be given to the importance oftheir national banking sectors to international financial stability.The Committee will make recommendations to its oversight body, theGroup of Governors and Heads of Supervision, for changes in BCBSmembership.The Secretariat will publish the list of BCBS members and observers onits website.5. BCBS members responsibilitiesBCBS members are committed to: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 20(a) Work together to achieve the mandate of the BCBS;(b) Promote financial stability;(c) Continuously enhance their quality of banking regulation andsupervision;(d) Actively contribute to the development of BCBS standards, guidelinesand sound practices;(e) Implement and apply BCBS standards in their domestic jurisdictions2 within the pre-defined timeframe established by the Committee;(f) Undergo and participate in BCBS reviews to assess the consistencyand effectiveness of domestic rules and supervisory practices in relationto BCBS standards; and(g) Promote the interests of global financial stability and not solelynational interests, while participating in BCBS work anddecision-making.III. Oversight6. The Group of Governors and Heads of Supervision (GHOS)The GHOS is the oversight body of the BCBS.The BCBS reports to the GHOS and seeks its endorsement for majordecisions.In addition, the BCBS looks to the GHOS to:(a) Approve the BCBS Charter and any amendments to this document;(b) Provide general direction for the BCBS work programme(c) Appoint the BCBS Chairman from among its members. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 21If the BCBS Chairman ceases to be a GHOS member before the end ofhis/her term, the GHOS will appoint a new Chairman.Until a new Chairman has been appointed, the Secretary General assumesthe Chairmans functions.IV. Organisation7. StructureThe internal organisational structure of the BCBS comprises:(a) The Committee(b) Groups, working groups and task forces(c) The Chairman(d) The Secretariat8. The CommitteeThe Committee is the ultimate decision-making body of the BCBS withresponsibility for ensuring that its mandate is achieved.8.1 ResponsibilitiesThe Committee is responsible for:(a) Developing, guiding and monitoring the BCBS work programmewithin the general direction provided by GHOS;(b) Establishing and promoting BCBS standards, guidelines and soundpractices;(c) Establishing and disbanding groups, working groups and task forces;approving and modifying their mandates; and monitoring their progress;(e) Recommending to the GHOS amendments to the BCBS Charter; and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 22(f) Deciding on the organisational regulations governing its activities.8.2 Number of Committee meetingsThe Committee generally meets four times every year.However, the Chairman can decide to hold additional meetings asnecessary.8.3 Representation at Committee meetingsThe Chairman presides over Committee meetings.All BCBS members and observers are entitled to appoint onerepresentative to attend Committee meetings.BCBS representatives should be senior officials of their organisations andshould have the authority to commit their institutions.Representation at Committee meetings is expected to be, for example, atthe level of head of banking supervision, head of bankingpolicy/regulation, central bank deputy governor, head of financialstability department or equivalent.8.4 DecisionsDecisions by the Committee are taken by consensus among its members.8.5 Communication of decisionsCommittee decisions of public interest shall be communicated throughthe BCBS website.The Committee shall issue, when appropriate, press statements tocommunicate its decisions.9. Groups, working groups and task forcesThe BCBSs work is largely organised around groups, working groupsand task forces. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 23The Secretariat will make publicly available the list of BCBS groups andworking groups.9.1 GroupsBCBS groups report directly to the Committee.They are composed of senior staff from BCBS members that guide orundertake themselves major areas of Committee work. BCBS groupsform part of the permanent internal structure of the BCBS and thusoperate without a specific deliverable or end date.9.2 Working groupsWorking groups consist of experts from BCBS members that support thetechnical work of BCBS groups.9.3 Task forcesTask forces are created to undertake specific tasks for a limited time.These are generally composed of technical experts from BCBS memberinstitutions.However, when these groupings are created by the Committee, theyconsist of BCBS representatives and deal with specific issues that requireprompt attention of the Committee. In such cases, they are calledhigh-level task forces.10. ChairmanThe Chairman directs the work of the Committee in accordance with theBCBS mandate.10.1 AppointmentThe Chairman is appointed by the GHOS for a term of three years thatcan be renewed once.10.2 ResponsibilitiesThe Chairmans main responsibilities are to: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 24(a) Convene and chair Committee meetings.If the Chairman is unable to attend a Committee meeting, he or she candesignate the Secretary General to chair the meeting on his/her behalf;(b) Monitor the progress of the BCBS work programme and provideoperational guidance between meetings to carry forward the decisionsand directions of the Committee;(c) Report to the GHOS when appropriate; and(d) Represent the BCBS externally and be the principal spokesperson forthe BCBS.11. The SecretariatThe Secretariat is provided by the Bank for International Settlements(BIS) and supports the work of the Committee, the Chairman and thegroups around which the Committee organises its work.The Secretariat is staffed mainly by professional staff, mostly ontemporary secondment from BCBS members.11.1 ResponsibilitiesThe Secretariats main responsibilities are to:(a) Provide support and assistance to the Committee, the Chairman,groups, working groups and task forces;(b) Ensure timely and effective information flow to all BCBS members;(c) Facilitate coordination across groups, working groups and task forces;(d) Facilitate a close contact between BCBS members and non-memberauthorities;(e) Support the cooperation between the BCBS and other institutions; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 25(f) Maintain the BCBS records, administer the BCBS website and dealwith correspondence of the BCBS; and(g) Carry out all other functions that are assigned by the Committee andthe Chairman.11.2 Secretary GeneralThe Secretary General reports to the Chairman and directs the work of theSecretariat.The Secretary General manages the financial, material and humanresources allocated to the Secretariat.He/she also assists the Chairman in representing the Committeeexternally.The Secretary General is selected by the Chairman on recommendation ofa selection panel comprising BCBS and/or GHOS members and a seniorrepresentative of the BIS.The term of appointment is typically three years with the potential to beextended.11.3 Deputy Secretaries GeneralDeputy Secretaries General report to and assist the Secretary General indischarging his/her duties.Deputy Secretaries General substitute for the Secretary General in case ofabsence, incapacity or as requested by the Secretary General.Deputy Secretaries General are selected by the Secretary General inconjunction with the Chairman.11.4 Location of the SecretariatThe Secretariat is located at the BIS in Basel. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 26V. BCBS standards, guidelines and sound practices12. StandardsThe BCBS sets standards for the prudential regulation and supervision ofbanks.The BCBS expects full implementation of its standards by BCBSmembers and their internationally active banks.However, BCBS standards constitute minimum requirements and BCBSmembers may decide to go beyond them.The Committee expects standards to be incorporated into local legalframeworks through each jurisdictions rule-making process within thepre-defined timeframe established by the Committee.If deviation from literal transposition into local legal frameworks isunavoidable, members should seek the greatest possible equivalence ofstandards and their outcome.13. GuidelinesGuidelines elaborate the standards in areas where they are considereddesirable for the prudential regulation and supervision of banks, inparticular international active banks.They generally supplement BCBS standards by providing additionalguidance for the purpose of their implementation.14. Sound practicesSound practices generally describe actual observed practices, with thegoal of promoting common understanding and improving supervisory orbanking practices.BCBS members are encouraged to compare these practices with thoseapplied by themselves and their supervised institutions to identifypotential areas for improvement. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 27VI. Consultation with non-member authorities15. Consultation with non-member authoritiesConsistent with the activities described under section 2, the BCBS iscommitted to consulting widely on its activities with non-memberauthorities through the following structures and mechanisms:15.1 The Basel Consultative Group (BCG)The BCG provides a forum for deepening the Committees engagementwith supervisors around the world on banking supervisory issues.It facilitates broad supervisory dialogue with non-member authorities onnew Committee initiatives early in the process by gathering seniorrepresentatives from various countries, international institutions andregional groups of banking supervisors that are not members of theCommittee.15.2 The International Conferences of Banking Supervisors (ICBS)The biennial ICBS provides a venue for supervisors around the world todiscuss issues of common interest.15.3 Participation in BCBS groups, working groups and task forcesBy participating as observers in BCBS bodies, non-member authoritiescontribute to the Committees policy development work.15.4 The Financial Stability Institute (FSI)The FSI is a joint initiative of the BCBS and the BIS to assist supervisorsaround the world in implementing sound prudential standards.The BCBS supports FSI activities, including in particular the BCBS-FSIHigh Level Meetings.These are targeted at senior policymakers within central banks andsupervisory authorities and provide a series of regional fora fordistributing information on BCBS standards, keeping participantsupdated on Committee work, sharing supervisory practices and concerns,and establishing and maintaining strong contacts. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 2815.5 Regional groups of banking supervisorsThe BCBS supports the work and activities of regional groups of bankingsupervisors worldwide.Secretariat staff may participate in meetings of such groups to exchangeideas and seek feedback on BCBS work.VII. Relationship with other international financial bodies16. International cooperationThe BCBS cooperates with other international financial standard settersand public sector bodies with the purpose of achieving an enhancedcoordination of policy development and implementation.In carrying out their responsibilities to support this cooperation, theChairman and the Secretariat will pay particular attention to the need tocomply with the BCBSs due process and governance arrangements.Together with other international financial standard setters, the BCBSsponsors the Joint Forum, where issues of common concern to thestandard setters can be addressed and recommendations for coordinatedaction can be developed.The BCBS is a member of the Financial Stability Board (FSB) andparticipates in the FSBs work to develop, coordinate and promote theimplementation of effective regulatory, supervisory and other financialsector policies.VIII. Public consultation process17. Public consultation process of draft BCBS standards, guidelinesand sound practicesIn principle, the BCBS seeks input from all relevant stakeholders onpolicy proposals. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 29The consultation process will include issuing a public invitation tointerested parties to provide comments in writing to the Secretariat onpolicy proposals issued by the Committee, within a specified timeframe.The consultation period shall normally last 90 calendar days, but couldexceptionally be shorter or longer.As a general rule, responses to public invitations for comments shall bepublished on the BCBS website, unless confidential treatment isrequested by respondents.This process is compulsory for BCBS standards. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 30Commissioner Michel BarnierThe impact of the latest BaselCommittee liquidity developments forCapital Requirements (CRD 4) in the EUIn the light of the Group of Governors and Heads of Supervision meetingand the Basel Committee on Banking Supervision press release dated 6January 2013"I welcome the unanimous agreement reached by the Basel Committeeon the revised liquidity coverage ratio and the gradual approach for itsphasing-in by clearly defined dates.This is significant progress which addresses issues already raised by theEuropean Commission.We now need to make full use of the observation period, and learn fromthe reports that the European Banking Authority will prepare on theresults of the observation period, before formally implementing in 2015the liquidity coverage ratio under EU law in line with the Baselstandards.The treatment of liquidity is fundamental, both for the stability of banksas well as for their role in supporting wider economic recovery.I now call upon the Parliament and the Council to successfully concludethe CRD 4 trilogue negotiations in the coming weeks."ContextThe Basel Committee on Banking Supervision (BCBS) has agreed apackage of LCR (liquidity coverage ratio) revisions unanimously as wellas its 2013 work plan.The LCR revisions include an expansion of eligible assets, a less severecalibration for certain cash flows and a phasing-in arrangement fromJanuary 2015 to 2019. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 31The current Commission approach to liquidity in the CRD4 negotiations,namely first a reporting period followed by comprehensive EuropeanBanking Authority (EBA) Reports and subsequently a delegated act bythe Commission to define the detailed ratio remains fully valid.Background informationThe Commissions approach to liquidity in CRD 4 still remains valid inthe light of the latest Basel Committee approval of the revision of anumber of parameters and calibrations on liquidity (GHOS meeting of 6January).In the Basel Committee, the European Central Bank, the EuropeanCommission and various countries including from the EU had argued forsuch a revision.At the level of the Basel Committee, the final package of LCR revisionswill now be subject to an observation period with a Quantitative ImpactStudy (QIS) that will take place in 2013 together with some otherimportant work that still needs to be completed in the coming year.The EU needs to take full benefit of this observation period and learnfrom it, as this is the first time in history that regulators are definingglobally harmonized, quantitative liquidity standards.The EBA will make reports on the results of the observation period forEU banks before the end of 2013.Based on the evaluation of this work, the Commission will proposedefining the detailed LCR through a delegated act (i.e. legislationadopted by the Commission provided no objections are raised by the EPand the Council).Nevertheless, important work still remains to be completed at the globaland European levels.This includes the determination of alternative, market-based indicatorsfor the definition of High Quality Liquid Assets (HQLA); the treatmentof Central Bank facilities which could impact upon the definition ofHQLA and related cash flows; and the treatment of market valuationchanges on derivative cash flows. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 32In this light, the best course continues to be rapid adoption of the CRD 4package while leaving the necessary flexibility to implement the finaldetailed LCR standard through a delegated act, taking into account theon-going work by Basel and the comprehensive EBA reports.Subject to this approach, the texts on the table now of the EuropeanParliament and Council should be adopted shortly, hopefully in thecoming weeks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 33Basel III: The LiquidityCoverage Ratio and liquidity riskmonitoring tools, January 2013Introduction1. This document presents one of the BaselCommittee’s key reforms to develop a moreresilient banking sector: the LiquidityCoverage Ratio (LCR).The objective of the LCR is to promote theshort-term resilience of the liquidity risk profile of banks.It does this by ensuring that banks have an adequate stock ofunencumbered high-quality liquid assets (HQLA) that can be convertedeasily and immediately in private markets into cash to meet their liquidityneeds for a 30 calendar day liquidity stress scenario.The LCR will improve the banking sector’s ability to absorb shocksarising from financial and economic stress, whatever the source, thusreducing the risk of spillover from the financial sector to the realeconomy.This document sets out the LCR standard and timelines for itsimplementation.2. During the early “liquidity phase” of the financial crisis that began in2007, many banks – despite adequate capital levels – still experienceddifficulties because they did not manage their liquidity in a prudentmanner.The crisis drove home the importance of liquidity to the properfunctioning of financial markets and the banking sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 34Prior to the crisis, asset markets were buoyant and funding was readilyavailable at low cost.The rapid reversal in market conditions illustrated how quickly liquiditycan evaporate, and that illiquidity can last for an extended period of time.The banking system came under severe stress, which necessitated centralbank action to support both the functioning of money markets and, insome cases, individual institutions.3. The difficulties experienced by some banks were due to lapses in basicprinciples of liquidity risk management.In response, as the foundation of its liquidity framework, theCommittee in 2008 published Principles for Sound Liquidity RiskManagement and Supervision (“Sound Principles”).The Sound Principles provide detailed guidance on the risk managementand supervision of funding liquidity risk and should help promote betterrisk management in this critical area, but only if there is fullimplementation by banks and supervisors.As such, the Committee will continue to monitor the implementation bysupervisors to ensure that banks adhere to these fundamental principles.4. To complement these principles, the Committee has furtherstrengthened its liquidity framework by developing two minimumstandards for funding liquidity.These standards have been developed to achieve two separate butcomplementary objectives.The first objective is to promote short-term resilience of a bank’s liquidityrisk profile by ensuring that it has sufficient HQLA to survive asignificant stress scenario lasting for one month.The Committee developed the LCR to achieve this objective. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 35The second objective is to promote resilience over a longer time horizonby creating additional incentives for banks to fund their activities withmore stable sources of funding on an ongoing basis.The Net Stable Funding Ratio (NSFR), which is not covered by thisdocument, supplements the LCR and has a time horizon of one year.It has been developed to provide a sustainable maturity structure of assetsand liabilities.5. These two standards are comprised mainly of specific parameterswhich are internationally “harmonised” with prescribed values.Certain parameters, however, contain elements of national discretion toreflect jurisdiction-specific conditions.In these cases, the parameters should be transparent and clearly outlinedin the regulations of each jurisdiction to provide clarity both within thejurisdiction and internationally.6. It should be stressed that the LCR standard establishes a minimumlevel of liquidity for internationally active banks.Banks are expected to meet this standard as well as adhere to the SoundPrinciples.Consistent with the Committee’s capital adequacy standards, nationalauthorities may require higher minimum levels of liquidity.In particular, supervisors should be mindful that the assumptions withinthe LCR may not capture all market conditions or all periods of stress.Supervisors are therefore free to require additional levels of liquidity to beheld, if they deem the LCR does not adequately reflect the liquidity risksthat their banks face.7. Given that the LCR is, on its own, insufficient to measure alldimensions of a bank’s liquidity profile, the Committee has also _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 36developed a set of monitoring tools to further strengthen and promoteglobal consistency in liquidity risk supervision.These tools are supplementary to the LCR and are to be used for ongoingmonitoring of the liquidity risk exposures of banks, and incommunicating these exposures among home and host supervisors.8. The Committee is introducing phase-in arrangements to implementthe LCR to help ensure that the banking sector can meet the standardthrough reasonable measures, while still supporting lending to theeconomy.9. The Committee remains firmly of the view that the LCR is an essentialcomponent of the set of reforms introduced by Basel III and, whenimplemented, will help deliver a more robust and resilient bankingsystem.However, the Committee has also been mindful of the implications of thestandard for financial markets, credit extension and economic growth,and of introducing the LCR at a time of ongoing strains in some bankingsystems.It has therefore decided to provide for a phased introduction of the LCR,in a manner similar to that of the Basel III capital adequacy requirements.10. Specifically, the LCR will be introduced as planned on 1 January 2015,but the minimum requirement will be set at 60% and rise in equal annualsteps to reach 100% on 1 January 2019.This graduated approach, coupled with the revisions made to the 2010publication of the liquidity standards, are designed to ensure that theLCR can be introduced without material disruption to the orderlystrengthening of banking systems or the ongoing financing of economicactivity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 3711. The Committee also reaffirms its view that, during periods of stress, itwould be entirely appropriate for banks to use their stock of HQLA,thereby falling below the minimum.Supervisors will subsequently assess this situation and will give guidanceon usability according to circumstances.Furthermore, individual countries that are receiving financial support formacroeconomic and structural reform purposes may choose a differentimplementation schedule for their national banking systems, consistentwith the design of their broader economic restructuring programme.12. The Committee is currently reviewing the NSFR, which continues tobe subject to an observation period and remains subject to review toaddress any unintended consequences.It remains the Committee’s intention that the NSFR, including anyrevisions, will become a minimum standard by 1 January 2018.13. This document is organised as follows:- Part 1 defines the LCR for internationally active banks and deals with application issues.- Part 2 presents a set of monitoring tools to be used by banks and supervisors in their monitoring of liquidity risks.Part 1: The Liquidity Coverage Ratio14. The Committee has developed the LCR to promote the short-termresilience of the liquidity risk profile of banks by ensuring that they havesufficient HQLA to survive a significant stress scenario lasting 30calendar days.15. The LCR should be a key component of the supervisory approach toliquidity risk, but must be supplemented by detailed supervisoryassessments of other aspects of the bank’s liquidity risk management _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 38framework in line with the Sound Principles, the use of the monitoringtools included in Part 2, and, in due course, the NSFR.In addition, supervisors may require an individual bank to adopt morestringent standards or parameters to reflect its liquidity risk profile andthe supervisor’s assessment of its compliance with the Sound Principles.I. Objective of the LCR and use of HQLA16. This standard aims to ensure that a bank has an adequate stock ofunencumbered HQLA that consists of cash or assets that can beconverted into cash at little or no loss of value in private markets, to meetits liquidity needs for a 30 calendar day liquidity stress scenario.At a minimum, the stock of unencumbered HQLA should enable thebank to survive until Day 30 of the stress scenario, by which time it isassumed that appropriate corrective actions can be taken by managementand supervisors, or that the bank can be resolved in an orderly way.Furthermore, it gives the central bank additional time to take appropriatemeasures, should they be regarded as necessary.As noted in the Sound Principles, given the uncertain timing of outflowsand inflows, banks are also expected to be aware of any potentialmismatches within the 30-day period and ensure that sufficient HQLAare available to meet any cash flow gaps throughout the period.17. The LCR builds on traditional liquidity “coverage ratio”methodologies used internally by banks to assess exposure to contingentliquidity events.The total net cash outflows for the scenario are to be calculated for 30calendar days into the future.The standard requires that, absent a situation of financial stress, the valueof the ratio be no lower than 100% (ie the stock of HQLA should at leastequal total net cash outflows) on an ongoing basis because the stock ofunencumbered HQLA is intended to serve as a defence against the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 39potential onset of liquidity stress.During a period of financial stress, however, banks may use their stock ofHQLA, thereby falling below 100%, as maintaining the LCR at 100%under such circumstances could produce undue negative effects on thebank and other market participants.Supervisors will subsequently assess this situation and will adjust theirresponse flexibly according to the circumstances.18. In particular, supervisory decisions regarding a bank’s use of itsHQLA should be guided by consideration of the core objective anddefinition of the LCR.Supervisors should exercise judgement in their assessment and accountnot only for prevailing macrofinancial conditions, but also considerforward-looking assessments of macroeconomic and financial conditions.In determining a response, supervisors should be aware that some actionscould be procyclical if applied in circumstances of market-wide stress.Supervisors should seek to take these considerations into account on aconsistent basis across jurisdictions.(a) Supervisors should assess conditions at an early stage, and takeactions if deemed necessary, to address potential liquidity risk.(b) Supervisors should allow for differentiated responses to a reportedLCR below 100%.Any potential supervisory response should be proportionate with thedrivers, magnitude, duration and frequency of the reported shortfall.(c) Supervisors should assess a number of firm- and market-specificfactors in determining the appropriate response as well as otherconsiderations related to both domestic and global frameworks andconditions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 40Potential considerations include, but are not limited to:(i) The reason(s) that the LCR fell below 100%.This includes use of the stock of HQLA, an inability to roll over fundingor large unexpected draws on contingent obligations.In addition, the reasons may relate to overall credit, funding and marketconditions, including liquidity in credit, asset and funding markets,affecting individual banks or all institutions, regardless of their owncondition;(ii) The extent to which the reported decline in the LCR is due to afirm-specific or market-wide shock;(iii) A bank’s overall health and risk profile, including activities, positionswith respect to other supervisory requirements, internal risk systems,controls and other management processes, among others;(iv) The magnitude, duration and frequency of the reported decline ofHQLA;(v) The potential for contagion to the financial system and additionalrestricted flow of credit or reduced market liquidity due to actions tomaintain an LCR of 100%;(vi) The availability of other sources of contingent funding such as centralbank funding, or other actions by prudential authorities.(d) Supervisors should have a range of tools at their disposal to address areported LCR below 100%.Banks may use their stock of HQLA in both idiosyncratic and systemicstress events, although the supervisory response may differ between thetwo.(i) At a minimum, a bank should present an assessment of its liquidityposition, including the factors that contributed to its LCR falling below _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 41100%, the measures that have been and will be taken and the expectationson the potential length of the situation.Enhanced reporting to supervisors should be commensurate with theduration of the shortfall.(ii) If appropriate, supervisors could also require actions by a bank toreduce its exposure to liquidity risk, strengthen its overall liquidity riskmanagement, or improve its contingency funding plan.(iii) However, in a situation of sufficiently severe system-wide stress,effects on the entire financial system should be considered.Potential measures to restore liquidity levels should be discussed, andshould be executed over a period of time considered appropriate toprevent additional stress on the bank and on the financial system as awhole.(e) Supervisors’ responses should be consistent with the overall approachto the prudential framework.II. Definition of the LCR19. The scenario for this standard entails a combined idiosyncratic andmarket-wide shock that would result in:(a) The run-off of a proportion of retail deposits;(b) A partial loss of unsecured wholesale funding capacity;(c) A partial loss of secured, short-term financing with certain collateraland counterparties;(d) Additional contractual outflows that would arise from a downgrade inthe bank’s public credit rating by up to and including three notches,including collateral posting requirements; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 42(e) Increases in market volatilities that impact the quality of collateral orpotential future exposure of derivative positions and thus require largercollateral haircuts or additional collateral, or lead to other liquidity needs;(f) Unscheduled draws on committed but unused credit and liquidityfacilities that the bank has provided to its clients; and(g) The potential need for the bank to buy back debt or honournon-contractual obligations in the interest of mitigating reputational risk.20. In summary, the stress scenario specified incorporates many of theshocks experienced during the crisis that started in 2007 into onesignificant stress scenario for which a bank would need sufficientliquidity on hand to survive for up to 30 calendar days.21. This stress test should be viewed as a minimum supervisoryrequirement for banks.Banks are expected to conduct their own stress tests to assess the level ofliquidity they should hold beyond this minimum, and construct their ownscenarios that could cause difficulties for their specific business activities.Such internal stress tests should incorporate longer time horizons thanthe one mandated by this standard.Banks are expected to share the results of these additional stress testswith supervisors.22. The LCR has two components:(a) Value of the stock of HQLA in stressed conditions; and(b) Total net cash outflows, calculated according to the scenarioparameters outlined below. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 43A. Stock of HQLA23. The numerator of the LCR is the “stock of HQLA”.Under the standard, banks must hold a stock of unencumbered HQLA tocover the total net cash outflows (as defined below) over a 30-day periodunder the prescribed stress scenario.In order to qualify as “HQLA”, assets should be liquid in markets duringa time of stress and, ideally, be central bank eligible.The following sets out the characteristics that such assets shouldgenerally possess and the operational requirements that they shouldsatisfy.1. Characteristics of HQLA24. Assets are considered to be HQLA if they can be easily andimmediately converted into cash at little or no loss of value.The liquidity of an asset depends on the underlying stress scenario, thevolume to be monetised and the timeframe considered.Nevertheless, there are certain assets that are more likely to generatefunds without incurring large discounts in sale or repurchase agreement(repo) markets due to fire-sales even in times of stress.This section outlines the factors that influence whether or not the marketfor an asset can be relied upon to raise liquidity when considered in thecontext of possible stresses.These factors should assist supervisors in determining which assets,despite meeting the criteria from paragraphs 49 to 54, are not sufficientlyliquid in private markets to be included in the stock of HQLA. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 44(i) Fundamental characteristics- Low risk: assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination increase an asset’s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset’s liquidity.- Ease and certainty of valuation: an asset’s liquidity increases if market participants are more likely to agree on its valuation. Assets with more standardised, homogenous and simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-quality liquid asset must be easy to calculate and not depend on strong assumptions. The inputs into the pricing formula must also be publicly available. In practice, this should rule out the inclusion of most structured or exotic products.- Low correlation with risky assets: the stock of HQLA should not be subject to wrong-way (highly correlated) risk. For example, assets issued by financial institutions are more likely to be illiquid in times of liquidity stress in the banking sector.- Listed on a developed and recognised exchange: being listed increases an asset’s transparency.(ii) Market-related characteristics- Active and sizable market: the asset should have active outright sale or repo markets at all times. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 45 This means that:- There should be historical evidence of market breadth and market depth. This could be demonstrated by low bid-ask spreads, high trading volumes, and a large and diverse number of market participants. Diversity of market participants reduces market concentration and increases the reliability of the liquidity in the market.- There should be robust market infrastructure in place.- The presence of multiple committed market makers increases liquidity as quotes will most likely be available for buying or selling HQLA.- Low volatility: Assets whose prices remain relatively stable and are less prone to sharp price declines over time will have a lower probability of triggering forced sales to meet liquidity requirements. Volatility of traded prices and spreads are simple proxy measures of market volatility. There should be historical evidence of relative stability of market terms (eg prices and haircuts) and volumes during stressed periods.- Flight to quality: historically, the market has shown tendencies to move into these types of assets in a systemic crisis. The correlation between proxies of market liquidity and banking system stress is one simple measure that could be used.25. As outlined by these characteristics, the test of whether liquid assetsare of “high quality” is that, by way of sale or repo, their liquidity -generating capacity is assumed to remain intact even in periods of severeidiosyncratic and market stress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 46Lower quality assets typically fail to meet that test.An attempt by a bank to raise liquidity from lower quality assets underconditions of severe market stress would entail acceptance of a largefire-sale discount or haircut to compensate for high market risk.That may not only erode the market’s confidence in the bank, but wouldalso generate mark-to-market losses for banks holding similarinstruments and add to the pressure on their liquidity position, thusencouraging further fire sales and declines in prices and market liquidity.In these circumstances, private market liquidity for such instruments islikely to disappear quickly.26. HQLA (except Level 2B assets as defined below) should ideally beeligible at central banks for intraday liquidity needs and overnightliquidity facilities.In the past, central banks have provided a further backstop to the supplyof banking system liquidity under conditions of severe stress.Central bank eligibility should thus provide additional confidence thatbanks are holding assets that could be used in events of severe stresswithout damaging the broader financial system.That in turn would raise confidence in the safety and soundness ofliquidity risk management in the banking system.27. It should be noted however, that central bank eligibility does not byitself constitute the basis for the categorisation of an asset as HQLA.2. Operational requirements28. All assets in the stock of HQLA are subject to the followingoperational requirements.The purpose of the operational requirements is to recognise that not allassets outlined in paragraphs 49-54 that meet the asset class, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 47risk-weighting and credit-rating criteria should be eligible for the stock asthere are other operational restrictions on the availability of HQLA thatcan prevent timely monetisation during a stress period.29. These operational requirements are designed to ensure that the stockof HQLA is managed in such a way that the bank can, and is able todemonstrate that it can, immediately use the stock of assets as a source ofcontingent funds that is available for the bank to convert into cashthrough outright sale or repo, to fill funding gaps between cash inflowsand outflows at any time during the 30-day stress period, with norestriction on the use of the liquidity generated.30. A bank should periodically monetise a representative proportion of theassets in the stock through repo or outright sale, in order to test its accessto the market, the effectiveness of its processes for monetisation, theavailability of the assets, and to minimise the risk of negative signallingduring a period of actual stress.31. All assets in the stock should be unencumbered.“Unencumbered” means free of legal, regulatory, contractual or otherrestrictions on the ability of the bank to liquidate, sell, transfer, or assignthe asset.An asset in the stock should not be pledged (either explicitly orimplicitly) to secure, collateralise or credit-enhance any transaction, norbe designated to cover operational costs (such as rents and salaries).Assets received in reverse repo and securities financing transactions thatare held at the bank, have not been rehypothecated, and are legally andcontractually available for the banks use can be considered as part of thestock of HQLA.In addition, assets which qualify for the stock of HQLA that have beenpre-positioned or deposited with, or pledged to, the central bank or apublic sector entity (PSE) but have not been used to generate liquiditymay be included in the stock. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 4832. A bank should exclude from the stock those assets that, althoughmeeting the definition of “unencumbered” specified in paragraph 31, thebank would not have the operational capability to monetise to meetoutflows during the stress period.Operational capability to monetise assets requires having procedures andappropriate systems in place, including providing the function identifiedin paragraph 33 with access to all necessary information to executemonetisation of any asset at any time.Monetisation of the asset must be executable, from an operationalperspective, in the standard settlement period for the asset class in therelevant jurisdiction.33. The stock should be under the control of the function charged withmanaging the liquidity of the bank (eg the treasurer), meaning thefunction has the continuous authority, and legal and operationalcapability, to monetise any asset in the stock.Control must be evidenced either by maintaining assets in a separate poolmanaged by the function with the sole intent for use as a source ofcontingent funds, or by demonstrating that the function can monetise theasset at any point in the 30-day stress period and that the proceeds ofdoing so are available to the function throughout the 30-day stress periodwithout directly conflicting with a stated business or risk managementstrategy.For example, an asset should not be included in the stock if the sale ofthat asset, without replacement throughout the 30-day period, wouldremove a hedge that would create an open risk position in excess ofinternal limits.34. A bank is permitted to hedge the market risk associated withownership of the stock of HQLA and still include the assets in the stock.If it chooses to hedge the market risk, the bank should take into account(in the market value applied to each asset) the cash outflow that would _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 49arise if the hedge were to be closed out early (in the event of the assetbeing sold).35. In accordance with Principle 9 of the Sound Principles a bank “shouldmonitor the legal entity and physical location where collateral is held andhow it may be mobilised in a timely manner”.Specifically, it should have a policy in place that identifies legal entities,geographical locations, currencies and specific custodial or bankaccounts where HQLA are held.In addition, the bank should determine whether any such assets shouldbe excluded for operational reasons and therefore, have the ability todetermine the composition of its stock on a daily basis.36. As noted in paragraphs 171 and 172, qualifying HQLA that are held tomeet statutory liquidity requirements at the legal entity or sub -consolidated level (where applicable) may only be included in the stock atthe consolidated level to the extent that the related risks (as measured bythe legal entity’s or sub-consolidated group’s net cash outflows in theLCR) are also reflected in the consolidated LCR.Any surplus of HQLA held at the legal entity can only be included in theconsolidated stock if those assets would also be freely available to theconsolidated (parent) entity in times of stress.37. In assessing whether assets are freely transferable for regulatorypurposes, banks should be aware that assets may not be freely available tothe consolidated entity due to regulatory, legal, tax, accounting or otherimpediments.Assets held in legal entities without market access should only beincluded to the extent that they can be freely transferred to other entitiesthat could monetise the assets.38. In certain jurisdictions, large, deep and active repo markets do notexist for eligible asset classes, and therefore such assets are likely to bemonetised through outright sale. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 50In these circumstances, a bank should exclude from the stock of HQLAthose assets where there are impediments to sale, such as large fire-salediscounts which would cause it to breach minimum solvencyequirements, or requirements to hold such assets, including, but notlimited to, statutory minimum inventory requirements for marketmaking.39. Banks should not include in the stock of HQLA any assets, or liquiditygenerated from assets, they have received under right of rehypothecation,if the beneficial owner has the contractual right to withdraw those assetsduring the 30-day stress period.40. Assets received as collateral for derivatives transactions that are notsegregated and are legally able to be rehypothecated may be included inthe stock of HQLA provided that the bank records an appropriate outflowfor the associated risks as set out in paragraph 116.41. As stated in Principle 8 of the Sound Principles, a bank should activelymanage its intraday liquidity positions and risks to meet payment andsettlement obligations on a timely basis under both normal and stressedconditions and thus contribute to the smooth functioning of payment andsettlement systems.Banks and regulators should be aware that the LCR stress scenario doesnot cover expected or unexpected intraday liquidity needs.42. While the LCR is expected to be met and reported in a single currency,banks are expected to be able to meet their liquidity needs in eachcurrency and maintain HQLA consistent with the distribution of theirliquidity needs by currency.The bank should be able to use the stock to generate liquidity in thecurrency and jurisdiction in which the net cash outflows arise.As such, the LCR by currency is expected to be monitored and reported toallow the bank and its supervisor to track any potential currencymismatch issues that could arise, as outlined in Part 2. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 51In managing foreign exchange liquidity risk, the bank should takeinto account the risk that its ability to swap currencies and access therelevant foreign exchange markets may erode rapidly under stressedconditions.It should be aware that sudden, adverse exchange rate movements couldsharply widen existing mismatched positions and alter the effectivenessof any foreign exchange hedges in place.43. In order to mitigate cliff effects that could arise, if an eligible liquidasset became ineligible (eg due to rating downgrade), a bank is permittedto keep such assets in its stock of liquid assets for an additional 30calendar days.This would allow the bank additional time to adjust its stock as needed orreplace the asset.3. Diversification of the stock of HQLA44. The stock of HQLA should be well diversified within the asset classesthemselves (except for sovereign debt of the bank’s home jurisdiction orfrom the jurisdiction in which the bank operates; central bank reserves;central bank debt securities; and cash).Although some asset classes are more likely to remain liquid irrespectiveof circumstances, ex-ante it is not possible to know with certainty whichspecific assets within each asset class might be subject to shocks ex-post.Banks should therefore have policies and limits in place in order toavoid concentration with respect to asset types, issue and issuer types,and currency (consistent with the distribution of net cash outflows bycurrency) within asset classes.4. Definition of HQLA45. The stock of HQLA should comprise assets with the characteristicsoutlined in paragraphs 24-27. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 52This section describes the type of assets that meet these characteristicsand can therefore be included in the stock.46. There are two categories of assets that can be included in the stock.Assets to be included in each category are those that the bank is holdingon the first day of the stress period, irrespective of their residual maturity.“Level 1” assets can be included without limit, while “Level 2” assets canonly comprise up to 40% of the stock.47. Supervisors may also choose to include within Level 2 an additionalclass of assets (Level 2B assets - see paragraph 53 below).If included, these assets should comprise no more than 15% of the totalstock of HQLA.They must also be included within the overall 40% cap on Level 2 assets.48. The 40% cap on Level 2 assets and the 15% cap on Level 2B assetsshould be determined after the application of required haircuts, and aftertaking into account the unwind of short-term securities financingtransactions and collateral swap transactions maturing within 30 calendardays that involve the exchange of HQLA.In this context, short term transactions are transactions with a maturitydate up to and including 30 calendar days.The details of the calculation methodology are provided in Annex 1.(i) Level 1 assets49. Level 1 assets can comprise an unlimited share of the pool and are notsubject to a haircut under the LCR.However, national supervisors may wish to require haircuts for Level 1securities based on, among other things, their duration, credit andliquidity risk, and typical repo haircuts. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 5350. Level 1 assets are limited to:(a) Coins and banknotes;(b) Central bank reserves (including required reserves), to the extent thatthe central bank policies allow them to be drawn down in times of stress;(c) Marketable securities representing claims on or guaranteed bysovereigns, central banks, PSEs, the Bank for International Settlements,the International Monetary Fund, the European Central Bank andEuropean Community, or multilateral development banks, and satisfyingall of the following conditions:- assigned a 0% risk-weight under the Basel II Standardised Approach for credit risk;- traded in large, deep and active repo or cash markets characterised by a low level of concentration;- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and- not an obligation of a financial institution or any of its affiliated entities.(d) where the sovereign has a non-0% risk weight, sovereign or centralbank debt securities issued in domestic currencies by the sovereign orcentral bank in the country in which the liquidity risk is being taken or inthe bank’s home country; and(e) where the sovereign has a non-0% risk weight, domestic sovereign orcentral bank debt securities issued in foreign currencies are eligible up tothe amount of the bank’s stressed net cash outflows in that specificforeign currency stemming from the bank’s operations in the jurisdictionwhere the bank’s liquidity risk is being taken. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 54(ii) Level 2 assets51. Level 2 assets (comprising Level 2A assets and any Level 2B assetspermitted by the supervisor) can be included in the stock of HQLA,subject to the requirement that they comprise no more than 40% of theoverall stock after haircuts have been applied.52. A 15% haircut is applied to the current market value of each Level 2Aasset held in the stock of HQLA.Level 2A assets are limited to the following:(a) Marketable securities representing claims on or guaranteed bysovereigns, central banks, PSEs or multilateral development banks thatsatisfy all of the following conditions:- assigned a 20% risk weight under the Basel II Standardised Approach for credit risk;- traded in large, deep and active repo or cash markets characterised by a low level of concentration;- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions (ie maximum decline of price not exceeding 10% or increase in haircut not exceeding 10 percentage points over a 30-day period during a relevant period of significant liquidity stress); and- not an obligation of a financial institution or any of its affiliated entities.(b) Corporate debt securities (including commercial paper) and coveredbonds that satisfy all of the following conditions:- in the case of corporate debt securities: not issued by a financial institution or any of its affiliated entities; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 55- in the case of covered bonds: not issued by the bank itself or any of its affiliated entities;- either (i) have a long-term credit rating from a recognised external credit assessment institution (ECAI) of at least AA-21 or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or (ii) do not have a credit assessment by a recognised ECAI but are internally rated as having a probability of default (PD) corresponding to a credit rating of at least AA-;- traded in large, deep and active repo or cash markets characterised by a low level of concentration; and- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions: ie maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%.(iii) Level 2B assets53. Certain additional assets (Level 2B assets) may be included in Level 2at the discretion of national authorities.In choosing to include these assets in Level 2 for the purpose of the LCR,supervisors are expected to ensure that such assets fully comply with thequalifying criteria.Supervisors are also expected to ensure that banks have appropriatesystems and measures to monitor and control the potential risks (egcredit and market risks) that banks could be exposed to in holding theseassets.54. A larger haircut is applied to the current market value of each Level 2Basset held in the stock of HQLA. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 56Level 2B assets are limited to the following:(a) Residential mortgage backed securities (RMBS) that satisfy all of thefollowing conditions may be included in Level 2B, subject to a 25%haircut:- not issued by, and the underlying assets have not been originated by the bank itself or any of its affiliated entities;- have a long-term credit rating from a recognised ECAI of AA or higher, or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating;- traded in large, deep and active repo or cash markets characterised by a low level of concentration;- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of price not exceeding 20% or increase in haircut over a 30-day period not exceeding 20 percentage points during a relevant period of significant liquidity stress;- the underlying asset pool is restricted to residential mortgages and cannot contain structured products;- the underlying mortgages are “full recourse’’ loans (ie in the case of foreclosure the mortgage owner remains liable for any shortfall in sales proceeds from the property) and have a maximum loan-to-value ratio (LTV) of 80% on average at issuance; and- the securitisations are subject to “risk retention” regulations which require issuers to retain an interest in the assets they securitise.(b) Corporate debt securities (including commercial paper) that satisfy allof the following conditions may be included in Level 2B, subject to a 50%haircut:- not issued by a financial institution or any of its affiliated entities; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 57- either- (i) have a long-term credit rating from a recognised ECAI between A+ and BBB- or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or- (ii) do not have a credit assessment by a recognised ECAI and are internally rated as having a PD corresponding to a credit rating of between A+ and BBB-;- traded in large, deep and active repo or cash markets characterised by a low level of concentration; and- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of price not exceeding 20% or increase in haircut over a 30-day period not exceeding 20 percentage points during a relevant period of significant liquidity stress.(c) Common equity shares that satisfy all of the following conditions maybe included in Level 2B, subject to a 50% haircut:- not issued by a financial institution or any of its affiliated entities;- exchange traded and centrally cleared;- a constituent of the major stock index in the home jurisdiction or where the liquidity risk is taken, as decided by the supervisor in the jurisdiction where the index is located;- denominated in the domestic currency of a bank’s home jurisdiction or in the currency of the jurisdiction where a bank’s liquidity risk is taken;- traded in large, deep and active repo or cash markets characterised by a low level of concentration; and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 58- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of share price not exceeding 40% or increase in haircut not exceeding 40 percentage points over a 30-day period during a relevant period of significant liquidity.(iv) Treatment for jurisdictions with insufficient HQLA(a) Assessment of eligibility for alternative liquidity approaches(ALA)55. Some jurisdictions may have an insufficient supply of Level 1 assets(or both Level 1 and Level 2 assets) in their domestic currency to meet theaggregate demand of banks with significant exposures in this currency.To address this situation, the Committee has developed alternativetreatments for holdings in the stock of HQLA, which are expected toapply to a limited number of currencies and jurisdictions.Eligibility for such alternative treatment will be judged on the basis of thequalifying criteria set out in Annex 2 and will be determined through anindependent peer review process overseen by the Committee.The purpose of this process is to ensure that the alternative treatments areonly used when there is a true shortfall in HQLA in the domestic currencyrelative to the needs in that currency.56. To qualify for the alternative treatment, a jurisdiction should be ableto demonstrate that:- there is an insufficient supply of HQLA in its domestic currency, taking into account all relevant factors affecting the supply of, and demand for, such HQLA;- the insufficiency is caused by long-term structural constraints that cannot be resolved within the medium term; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 59- it has the capacity, through any mechanism or control in place, to limit or mitigate the risk that the alternative treatment cannot work as expected; and- it is committed to observing the obligations relating to supervisory monitoring, disclosure, and periodic self-assessment and independent peer review of its eligibility for alternative treatment.All of the above criteria have to be met to qualify for the alternativetreatment.57. Irrespective of whether a jurisdiction seeking ALA treatment willadopt the phase-in arrangement set out in paragraph 10 for implementingthe LCR, the eligibility for that jurisdiction to adopt ALA treatment willbe based on a fully implemented LCR standard (ie 100% requirement).(b) Potential options for alternative treatment58. Option 1 – Contractual committed liquidity facilities from the relevantcentral bank, with a fee:For currencies that do not have sufficient HQLA, as determined byreference to the qualifying principles and criteria, Option 1 would allowbanks to access contractual committed liquidity facilities provided by therelevant central bank (ie relevant given the currency in question) for a fee.These facilities should not be confused with regular central bankstanding arrangements.In particular, these facilities are contractual arrangements between thecentral bank and the commercial bank with a maturity date which, at aminimum, falls outside the 30-day LCR window.Further, the contract must be irrevocable prior to maturity and involve noex-post credit decision by the central bank.Such facilities are only permissible if there is also a fee for the facilitywhich is charged regardless of the amount, if any, drawn down against _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 60that facility and the fee is set so that banks which claim the facility line tomeet the LCR, and banks which do not, have similar financial incentivesto reduce their exposure to liquidity risk.That is, the fee should be set so that the net yield on the assets used tosecure the facility should not be higher than the net yield on arepresentative portfolio of Level 1 and Level 2 assets, after adjusting forany material differences in credit risk.A jurisdiction seeking to adopt Option 1 should justify in the independentpeer review that the fee is suitably set in a manner as prescribed in thisparagraph.59. Option 2 – Foreign currency HQLA to cover domestic currencyliquidity needs:For currencies that do not have sufficient HQLA, as determined byreference to the qualifying principles and criteria, Option 2 would allowsupervisors to permit banks that evidence a shortfall of HQLA in thedomestic currency (which would match the currency of the underlyingrisks) to hold HQLA in a currency that does not match the currency of theassociated liquidity risk, provided that the resulting currency mismatchpositions are justifiable and controlled within limits agreed by theirsupervisors.Supervisors should restrict such positions within levels consistent withthe bank’s foreign exchange risk management capacity and needs, andensure that such positions relate to currencies that are freely and reliablyconvertible, are effectively managed by the bank, and would not poseundue risk to its financial strength.In managing those positions, the bank should take into account therisks that its ability to swap currencies, and its access to the relevantforeign exchange markets, may erode rapidly under stressed conditions.It should also take into account that sudden, adverse exchange ratemovements could sharply widen existing mismatch positions and alterthe effectiveness of any foreign exchange hedges in place. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 6160. To account for foreign exchange risk associated with foreign currencyHQLA used to cover liquidity needs in the domestic currency, such liquidassets should be subject to a minimum haircut of 8% for major currenciesthat are active in global foreign exchange markets.For other currencies, jurisdictions should increase the haircut to anappropriate level on the basis of historical (monthly) exchange ratevolatilities between the currency pair over an extended period of time.If the domestic currency is formally pegged to another currency under aneffective mechanism, the haircut for the pegged currency can be loweredto a level that reflects the limited exchange rate risk under the pegarrangement.To qualify for this treatment, the jurisdiction concerned shoulddemonstrate in the independent peer review the effectiveness of itscurrency peg mechanism and assess the long-term prospect of keepingthe peg.61. Haircuts for foreign currency HQLA used under Option 2 would applyonly to HQLA in excess of a threshold specified by supervisors which isnot greater than 25%.This is to accommodate a certain level of currency mismatch that maycommonly exist among banks in their ordinary course of business.62. Option 3 – Additional use of Level 2 assets with a higher haircut: Thisoption addresses currencies for which there are insufficient Level 1 assets,as determined by reference to the qualifying principles and criteria, butwhere there are sufficient Level 2A assets.In this case, supervisors may choose to allow banks that evidence ashortfall of HQLA in the domestic currency (to match the currency of theliquidity risk incurred) to hold additional Level 2A assets in the stock.These additional Level 2A assets would be subject to a minimum haircutof 20%, ie 5% higher than the 15% haircut applicable to Level 2A assetsthat are included in the 40% cap. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 62The higher haircut is used to cover any additional price and marketliquidity risks arising from increased holdings of Level 2A assets beyondthe 40% cap, and to provide a disincentive for banks to use this optionbased on yield considerations.Supervisors have the obligation to conduct an analysis to assess whetherthe additional haircut is sufficient for Level 2A assets in their markets,and should increase the haircut if this is warranted to achieve the purposefor which it is intended.Supervisors should explain and justify the outcome of the analysis(including the level of increase in the haircut, if applicable) during theindependent peer review assessment process. Any Level 2B assets held bythe bank would remain subject to the cap of 15%, regardless of theamount of other Level 2 assets held.(c) Maximum level of usage of options for alternative treatment63. The usage of any of the above options would be constrained by a limitspecified by supervisors in jurisdictions whose currency is eligible for thealternative treatment.The limit should be expressed in terms of the maximum amount ofHQLA associated with the use of the options (whether individually or incombination) that a bank is allowed to include in its LCR, as a percentageof the total amount of HQLA the bank is required to hold in the currencyconcerned.HQLA associated with the options refer to:(i) In the case of Option 1, the amount of committed liquidity facilitiesgranted by the relevant central bank;(ii) In the case of Option 2, the amount of foreign currency HQLA used tocover the shortfall of HQLA in the domestic currency; and(iii) In the case of Option 3, the amount of Level 2 assets held (includingthose within the 40% cap). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 6364. If, for example, the maximum level of usage of the options is set at80%, it means that a bank adopting the options, either individually or incombination, would only be allowed to include HQLA associated withthe options (after applying any relevant haircut) up to 80% of the requiredamount of HQLA in the relevant currency.Thus, at least 20% of the HQLA requirement will have to be met by Level1 assets in the relevant currency.The maximum usage of the options is of course further constrained by thebank’s actual shortfall of HQLA in the currency concerned.65. The appropriateness of the maximum level of usage of the optionsallowed by a supervisor will be evaluated in the independent peer reviewprocess.The level set should be consistent with the projected size of the HQLAgap faced by banks subject to the LCR in the currency concerned, takinginto account all relevant factors that may affect the size of the gap overtime.The supervisor should explain how this level is derived, and justify whythis is supported by the insufficiency of HQLA in the banking system.Where a relatively high level of usage of the options is allowed by thesupervisor (eg over 80%), the suitability of this level will come undercloser scrutiny in the independent peer review.(d) Supervisory obligations and requirements66. A jurisdiction with insufficient HQLA must, among other things, fulfilthe following obligations (the detailed requirements are set out in Annex2):- Supervisory monitoring: There should be a clearly documented supervisory framework for overseeing and controlling the usage of the options by its banks, and for monitoring their compliance with the relevant requirements applicable to their use of the options; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 64- Disclosure framework: The jurisdiction should disclose its framework for applying the options to its banks (whether on its website or through other means). The disclosure should enable other national supervisors and stakeholders to gain a sufficient understanding of its compliance with the qualifying principles and criteria and the manner in which it supervises the use of the options by its banks;- Periodic self-assessment of eligibility for alternative treatment: The jurisdiction should perform a self-assessment of its eligibility for alternative treatment every five years after it has adopted the options, and disclose the results to other national supervisors and stakeholders.67. Supervisors in jurisdictions with insufficient HQLA should deviserules and requirements governing the use of the options by their banks,having regard to the guiding principles set out below.- Principle 1: Supervisors should ensure that banks’ use of the options is not simply an economic choice that maximises the profits of the bank through the selection of alternative HQLA based primarily on yield considerations. The liquidity characteristics of an alternative HQLA portfolio must be considered to be more important than its net yield.- Principle 2: Supervisors should ensure that the use of the options is constrained, both for all banks with exposures in the relevant currency and on a bank-by-bank basis.- Principle 3: Supervisors should ensure that banks have, to the extent practicable, taken reasonable steps to use Level 1 and Level 2 assets and reduce their overall level of liquidity risk to improve the LCR, before the alternative treatment can be applied.- Principle 4: Supervisors should have a mechanism for restraining the usage of the options to mitigate risks of non-performance of the alternative HQLA. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 65(v) Treatment for Shari’ah compliant banks68. Shari’ah compliant banks face a religious prohibition on holdingcertain types of assets, such as interest-bearing debt securities.Even in jurisdictions that have a sufficient supply of HQLA, aninsurmountable impediment to the ability of Shari’ah compliant banks tomeet the LCR requirement may still exist.In such cases, national supervisors in jurisdictions in which Shari’ahcompliant banks operate have the discretion to define Shari’ah compliantfinancial products (such as Sukuk) as alternative HQLA applicable tosuch banks only, subject to such conditions or haircuts that thesupervisors may require.It should be noted that the intention of this treatment is not to allowShari’ah compliant banks to hold fewer HQLA.The minimum LCR standard, calculated based on alternative HQLA(post-haircut) recognised as HQLA for these banks, should not be lowerthan the minimum LCR standard applicable to other banks in thejurisdiction concerned.National supervisors applying such treatment for Shari’ah compliantbanks should comply with supervisory monitoring and disclosureobligations similar to those set out in paragraph 66 above. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 66B. Total net cash outflows69. The term total net cash outflows is defined as the total expected cashoutflows minus total expected cash inflows in the specified stress scenariofor the subsequent 30 calendar days.Total expected cash outflows are calculated by multiplying theoutstanding balances of various categories or types of liabilities andoff-balance sheet commitments by the rates at which they are expected torun off or be drawn down.Total expected cash inflows are calculated by multiplying the outstandingbalances of various categories of contractual receivables by the rates atwhich they are expected to flow in under the scenario up to an aggregatecap of 75% of total expected cash outflows.70. While most roll-off rates, draw-down rates and similar factors areharmonised across jurisdictions as outlined in this standard, a fewparameters are to be determined by supervisory authorities at the nationallevel.Where this is the case, the parameters should be transparent and madepublicly available.71. Annex 4 provides a summary of the factors that are applied to eachcategory.72. Banks will not be permitted to double count items, ie if an asset isincluded as part of the “stock of HQLA” (ie the numerator), theassociated cash inflows cannot also be counted as cash inflows (ie part ofthe denominator).Where there is potential that an item could be counted in multiple outflowcategories, (eg committed liquidity facilities granted to cover debt _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 67maturing within the 30 calendar day period), a bank only has to assumeup to the maximum contractual outflow for that product.1. Cash outflows(i) Retail deposit run-off73. Retail deposits are defined as deposits placed with a bank by a naturalperson.Deposits from legal entities, sole proprietorships or partnerships arecaptured in wholesale deposit categories.Retail deposits subject to the LCR include demand deposits and termdeposits, unless otherwise excluded under the criteria set out inparagraphs 82 and 83.74. These retail deposits are divided into “stable” and “less stable”portions of funds as described below, with minimum run-off rates listedfor each category.The run-off rates for retail deposits are minimum floors, with higherrun-off rates established by individual jurisdictions as appropriate tocapture depositor behaviour in a period of stress in each jurisdiction.(a) Stable deposits (run-off rate = 3% and higher)75. Stable deposits, which usually receive a run-off factor of 5%, are theamount of the deposits that are fully insured by an effective depositinsurance scheme or by a public guarantee that provides equivalentprotection and where:- the depositors have other established relationships with the bank that make deposit withdrawal highly unlikely; or- the deposits are in transactional accounts (eg accounts where salaries are automatically deposited). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 6876. For the purposes of this standard, an “effective deposit insurancescheme” refers to a scheme(i) That guarantees that it has the ability to make prompt payouts,(ii) For which the coverage is clearly defined and(iii) Of which public awareness is high.The deposit insurer in an effective deposit insurance scheme has formallegal powers to fulfil its mandate and is operationally independent,transparent and accountable.A jurisdiction with an explicit and legally binding sovereign depositguarantee that effectively functions as deposit insurance can be regardedas having an effective deposit insurance scheme.77. The presence of deposit insurance alone is not sufficient to consider adeposit “stable”.78. Jurisdictions may choose to apply a run-off rate of 3% to stabledeposits in their jurisdiction, if they meet the above stable deposit criteriaand the following additional criteria for deposit insurance schemes:- the insurance scheme is based on a system of prefunding via the periodic collection of levies on banks with insured deposits;- the scheme has adequate means of ensuring ready access to additional funding in the event of a large call on its reserves, eg an explicit and legally binding guarantee from the government, or a standing authority to borrow from the government- access to insured deposits is available to depositors in a short period of time once the deposit insurance scheme is triggered.Jurisdictions applying the 3% run-off rate to stable deposits with depositinsurance arrangements that meet the above criteria should be able to _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 69provide evidence of run-off rates for stable deposits within the bankingsystem below 3% during any periods of stress experienced that areconsistent with the conditions within the LCR.(b) Less stable deposits (run-off rates = 10% and higher)79. Supervisory authorities are expected to develop additional bucketswith higher runoff rates as necessary to apply to buckets of potentially lessstable retail deposits in their jurisdictions, with a minimum run-off rate of10%.These jurisdiction-specific run-off rates should be clearly outlined andpublicly transparent.Buckets of less stable deposits could include deposits that are not fullycovered by an effective deposit insurance scheme or sovereign depositguarantee, high-value deposits, deposits from sophisticated or high networth individuals, deposits that can be withdrawn quickly (eg internetdeposits) and foreign currency deposits, as determined by eachjurisdiction.80. If a bank is not able to readily identify which retail deposits wouldqualify as “stable” according to the above definition (eg the bank cannotdetermine which deposits are covered by an effective deposit insurancescheme or a sovereign deposit guarantee), it should place the full amountin the “less stable” buckets as established by its supervisor.81. Foreign currency retail deposits are deposits denominated in any othercurrency than the domestic currency in a jurisdiction in which the bankoperates.Supervisors will determine the run-off factor that banks in theirjurisdiction should use for foreign currency deposits.Foreign currency deposits will be considered as “less stable” if there is areason to believe that such deposits are more volatile than domesticcurrency deposits. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 70Factors affecting the volatility of foreign currency deposits include thetype and sophistication of the depositors, and the nature of such deposits(eg whether the deposits are linked to business needs in the samecurrency, or whether the deposits are placed in a search for yield).82. Cash outflows related to retail term deposits with a residual maturityor withdrawal notice period of greater than 30 days will be excluded fromtotal expected cash outflows if the depositor has no legal right towithdraw deposits within the 30-day horizon of the LCR, or if earlywithdrawal results in a significant penalty that is materially greater thanthe loss of interest.83. If a bank allows a depositor to withdraw such deposits withoutapplying the corresponding penalty, or despite a clause that says thedepositor has no legal right to withdraw, the entire category of thesefunds would then have to be treated as demand deposits (ie regardless ofthe remaining term, the deposits would be subject to the deposit run-offrates as specified in paragraphs 74-81).Supervisors in each jurisdiction may choose to outline exceptionalcircumstances that would qualify as hardship, under which theexceptional term deposit could be withdrawn by the depositor withoutchanging the treatment of the entire pool of deposits.Such reasons could include, but are not limited to, supervisory concernsthat depositors would withdraw term deposits in a similar fashion as retaildemand deposits during either normal or stress times, concern that banksmay repay such deposits early in stressed times for reputational reasons,or the presence of unintended incentives on banks to impose materialpenalties on consumers if deposits are withdrawn early.In these cases supervisors would assess a higher run-off against all orsome of such deposits.(ii) Unsecured wholesale funding run-off85. For the purposes of the LCR, "unsecured wholesale funding” isdefined as those liabilities and general obligations that are raised from _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 71non-natural persons (ie legal entities, including sole proprietorships andpartnerships) and are not collateralised by legal rights to specificallydesignated assets owned by the borrowing institution in the case ofbankruptcy, insolvency, liquidation or resolution.Obligations related to derivative contracts are explicitly excluded fromthis definition.86. The wholesale funding included in the LCR is defined as all fundingthat is callable within the LCR’s horizon of 30 days or that has its earliestpossible contractual maturity date situated within this horizon (such asmaturing term deposits and unsecured debt securities) as well as fundingwith an undetermined maturity.This should include all funding with options that are exercisable at theinvestor’s discretion within the 30 calendar day horizon.For funding with options exercisable at the bank’s discretion, supervisorsshould take into account reputational factors that may limit a banksability not to exercise the option.In particular, where the market expects certain liabilities to be redeemedbefore their legal final maturity date, banks and supervisors shouldassume such behaviour for the purpose of the LCR and include theseliabilities as outflows.87. Wholesale funding that is callable by the funds provider subject to acontractually defined and binding notice period surpassing the 30-dayhorizon is not included.88. For the purposes of the LCR, unsecured wholesale funding is to becategorised as detailed below, based on the assumed sensitivity of thefunds providers to the rate offered and the credit quality and solvency ofthe borrowing bank.This is determined by the type of funds providers and their level ofsophistication, as well as their operational relationships with the bank. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 72The run-off rates for the scenario are listed for each category.(a) Unsecured wholesale funding provided by small businesscustomers: 5%, 10% and Higher89. Unsecured wholesale funding provided by small business customersis treated the same way as retail deposits for the purposes of this standard,effectively distinguishing between a "stable" portion of funding providedby small business customers and different buckets of less stable fundingdefined by each jurisdiction.The same bucket definitions and associated run-off factors apply as forretail deposits.90. This category consists of deposits and other extensions of funds madeby nonfinancial small business customers.“Small business customers” are defined in line with the definition ofloans extended to small businesses in paragraph 231 of the Basel IIframework that are managed as retail exposures and are generallyconsidered as having similar liquidity risk characteristics to retailaccounts provided the total aggregated funding raised from onesmall business customer is less than €1 million (on a consolidated basiswhere applicable).91. Where a bank does not have any exposure to a small businesscustomer that would enable it to use the definition under paragraph 231 ofthe Basel II Framework, the bank may include such a deposit in thiscategory provided that the total aggregate funding raised from thecustomer is less than €1 million (on a consolidated basis whereapplicable) and the deposit is managed as a retail deposit.This means that the bank treats such deposits in its internal riskmanagement systems consistently over time and in the same manner asother retail deposits, and that the deposits are not individually managedin a way comparable to larger corporate deposits. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 7392. Term deposits from small business customers should be treated inaccordance with the treatment for term retail deposits as outlined inparagraph 82, 83, and 84.(b) Operational deposits generated by clearing, custody andcash management activities: 25%93. Certain activities lead to financial and non-financial customersneeding to place, or leave, deposits with a bank in order to facilitate theiraccess and ability to use payment and settlement systems and otherwisemake payments.These funds may receive a 25% run-off factor only if the customer has asubstantive dependency with the bank and the deposit is required forsuch activities.Supervisory approval would have to be given to ensure that banksutilising this treatment actually are conducting these operationalactivities at the level indicated.Supervisors may choose not to permit banks to utilise the operationaldeposit runoff rates in cases where, for example, a significant portion ofoperational deposits are provided by a small proportion of customers (ieconcentration risk).94. Qualifying activities in this context refer to clearing, custody or cashmanagement activities that meet the following criteria:- The customer is reliant on the bank to perform these services as an independent third party intermediary in order to fulfil its normal banking activities over the next 30 days. For example, this condition would not be met if the bank is aware that the customer has adequate back-up arrangements.- These services must be provided under a legally binding agreement to institutional customers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 74- The termination of such agreements shall be subject either to a notice period of at least 30 days or significant switching costs (such as those related to transaction, information technology, early termination or legal costs) to be borne by the customer if the operational deposits are moved before 30 days.95. Qualifying operational deposits generated by such an activity are oneswhere:- The deposits are by-products of the underlying services provided by the banking organisation and not sought out in the wholesale market in the sole interest of offering interest income.- The deposits are held in specifically designated accounts and priced without giving an economic incentive to the customer (not limited to paying market interest rates) to leave any excess funds on these accounts. In the case that interest rates in a jurisdiction are close to zero, it would be expected that such accounts are noninterest bearing. Banks should be particularly aware that during prolonged periods of low interest rates, excess balances (as defined below) could be significant.96. Any excess balances that could be withdrawn and would still leaveenough funds to fulfil these clearing, custody and cash managementactivities do not qualify for the 25% factor.In other words, only that part of the deposit balance with the serviceprovider that is proven to serve a customer’s operational needs can qualifyas stable.Excess balances should be treated in the appropriate category fornon-operational deposits. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 75If banks are unable to determine the amount of the excess balance, thenthe entire deposit should be assumed to be excess to requirements and,therefore, considered non-operational.97. Banks must determine the methodology for identifying excessdeposits that are excluded from this treatment.This assessment should be conducted at a sufficiently granular level toadequately assess the risk of withdrawal in an idiosyncratic stress.The methodology should take into account relevant factors such as thelikelihood that wholesale customers have above average balances inadvance of specific payment needs, and consider appropriate indicators(eg ratios of account balances to payment or settlement volumes or toassets under custody) to identify those customers that are not activelymanaging account balances efficiently.98. Operational deposits would receive a 0% inflow assumption for thedepositing bank given that these deposits are required for operationalreasons, and are therefore not available to the depositing bank to repayother outflows.99. Notwithstanding these operational categories, if the deposit underconsideration arises out of correspondent banking or from the provisionof prime brokerage services, it will be treated as if there were nooperational activity for the purpose of determining run-off factors.42100. The following paragraphs describe the types of activities that maygenerate operational deposits.A bank should assess whether the presence of such an activity doesindeed generate an operational deposit as not all such activities qualifydue to differences in customer dependency, activity and practices.101. A clearing relationship, in this context, refers to a servicearrangement that enables customers to transfer funds (or securities)indirectly through direct participants in domestic settlement systems tofinal recipients. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 76Such services are limited to the following activities: transmission,reconciliation and confirmation of payment orders; daylight overdraft,overnight financing and maintenance of post-settlement balances; anddetermination of intra-day and final settlement positions.102. A custody relationship, in this context, refers to the provision ofsafekeeping, reporting, processing of assets or the facilitation of theoperational and administrative elements of related activities on behalf ofcustomers in the process of their transacting and retaining financialassets.Such services are limited to the settlement of securities transactions, thetransfer of contractual payments, the processing of collateral, and theprovision of custody related cash management services.Also included are the receipt of dividends and other income, clientsubscriptions and redemptions.Custodial services can furthermore extend to asset and corporate trustservicing, treasury, escrow, funds transfer, stock transfer and agencyservices, including payment and settlement services (excludingcorrespondent banking), and depository receipts.103. A cash management relationship, in this context, refers to theprovision of cash management and related services to customers.Cash management services, in this context, refers to those products andservices provided to a customer to manage its cash flows, assets andliabilities, and conduct financial transactions necessary to the customer’songoing operations.Such services are limited to payment remittance, collection andaggregation of funds, payroll administration, and control over thedisbursement of funds.104. The portion of the operational deposits generated by clearing,custody and cash management activities that is fully covered by depositinsurance can receive the same treatment as “stable” retail deposits _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 77(c) Treatment of deposits in institutional networks ofcooperative banks: 25% or 100%105. An institutional network of cooperative (or otherwise named) banksis a group of legally autonomous banks with a statutory framework ofcooperation with common strategic focus and brand where specificfunctions are performed by central institutions or specialized serviceproviders.A 25% run-off rate can be given to the amount of deposits of memberinstitutions with the central institution or specialised central serviceproviders that are placed(a) due to statutory minimum deposit requirements, which are registeredat regulators or(b) in the context of common task sharing and legal, statutory orcontractual arrangements so long as both the bank that has received themonies and the bank that has deposited participate in the sameinstitutional network’s mutual protection scheme against illiquidity andinsolvency of its members.As with other operational deposits, these deposits would receive a 0%inflow assumption for the depositing bank, as these funds are consideredto remain with the centralised institution.106. Supervisory approval would have to be given to ensure that banksutilising this treatment actually are the central institution or a centralservice provider of such a cooperative (or otherwise named) network.Correspondent banking activities would not be included in this treatmentand would receive a 100% outflow treatment, as would funds placed at thecentral institutions or specialised service providers for any other reasonother than those outlined in (a) and (b) in the paragraph above, or foroperational functions of clearing, custody, or cash management asoutlined in paragraphs 101-103. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 78(d) Unsecured wholesale funding provided by non-financialcorporates and sovereigns, central banks, multilateraldevelopment banks, and PSEs: 20% or 40%107. This category comprises all deposits and other extensions ofunsecured funding from non-financial corporate customers (that are notcategorised as small business customers) and (both domestic andforeign) sovereign, central bank, multilateral development bank, and PSEcustomers that are not specifically held for operational purposes (asdefined above).The run-off factor for these funds is 40%, unless the criteria inparagraph 108 are met.108. Unsecured wholesale funding provided by non-financial corporatecustomers, sovereigns, central banks, multilateral development banks,and PSEs without operational relationships can receive a 20% run-offfactor if the entire amount of the deposit is fully covered by an effectivedeposit insurance scheme or by a public guarantee that providesequivalent protection.(e) Unsecured wholesale funding provided by other legal entitycustomers: 100%109. This category consists of all deposits and other funding from otherinstitutions (including banks, securities firms, insurance companies, etc),fiduciaries, beneficiaries, conduits and special purpose vehicles, affiliatedentities of the bank and other entities that are not specifically held foroperational purposes (as defined above) and not included in theprior three categories.The run-off factor for these funds is 100%.110. All notes, bonds and other debt securities issued by the bank areincluded in this category regardless of the holder, unless the bond is soldexclusively in the retail market and held in retail accounts (including _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 79small business customer accounts treated as retail per paragraphs 89-91),in which case the instruments can be treated in the appropriate retail orsmall business customer deposit category.To be treated in this manner, it is not sufficient that the debt instrumentsare specifically designed and marketed to retail or small businesscustomers.Rather there should be limitations placed such that those instrumentscannot be bought and held by parties other than retail or small businesscustomers.111. Customer cash balances arising from the provision of primebrokerage services, including but not limited to the cash arising fromprime brokerage services as identified in paragraph 99, should beconsidered separate from any required segregated balances relatedto client protection regimes imposed by national regulations, and shouldnot be netted against other customer exposures included in this standard.These offsetting balances held in segregated accounts are treated asinflows in paragraph 154 and should be excluded from the stock ofHQLA.(iii) Secured funding run-off112. For the purposes of this standard, “secured funding” is defined asthose liabilities and general obligations that are collateralised by legalrights to specifically designated assets owned by the borrowinginstitution in the case of bankruptcy, insolvency, liquidation orresolution.113. Loss of secured funding on short-term financing transactions: In thisscenario, the ability to continue to transact repurchase, reverserepurchase and other securities financing transactions is limited totransactions backed by HQLA or with the bank’s domesticsovereign, PSE or central bank. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 80Collateral swaps should be treated as repurchase or reverse repurchaseagreements, as should any other transaction with a similar form.Additionally, collateral lent to the bank’s customers to effect shortpositions should be treated as a form of secured funding.For the scenario, a bank should apply the following factors to alloutstanding secured funding transactions with maturities within the 30calendar day stress horizon, including customer short positions that donot have a specified contractual maturity.The amount of outflow is calculated based on the amount of funds raisedthrough the transaction, and not the value of the underlying collateral.114. Due to the high-quality of Level 1 assets, no reduction in fundingavailability against these assets is assumed to occur.Moreover, no reduction in funding availability is expected for anymaturing secured funding transactions with the bank’s domestic centralbank.A reduction in funding availability will be assigned to maturingtransactions backed by Level 2 assets equivalent to the required haircuts.A 25% factor is applied for maturing secured funding transactions withthe bank’s domestic sovereign, multilateral development banks, ordomestic PSEs that have a 20% or lower risk weight, when thetransactions are backed by assets other than Level 1 or Level 2A assets, inrecognition that these entities are unlikely to withdraw secured fundingfrom banks in a time of market-wide stress.This, however, gives credit only for outstanding secured fundingtransactions, and not for unused collateral or merely the capacity toborrow.115. For all other maturing transactions the run-off factor is 100%,including transactions where a bank has satisfied customers’ shortpositions with its own long inventory. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 81The table below summarises the applicable standards:(iv) Additional requirements116. Derivatives cash outflows: the sum of all net cash outflows shouldreceive a 100% factor.Banks should calculate, in accordance with their existing valuationmethodologies, expected contractual derivative cash inflows andoutflows.Cash flows may be calculated on a net basis (ie inflows can offsetoutflows) by counterparty, only where a valid master netting agreementexists.Banks should exclude from such calculations those liquidityrequirements that would result from increased collateral needs due tomarket value movements or falls in value of collateral posted.Options should be assumed to be exercised when they are ‘in the money’to the option buyer.117. Where derivative payments are collateralised by HQLA, cashoutflows should be calculated net of any corresponding cash or collateralinflows that would result, all other things being equal, from contractual _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 82obligations for cash or collateral to be provided to the bank, if the bank islegally entitled and operationally capable to re-use the collateral in newcash raising transactions once the collateral is received.This is in line with the principle that banks should not double countliquidity inflows and outflows.118. Increased liquidity needs related to downgrade triggers embedded infinancing transactions, derivatives and other contracts: (100% of theamount of collateral that would be posted for, or contractual cashoutflows associated with, any downgrade up to and including a 3-notchdowngrade).Often, contracts governing derivatives and other transactions haveclauses that require the posting of additional collateral, drawdown ofcontingent facilities, or early repayment of existing liabilities upon thebank’s downgrade by a recognised credit rating organisation.The scenario therefore requires that for each contract in which“downgrade triggers” exist, the bank assumes that 100% of this additionalcollateral or cash outflow will have to be posted for any downgrade up toand including a 3-notch downgrade of the bank’s long-term credit rating.Triggers linked to a bank’s short-term rating should be assumed to betriggered at the corresponding long-term rating in accordance withpublished ratings criteria.The impact of the downgrade should consider impacts on all types ofmargin collateral and contractual triggers which change rehypothecationrights for non-segregated collateral.119. Increased liquidity needs related to the potential for valuationchanges on posted collateral securing derivative and other transactions:(20% of the value of non- Level 1 posted collateral).Observation of market practices indicates that most counterparties toderivatives transactions typically are required to secure themark-to-market valuation of their positions and that this is predominantly _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 83done using cash or sovereign, central bank, multilateral developmentbanks, or PSE debt securities with a 0% risk weight under the BaselII standardised approach.When these Level 1 liquid asset securities are posted as collateral, theframework will not require that an additional stock of HQLA bemaintained for potential valuation changes.If however, counterparties are securing mark-to-market exposures withother forms of collateral, to cover the potential loss of market value onthose securities, 20% of the value of all such posted collateral, net ofcollateral received on a counterparty basis (provided that the collateralreceived is not subject to restrictions on reuse or rehypothecation) will beadded to the stock of required HQLA by the bank posting suchcollateral.This 20% will be calculated based on the notional amount required to beposted as collateral after any other haircuts have been applied that may beapplicable to the collateral category.Any collateral that is in a segregated margin account can only be used tooffset outflows that are associated with payments that are eligible to beoffset from that same account.120. Increased liquidity needs related to excess non-segregated collateralheld by the bank that could contractually be called at any time by thecounterparty: 100% of the non-segregated collateral that couldcontractually be recalled by the counterparty because the collateral is inexcess of the counterparty’s current collateral requirements.121. Increased liquidity needs related to contractually required collateralon transactions for which the counterparty has not yet demanded thecollateral be posted: 100% of the collateral that is contractually due butwhere the counterparty has not yet demanded the posting of suchcollateral.122. Increased liquidity needs related to contracts that allow collateralsubstitution to non-HQLA assets: 100% of the amount of HQLA _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 84collateral that can be substituted for non-HQLA assets without the bank’sconsent that have been received to secure transactions that have not beensegregated.123. Increased liquidity needs related to market valuation changes onderivative or other transactions: As market practice requirescollateralisation of mark-to-market exposures on derivative and othertransactions, banks face potentially substantial liquidity risk exposures tothese valuation changes. Inflows and outflows of transactions executedunder the same master netting agreement can be treated on a net basis.Any outflow generated by increased needs related to market valuationchanges should be included in the LCR calculated by identifying thelargest absolute net 30-day collateral flow realised during the preceding 24months.The absolute net collateral flow is based on both realised outflows andinflows. Supervisors may adjust the treatment flexibly according tocircumstances.124. Loss of funding on asset-backed securities, 49 covered bonds andother structured financing instruments: The scenario assumes theoutflow of 100% of the funding transaction maturing within the 30-dayperiod, when these instruments are issued by the bank itself (as thisassumes that the re-financing market will not exist).125. Loss of funding on asset-backed commercial paper, conduits,securities investment vehicles and other such financing facilities: (100%of maturing amount and 100% of returnable assets).Banks having structured financing facilities that include the issuance ofshort-term debt instruments, such as asset backed commercial paper,should fully consider the potential liquidity risk arising from thesestructures.These risks include, but are not limited to,(i) the inability to refinance maturing debt, and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 85(ii) the existence of derivatives or derivative-like componentscontractually written into the documentation associated with thestructure that would allow the “return” of assets in a financingarrangement, or that require the original asset transferor to provideliquidity, effectively ending the financing arrangement (“liquidity puts”)within the 30-day period.Where the structured financing activities of a bank are conducted througha special purpose entity50 (such as a special purpose vehicle, conduit orstructured investment vehicle - SIV), the bank should, in determining theHQLA requirements, look through to the maturity of the debtinstruments issued by the entity and any embedded options in financingarrangements that may potentially trigger the “return” of assets or theneed for liquidity, irrespective of whether or not the SPV is consolidated.126. Drawdowns on committed credit and liquidity facilities: For thepurpose of the standard, credit and liquidity facilities are defined asexplicit contractual agreements or obligations to extend funds at a futuredate to retail or wholesale counterparties.For the purpose of the standard, these facilities only include contractuallyirrevocable (“committed”) or conditionally revocable agreements toextend funds in the future.Unconditionally revocable facilities that are unconditionally cancellableby the bank (in particular, those without a precondition of a materialchange in the credit condition of the borrower) are excluded from thissection and included in “Other Contingent Funding Liabilities”. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 86These off balance sheet facilities or funding commitments can have longor short-term maturities, with short-term facilities frequently renewing orautomatically rolling-over.In a stressed environment, it will likely be difficult for customers drawingon facilities of any maturity, even short-term maturities, to be able toquickly pay back the borrowings.Therefore, for purposes of this standard, all facilities that are assumed tobe drawn (as outlined in the paragraphs below) will remain outstanding atthe amounts assigned throughout the duration of the test, regardless ofmaturity.127. For the purposes of this standard, the currently undrawn portion ofthese facilities is calculated net of any HQLA eligible for the stock ofHQLA, if the HQLA have already been posted as collateral by thecounterparty to secure the facilities or that are contractually obliged to beposted when the counterparty will draw down the facility (eg a liquidityfacility structured as a repo facility), if the bank is legally entitled andoperationally capable to re-use the collateral in new cash raisingtransactions once the facility is drawn, and there is no undue correlationbetween the probability of drawing the facility and the market value of thecollateral.The collateral can be netted against the outstanding amount of the facilityto the extent that this collateral is not already counted in the stock ofHQLA, in line with the principle in paragraph 72 that items cannot bedouble-counted in the standard.128. A liquidity facility is defined as any committed, undrawn back-upfacility that would be utilised to refinance the debt obligations of acustomer in situations where such a customer is unable to rollover thatdebt in financial markets (eg pursuant to a commercial paperprogramme, secured financing transactions, obligations to redeem units,etc).For the purpose of this standard, the amount of the commitment to betreated as a liquidity facility is the amount of the currently outstanding _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 87debt issued by the customer (or proportionate share, if a syndicatedfacility) maturing within a 30 day period that is backstopped by thefacility.The portion of a liquidity facility that is backing debt that does notmature within the 30-day window is excluded from the scope of thedefinition of a facility.Any additional capacity of the facility (ie the remaining commitment)would be treated as a committed credit facility with its associateddrawdown rate as specified in paragraph 131.General working capital facilities for corporate entities (eg revolvingcredit facilities in place for general corporate or working capital purposes)will not be classified as liquidity facilities, but as credit facilities.129. Notwithstanding the above, any facilities provided to hedge funds,money market funds and special purpose funding vehicles, for exampleSPEs (as defined in paragraph 125) or conduits, or other vehicles used tofinance the banks own assets, should be captured in their entirety as aliquidity facility to other legal entities.130. For that portion of financing programs that are captured inparagraphs 124 and 125 (ie are maturing or have liquidity puts that may beexercised in the 30-day horizon), banks that are providers of associatedliquidity facilities do not need to double count the maturing financinginstrument and the liquidity facility for consolidated programs.131. Any contractual loan drawdowns from committed facilities 51 andestimated drawdowns from revocable facilities within the 30-day periodshould be fully reflected as outflows.(a) Committed credit and liquidity facilities to retail and small businesscustomers:Banks should assume a 5% drawdown of the undrawn portion of thesefacilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 88(b) Committed credit facilities to non-financial corporates, sovereignsand central banks, PSEs and multilateral development banks: Banksshould assume a 10% drawdown of the undrawn portion of these creditfacilities.(c) Committed liquidity facilities to non-financial corporates, sovereignsand central banks, PSEs, and multilateral development banks: Banksshould assume a 30% drawdown of the undrawn portion of these liquidityfacilities.(d) Committed credit and liquidity facilities extended to banks subject toprudential supervision: Banks should assume a 40% drawdown of theundrawn portion of these facilities.(e) Committed credit facilities to other financial institutions includingsecurities firms, insurance companies, fiduciaries and beneficiaries:Banks should assume a 40% drawdown of the undrawn portion of thesecredit facilities.(f) Committed liquidity facilities to other financial institutions includingsecurities firms, insurance companies, fiduciaries, and beneficiaries:Banks should assume a 100% drawdown of the undrawn portion of theseliquidity facilities.(g) Committed credit and liquidity facilities to other legal entities(including SPEs (as defined on paragraph 125), conduits and specialpurpose vehicles,54 and other entities not included in the priorcategories): Banks should assume a 100% drawdown of the undrawnportion of these facilities.132. Contractual obligations to extend funds within a 30-day period. Anycontractual lending obligations to financial institutions not capturedelsewhere in this standard should be captured here at a 100% outflow rate.133. If the total of all contractual obligations to extend funds to retail andnon-financial corporate clients within the next 30 calendar days (notcaptured in the prior categories) exceeds 50% of the total contractual _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 89inflows due in the next 30 calendar days from these clients, the differenceshould be reported as a 100% outflow.134. Other contingent funding obligations: (run-off rates at nationaldiscretion).National supervisors will work with supervised institutions in theirjurisdictions to determine the liquidity risk impact of these contingentliabilities and the resulting stock of HQLA that should accordingly bemaintained.Supervisors should disclose the run-off rates they assign to each categorypublicly.135. These contingent funding obligations may be either contractual ornon-contractual and are not lending commitments.Non-contractual contingent funding obligations include associationswith, or sponsorship of, products sold or services provided that mayrequire the support or extension of funds in the future under stressedconditions.Non-contractual obligations may be embedded in financial products andinstruments sold, sponsored, or originated by the institution that can giverise to unplanned balance sheet growth arising from support given forreputational risk considerations.These include products and instruments for which the customer or holderhas specific expectations regarding the liquidity and marketability of theproduct or instrument and for which failure to satisfy customerexpectations in a commercially reasonable manner would likely causematerial reputational damage to the institution or otherwise impairongoing viability.136. Some of these contingent funding obligations are explicitlycontingent upon a credit or other event that is not always related to theliquidity events simulated in the stress scenario, but may neverthelesshave the potential to cause significant liquidity drains in times of stress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 90For this standard, each supervisor and bank should consider which ofthese “other contingent funding obligations” may materialise under theassumed stress events.The potential liquidity exposures to these contingent funding obligationsare to be treated as a nationally determined behavioural assumptionwhere it is up to the supervisor to determine whether and to what extentthese contingent outflows are to be included in the LCR.All identified contractual and non-contractual contingent liabilities andtheir assumptions should be reported, along with their related triggers.Supervisors and banks should, at a minimum, use historical behaviour indetermining appropriate outflows.137. Non contractual contingent funding obligations related to potentialliquidity draws from joint ventures or minority investments in entities,which are not consolidated per paragraph 164 should be captured wherethere is the expectation that the bank will be the main liquidity providerwhen the entity is in need of liquidity.The amount included should be calculated in accordance with themethodology agreed by the bank’s supervisor.138. In the case of contingent funding obligations stemming from tradefinance instruments, national authorities can apply a relatively low run-offrate (eg 5% or less).Trade finance instruments consist of trade-related obligations directlyunderpinned by the movement of goods or the provision of services, suchas:- documentary trade letters of credit, documentary and clean collection, import bills, and export bills; and- guarantees directly related to trade finance obligations, such as shipping guarantees. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 91139. Lending commitments, such as direct import or export financing fornon-financial corporate firms, are excluded from this treatment andbanks will apply the draw-down rates specified in paragraph 131.140. National authorities should determine the run-off rates for the othercontingent funding obligations listed below in accordance withparagraph 134.Other contingent funding obligations include products and instrumentssuch as:- unconditionally revocable "uncommitted" credit and liquidity facilities;- guarantees and letters of credit unrelated to trade finance obligations (as described in paragraph 138);- non-contractual obligations such as:- potential requests for debt repurchases of the banks own debt or that of related conduits, securities investment vehicles and other such financing facilities;- structured products where customers anticipate ready marketability, such as adjustable rate notes and variable rate demand notes (VRDNs); and- managed funds that are marketed with the objective of maintaining a stable value such as money market mutual funds or other types of stable value collective investment funds etc.- For issuers with an affiliated dealer or market maker, there may be a need to include an amount of the outstanding debt securities (unsecured and secured, term as well as short-term) having maturities greater than 30 calendar days, to cover the potential repurchase of such outstanding securities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 92- Non contractual obligations where customer short positions are covered by other customers’ collateral: A minimum 50% run-off factor of the contingent obligations should be applied where banks have internally matched client assets against other clients’ short positions where the collateral does not qualify as Level 1 or Level 2, and the bank may be obligated to find additional sources of funding for these positions in the event of client withdrawals.141. Other contractual cash outflows: (100%). Any other contractual cashoutflows within the next 30 calendar days should be captured in thisstandard, such as outflows to cover unsecured collateral borrowings,uncovered short positions, dividends or contractual interest payments,with explanation given as to what comprises this bucket.Outflows related to operating costs, however, are not included in thisstandard.2. Cash inflows142. When considering its available cash inflows, the bank should onlyinclude contractual inflows (including interest payments) fromoutstanding exposures that are fully performing and for which the bankhas no reason to expect a default within the 30-day time horizon.Contingent inflows are not included in total net cash inflows.143. Banks and supervisors need to monitor the concentration of expectedinflows across wholesale counterparties in the context of banks’ liquiditymanagement in order to ensure that their liquidity position is not overlydependent on the arrival of expected inflows from one or a limitednumber of wholesale counterparties.144. Cap on total inflows: In order to prevent banks from relying solely onanticipated inflows to meet their liquidity requirement, and also to ensurea minimum level of HQLA holdings, the amount of inflows that can offsetoutflows is capped at 75% of total expected cash outflows as calculated inthe standard. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 93This requires that a bank must maintain a minimum amount of stock ofHQLA equal to 25% of the total net cash outflows.(i) Secured lending, including reverse repos and securities borrowing145. A bank should assume that maturing reverse repurchase or securitiesborrowing agreements secured by Level 1 assets will be rolled-over andwill not give rise to any cash inflows (0%).Maturing reverse repurchase or securities lending agreements secured byLevel 2 HQLA will lead to cash inflows equivalent to the relevant haircutfor the specific assets.A bank is assumed not to roll-over maturing reverse repurchase orsecurities borrowing agreements secured by non-HQLA assets, and canassume to receive back 100% of the cash related to those agreements.Collateralised loans extended to customers for the purpose of takingleveraged trading positions (“margin loans”) should also be consideredas a form of secured lending; however, for this scenario banks mayrecognise no more than 50% of contractual inflows from maturing marginloans made against non-HQLA collateral.This treatment is in line with the assumptions outlined for securedfunding in the outflows section.146. As an exception to paragraph 145, if the collateral obtained throughreverse repo, securities borrowing, or collateral swaps, which matureswithin the 30-day horizon, is re-used (ie rehypothecated) and is used tocover short positions that could be extended beyond 30 days, a bankshould assume that such reverse repo or securities borrowingarrangements will be rolled-over and will not give rise to any cash inflows(0%), reflecting its need to continue to cover the short position or tore-purchase the relevant securities.Short positions include both instances where in its ‘matched book’ thebank sold short a security outright as part of a trading or hedging strategyand instances where the bank is short a security in the ‘matched’ repo _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 94book (ie it has borrowed a security for a given period and lent the securityout for a longer period).147. In the case of a bank’s short positions, if the short position is beingcovered by an unsecured security borrowing, the bank should assume theunsecured security borrowing of collateral from financial marketparticipants would run-off in full, leading to a 100% outflow of either cashor HQLA to secure the borrowing, or cash to close out the short positionby buying back the security.This should be recorded as a 100% other contractual outflow according toparagraph 141.If, however, the bank’s short position is being covered by a collateralisedsecurities financing transaction, the bank should assume the shortposition will be maintained throughout the 30-day period and receive a0% outflow.148. Despite the roll-over assumptions in paragraphs 145 and 146, a bankshould manage its collateral such that it is able to fulfil obligations toreturn collateral whenever the counterparty decides not to roll-over anyreverse repo or securities lending transaction.This is especially the case for non-HQLA collateral, since such outflowsare not captured in the LCR framework. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 95Supervisors should monitor the banks collateral management.(ii) Committed facilities149. No credit facilities, liquidity facilities or other contingent fundingfacilities that the bank holds at other institutions for its own purposes areassumed to be able to be drawn.Such facilities receive a 0% inflow rate, meaning that this scenario doesnot consider inflows from committed credit or liquidity facilities.This is to reduce the contagion risk of liquidity shortages at one bankcausing shortages at other banks and to reflect the risk that other banksmay not be in a position to honour credit facilities, or may decide to incurthe legal and reputational risk involved in not honouring thecommitment, in order to conserve their own liquidity or reduce theirexposure to that bank.(iii) Other inflows by counterparty150. For all other types of transactions, either secured or unsecured, theinflow rate will be determined by counterparty.In order to reflect the need for a bank to conduct ongoing loanorigination/roll-over with different types of counterparties, even during atime of stress, a set of limits on contractual inflows by counterparty type isapplied.151. When considering loan payments, the bank should only includeinflows from fully performing loans.Further, inflows should only be taken at the latest possible date, based onthe contractual rights available to counterparties.For revolving credit facilities, this assumes that the existing loan is rolledover and that any remaining balances are treated in the same way as acommitted facility according to paragraph 131. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 96152. Inflows from loans that have no specific maturity (ie havenon-defined or open maturity) should not be included; therefore, noassumptions should be applied as to when maturity of such loans wouldoccur.An exception to this would be minimum payments of principal, fee orinterest associated with an open maturity loan, provided that suchpayments are contractually due within 30 days.These minimum payment amounts should be captured as inflows at therates prescribed in paragraphs 153 and 154.(a) Retail and small business customer inflows153. This scenario assumes that banks will receive all payments(including interest payments and instalments) from retail and smallbusiness customers that are fully performing and contractually due withina 30-day horizon.At the same time, however, banks are assumed to continue to extendloans to retail and small business customers, at a rate of 50% ofcontractual inflows.This results in a net inflow number of 50% of the contractual amount.(b) Other wholesale inflows154. This scenario assumes that banks will receive all payments(including interest payments and instalments) from wholesale customersthat are fully performing and contractually due within the 30-day horizon.In addition, banks are assumed to continue to extend loans to wholesaleclients, at a rate of 0% of inflows for financial institutions and centralbanks, and 50% for all others, including non-financial corporates,sovereigns, multilateral development banks, and PSEs.This will result in an inflow percentage of: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 97- 100% for financial institution and central bank counterparties; and- 50% for non-financial wholesale counterparties.155. Inflows from securities maturing within 30 days not included in thestock of HQLA should be treated in the same category as inflows fromfinancial institutions (ie 100% inflow).Banks may also recognise in this category inflows from the release ofbalances held in segregated accounts in accordance with regulatoryrequirements for the protection of customer trading assets, provided thatthese segregated balances are maintained in HQLA.This inflow should be calculated in line with the treatment of otherrelated outflows and inflows covered in this standard.Level 1 and Level 2 securities maturing within 30 days should be includedin the stock of liquid assets, provided that they meet all operational anddefinitional requirements, as laid out in paragraphs 28-54.156. Operational deposits: Deposits held at other financial institutions foroperational purposes, as outlined in paragraphs 93-103, such as forclearing, custody, and cash management purposes, are assumed to stay atthose institutions, and no inflows can be counted for these funds – ie theywill receive a 0% inflow rate, as noted in paragraph 98.157. The same treatment applies for deposits held at the centralisedinstitution in a cooperative banking network, that are assumed to stay atthe centralised institution as outlined in paragraphs 105 and 106; in otherwords, the depositing bank should not count any inflow for these funds –ie they will receive a 0% inflow rate.(iv) Other cash inflows158. Derivatives cash inflows: the sum of all net cash inflows shouldreceive a 100% inflow factor. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 98The amounts of derivatives cash inflows and outflows should becalculated in accordance with the methodology described in paragraph116.159. Where derivatives are collateralised by HQLA, cash inflows shouldbe calculated net of any corresponding cash or contractual collateraloutflows that would result, all other things being equal, from contractualobligations for cash or collateral to be posted by the bank, given thesecontractual obligations would reduce the stock of HQLA.This is in accordance with the principle that banks should notdouble-count liquidity inflows or outflows.160. Other contractual cash inflows: Other contractual cash inflowsshould be captured here, with explanation given to what comprises thisbucket.Inflow percentages should be determined as appropriate for each type ofinflow by supervisors in each jurisdiction.Cash inflows related to non-financial revenues are not taken into accountin the calculation of the net cash outflows for the purposes of thisstandard. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 99III. Application issues for the LCR161. This section outlines a number of issues related to the application ofthe LCR.These issues include the frequency with which banks calculate and reportthe LCR, the scope of application of the LCR (whether they apply atgroup or entity level and to foreign bank branches) and the aggregation ofcurrencies within the LCR.A. Frequency of calculation and reporting162. The LCR should be used on an ongoing basis to help monitor andcontrol liquidity risk.The LCR should be reported to supervisors at least monthly, with theoperational capacity to increase the frequency to weekly or even daily instressed situations at the discretion of the supervisor.The time lag in reporting should be as short as feasible and ideally shouldnot surpass two weeks.163. Banks are expected to inform supervisors of their LCR and theirliquidity profile on an ongoing basis.Banks should also notify supervisors immediately if their LCR has fallen,or is expected to fall, below 100%.B. Scope of application164. The application of the requirements in this document follow theexisting scope of application set out in Part I (Scope of Application) of theBasel II Framework.The LCR standard and monitoring tools should be applied to allinternationally active banks on a consolidated basis, but may be used forother banks and on any subset of entities of internationally active banks _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 100as well to ensure greater consistency and a level playing field betweendomestic and cross-border banks.The LCR standard and monitoring tools should be applied consistentlywherever they are applied.165. National supervisors should determine which investments inbanking, securities and financial entities of a banking group that are notconsolidated per paragraph 164 should be considered significant, takinginto account the liquidity impact of such investments on the group underthe LCR standard.Normally, a non-controlling investment (eg a joint-venture orminority-owned entity) can be regarded as significant if the bankinggroup will be the main liquidity provider of such investment in times ofstress (for example, when the other shareholders are non-banks or wherethe bank is operationally involved in the day-to-day management andmonitoring of the entity’s liquidity risk).National supervisors should agree with each relevant bank on acase-by-case basis on an appropriate methodology for how to quantifysuch potential liquidity draws, in particular, those arising from the needto support the investment in times of stress out of reputational concernsfor the purpose of calculating the LCR standard.To the extent that such liquidity draws are not included elsewhere, theyshould be treated under “Other contingent funding obligations”, asdescribed in paragraph 137.166. Regardless of the scope of application of the LCR, in keeping withPrinciple 6 as outlined in the Sound Principles, a bank should activelymonitor and control liquidity risk exposures and funding needs at thelevel of individual legal entities, foreign branches and subsidiaries, andthe group as a whole, taking into account legal, regulatory andoperational limitations to the transferability of liquidity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 101167. To ensure consistency in applying the consolidated LCR acrossjurisdictions, further information is provided below on two applicationissues.1. Differences in home / host liquidity requirements168. While most of the parameters in the LCR are internationally“harmonised”, national differences in liquidity treatment may occur inthose items subject to national discretion (eg deposit run-off rates,contingent funding obligations, market valuation changes on derivativetransactions, etc) and where more stringent parameters are adopted bysome supervisors.169. When calculating the LCR on a consolidated basis, a cross-borderbanking group should apply the liquidity parameters adopted in the homejurisdiction to all legal entities being consolidated except for thetreatment of retail / small business deposits that should follow therelevant parameters adopted in host jurisdictions in which the entities(branch or subsidiary) operate.This approach will enable the stressed liquidity needs of legal entities ofthe group (including branches of those entities) operating in hostjurisdictions to be more suitably reflected, given that deposit run-off ratesin host jurisdictions are more influenced by jurisdiction-specific factorssuch as the type and effectiveness of deposit insurance schemes in placeand the behaviour of local depositors.170. Home requirements for retail and small business deposits shouldapply to the relevant legal entities (including branches of those entities)operating in host jurisdictions if:(i) there are no host requirements for retail and small business deposits inthe particular jurisdictions;(ii) those entities operate in host jurisdictions that have not implementedthe LCR; or _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 102(iii) the home supervisor decides that home requirements should be usedthat are stricter than the host requirements.2. Treatment of liquidity transfer restrictions171. As noted in paragraph 36, as a general principle, no excess liquidityshould be recognised by a cross-border banking group in its consolidatedLCR if there is reasonable doubt about the availability of such liquidity.Liquidity transfer restrictions (eg ring-fencing measures, non -convertibility of local currency, foreign exchange controls, etc) injurisdictions in which a banking group operates will affect the availabilityof liquidity by inhibiting the transfer of HQLA and fund flows within thegroup.The consolidated LCR should reflect such restrictions in a mannerconsistent with paragraph 36.For example, the eligible HQLA that are held by a legal entity beingconsolidated to meet its local LCR requirements (where applicable) canbe included in the consolidated LCR to the extent that such HQLA areused to cover the total net cash outflows of that entity, notwithstandingthat the assets are subject to liquidity transfer restrictions.If the HQLA held in excess of the total net cash outflows are nottransferable, such surplus liquidity should be excluded from the standard.172. For practical reasons, the liquidity transfer restrictions to beaccounted for in the consolidated ratio are confined to existingrestrictions imposed under applicable laws, regulations and supervisoryrequirements.A banking group should have processes in place to capture all liquiditytransfer restrictions to the extent practicable, and to monitor the rulesand regulations in the jurisdictions in which the group operates andassess their liquidity implications for the group as a whole. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 103C. Currencies173. As outlined in paragraph 42, while the LCR is expected to be met on aconsolidated basis and reported in a common currency, supervisors andbanks should also be aware of the liquidity needs in each significantcurrency.As indicated in the LCR, the currencies of the stock of HQLA should besimilar in composition to the operational needs of the bank.Banks and supervisors cannot assume that currencies will remaintransferable and convertible in a stress period, even for currencies that innormal times are freely transferable and highly convertible. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 104Summary ResponsesTo the Commissions’ GreenPaper on Shadow Banking1. Executive SummaryThe European Commissions consultation on shadow banking attractedhigh interest from stakeholders.The comments provided cover a broad range of issues and responded toall the questions raised by the European Commission Green Paper.The Commission received in total 140 contributions, of which 24 fromPublic Authorities; 47 from registered organisations; and, 64 fromindividual organisations.Five organisations asked for their submissions to remain confidential.The key messages received from stakeholders are broadly in line with thefeedback received at the shadow banking conference, organised by theEuropean Commission on 27 April 2012 in Brussels: - There is general support for the European Commissions initiative inthis area. Work should continue to improve the regulatory system in theEU and to ensure global consistency - There is a growing consensus that supervision and a strengthenedregulatory framework is needed to harness the shadow banking system - It is necessary to preserve a useful channel of financial intermediationthat can provide benefits to the real economy at a time when bankfinancing is more constrained - The scope of regulation should be comprehensive and flexible enoughto be adaptable to future developments _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 105- The room for regulatory arbitrage should be reduced and regulatorydivergence in the EU eliminated- The focus should be on activities and entities that could pose systemic risk to the financial markets - Potential legislative measures should take existing legislation intoaccount and should be proportionate; and - Transparency and data collection need to be improved in order tostrengthen the basis for further policy decisions.In addition to the key messages, more detailed comments have beenprovided in response to the different areas covered by the Green Paper.Scope and definitionRespondents to the consultation acknowledged that the term "shadowbanking" is widely used and broadly supported, but some stakeholderssuggested that the term should be changed.They argued that the current term is very broad and provides a negativeconnotation.Some stakeholders suggested that the term should better reflect thecharacteristics of the entities or activities and suggested to replace it by"activities that are not regulated and not supervised"; "parallel banking";or "market-based finance".Some stakeholders underlined the need for more specified definitions.For example, issues such as credit activities, credit guarantees, leasing orfinance companies providing credit or credit guarantees should be usedin a more consistent manner, at least at European level.On the other hand, some respondents commented that a definition forshadow banking needs to be sufficiently flexible to be adaptable to futuredevelopments in the area of shadow banking. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 106Other stakeholders suggested that the scope of shadow banking needs tobe further specified.The Financial Stability Board (FSB) has put forward a definition which isacceptable to many stakeholders (in short: non-banks performing creditintermediation), although some of them argue that it should either bemore comprehensive or should provide a better distinction betweenentities and activities.Stakeholders commented that shadow banking should only includeentities and credit activities which are currently not (or not sufficiently)regulated and pose a systemic risk to the financial system.According to them credit intermediation and maturity transformation arekey features of shadow banking activities.More focus should be on the issue of systemically relevant activities.Representatives of certain industries (e.g. investment funds, leasingcompanies, Factoring companies or credit insurance undertakings)argued that their activities should not be within the scope of shadowbanking either because they don’t meet the definition, or because they arealready subject to regulation and double regulation should be avoided.General principles to followMany stakeholders underlined that shadow banking activities largelyserve the real economy.Existing channels of financing should be preserved.However, some expressed concerns about the usefulness of certainactivities in view of their contribution to the overall social welfare.Stakeholders in general expressed support for measures already taken atEU level, although some respondents suggested that non-bindingmeasures might not be sufficient to address existing shortcomings ofregulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 107The point was made that new regulation should take currentdevelopments in other areas where existing regulation is currently beingrevised (CRD IV, Solvency II, etc.) into account, since they may alter thestructural characteristics of the EU financial system.Stakeholders reminded that bank and non-bank activities are intertwined.Several stakeholders asked for a careful assessment of the potentialconsequences of any new initiatives and their cumulative impacts withother financial regulations to be implemented.Any legal measure should be proportionate and primarily targeted atentities and activities that pose significant systemic risk to the financialsystem.Support was expressed for the general principles for the supervision ofshadow banking, including that it should:(i) Be performed at the appropriate level, i.e. national and/or European(ii) Be proportionate(iii) Take into account existing supervisory capacity and expertise(iv) Be integrated with the macro-prudential frameworkOther respondents proposed the elimination of existing differences in EUsupervision in order to reduce regulatory arbitrage, at least in Europe, butalso internationally.Ideally, stakeholders would like to see any response to "shadow banking"activities to be coordinated on a global level in a coherent way andstressed that coordination is needed between existing work streams at thelevel of FSB, IOSCO, ECB, ESMA and the Basel Committee.Some stakeholders expressed concerns whether traditional bankingregulation per se may be appropriate to address the risks inherent in theshadow banking system. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 108However, they underlined that activities that involve credit risk should besubject to similar solvency and liquidity requirements as creditinstitutions starting from a certain threshold, i.e. similar activities shouldbe subject to similar regulations.In addition, respondents to the consultation (called for?) improvedconvergence and equivalence in the area of related internationalstandards, such as Basel requirements or International FinancialReporting Standards (IFRS), which could result in improvedtransparency for example regarding off-balance sheet activities.Many stakeholders expressed support for an enhancement of the existinglegal framework, (e.g. UCITs, AIFMD, EMIR, CRD, etc.), rather thanthe development of a separate regulatory regime focusing on shadowbanking activities.They feared that this would avoid distortion of the competitiveness of theEU financial sector.Key prioritiesThe Green Paper suggested five priorities for investigation, which werebroadly in line with the FSB work plan:i. Banking regulation and interactions with shadow bankingii. Asset management regulation issues with a specific focus onMoney Market Fundsiii. Securities lending and repurchase agreementsiv. Securitisation practices in terms of incentives alignment andtransparencyv. Other shadow banking entities which may constitute a source ofsystemic risk.Stakeholders expressed general support for the five proposed key areas _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 109where the Commission is further investigating options.However, a number of other suggestions have been provided.Some stakeholders argued for an extension of the scope of the existingbanking supervisory regime as far as appropriate.Some stakeholders argued that Money Market Funds (MMFs) andExchanged Traded Funds (ETFs) should not be subject to furtherregulation in view of the existing regulation on asset management and theESMA guidelines, whereas others preferred these areas being subject tostricter regulation.On securities lending and repurchase agreements respondents argued fora holistic regulation addressing directly the issue of increased leveragebut expressed also concerns regarding haircut requirements due to thepotential risk of increased pro-cyclicality.Instead, the generation of "safe assets" would be critical, as somerespondents stressed.Stakeholders did not insist on regulation on securitisation given that theEU regulatory framework has already been strengthened to deal withsome of the issues.On other financial entities (e.g. financial companies or broker-dealers),which are not explicitly targeted by the Green Paper, it was stronglyrecommended to wait for the final outcome of the work conducted by theFSB in order to ensure a consistent international approach.Monitoring and transparencyThere was broad agreement amongst stakeholders that transparencyshould be enhanced with a view to improve supervision and marketdiscipline.Data collection was seen by many respondents as a prerequisite for a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 110better understanding of shadow banking activities and their implicationsin order to facilitate monitoring solutions, which would allow for bettertargeted interventions.Indirect regulation was regarded by a number of respondents as anefficient tool to capture some of the risks posed by shadow banks.It was suggested that for example the large exposures regime should actas a backstop regime also to shadow banking activities and tackle the riskof interconnectivity by ensuring proper identification of interconnections.Stakeholders did not object to the idea of regular monitoring and datacollection in general and welcomed the work of the European CentralBank (ECB) in this area so far.In addition, they suggested that the role of the European Systemic RiskBoard (ESRB) regarding monitoring macroeconomic risks by collectingand bundling EU wide information should be further clarified.Conclusion and next stepsThe analysis of comments received suggests that there is support forregulatory measures in the EU subject to key principles, i.e. they have toimprove financial stability, they are proportionate, they reduce regulatoryarbitrage, they reflect the global characteristics of shadow banking, theyimprove transparency and they facilitate long-term growth.Following the Green Paper consultation and the public conference inApril 2012, the European Commission has initiated a number ofdiscussions with stakeholders and has launched specific and targetedconsultations, e.g. on UCITS and on the resolution of non-banks.The objective was to gain additional information in view of thepreparation of appropriate policy reactions.All information available will be taken into account for the developmentof policy proposals, which should be compatible with recommendationsput forward by international organisations. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 111A Communication by the European Commission is planned for Q1 2013and will provide further details regarding areas for which legal proposalsmight be developed and their respective timing.2. Feedback Statement2.1. Introduction and international developmentsThe 2008 global financial crisis was caused by regulatory gaps, ineffectivesupervision, opaque markets and overly-complex products.The European Union has shown global leadership in implementing theG20 commitments and has undertaken the biggest financial regulatoryreform ever.However, there is still an increasing area of non-bank credit activity, orshadow banking, which has not been the prime focus of prudentialregulation and supervision to date.Although shadow banking performs important functions in the financialsystem, there is a common understanding that it can also pose potentialthreats to long-term financial stability.Against this background, the Commission considers it a priority toexamine in detail the issues posed by shadow banking activities andentities.The objectives are to respond actively and further contribute to the globaldebate; to continue to increase the resilience of the Union’s financialsystem; and, to ensure that all financial activities contribute to economicgrowth.The European Commission Green Paper described shadow banking as"the system of credit intermediation that involves entities and activities(fully or partially) outside the regular banking system."This definition is in line with the definition proposed by theFinancial Stability Board (FSB). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 112Developments at international levelIn November 2011, G20 Leaders adopted the FSB report ShadowBanking: Strengthening Oversight and Regulation which set out a workplan to develop policy recommendations in 2012.On 18 November 2012 the FSB published for consultation (until 14January 2013) an initial integrated set of policy recommendations tostrengthen oversight and regulation of the shadow banking system.The set of documents published includes the following reports:- An integrated Overview of Policy Recommendations- Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities- Policy recommendations to Address Shadow Banking Risks in Securities lending and Repos- Global Shadow Banking Monitoring Report 2012These consultations will feed into the FSBs work to finalise acomprehensive and integrated set of policy recommendations to addressshadow banking issues.These are then due to be endorsed by to the G20 leaders at the St.Petersburg Summit planned in September 2013.To finalise these policy measures, the FSB is also involving with otherinternational standard-setters.In 2013 the Basel Committee on Banking Supervision (BCBS) willdevelop policy recommendations to mitigate the spill-over effectsbetween the regular banking system and the shadow banking system.The International Organisation of Securities Commissions (IOSCO) hasalready set out final policy recommendations in its reports entitled _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 113"Policy Recommendations for Money Market Funds" and "GlobalDevelopments in Securitisation Markets".Two specific areas are directly investigated by the FSB:i) The regulation of other shadow banking entities posing systemic risks;andii) The regulations of securities financing transactions.On these two topics, public consultations have been launched.Developments at the EU levelOn 20 November 2012 the European Parliament adopted an own initiativereport (Motion for Resolution) on shadow banking, in which it putforward the need for additional regulation of the shadow banking system.It mentions that shadow banks, such as hedge funds or trading houses,benefit the real economy by lending to risky ventures that regular banksavoid.However, if their loans turn bad, they may collapse, taking regular bankswith them, because they lack a capital cushion.The report argues that better prudential oversight is needed to reduceshadow bankings systemic risks, without stifling its benefits to theeconomy.In response to the European Commission Green Paper the EuropeanEconomic and Social Committee (EESC) adopted on 15 November 2012 areport, which concludes that measures need to be taken to address risksposed by the shadow banking system.The size of the shadow banking sectorThe FSBs 2012 Global Shadow Banking Monitoring Report issued on 18November 2012 highlights 3 key developments: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 114a) The global shadow banking system grew rapidly before the crisis (inparallel to the regular banking system), rising from USD 26 trillion in 2002to USD 62 trillion in 2007.The size of the total system declined slightly in 2008 but increasedsubsequently, although at a slower pace, to reach USD 67 trillion (basedon 2011 figures)b) There is considerable diversity in the relative size, composition andgrowth of the shadow banking system across jurisdictionsc) The granularity of available data is improving with the share ofunidentified non-bank financial intermediaries within overall non-bankintermediation falling from 36% in the year 2010 to 18% in the year 2011.However, further improvements are needed to better capture the size andnature of risks in the shadow banking system on a global basis.Stakeholders expressed concerns that the on-going reform of financialregulation of the banking (and insurance) sector may lead to a furthergrowing market for non-regulated financial intermediaries.Therefore, measures need to be developed and have to become effectivein time.Global coordination based on recommendations published by the FSB iscrucial.2.2. Responses to the Consultation2.2.1. Summary of ResponsesGeneral CommentsConsultation respondents provided very detailed responses to the specificquestions raised by the Green Paper.Many of them also provided general comments covering a broad range ofareas. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 115Some respondents regarded the term shadow banking inappropriatesince it seems to suggest – in particular when translated into otherlanguages - that activities within the scope of the shadow bankingdefinition are regarded as harmful and that there is a lack of regulationoutside the banking sector in Europe.Although a large number of respondents agreed with the definition ofshadow banking used in the Green Paper, some stakeholders argued thatthe definition developed by FSB is generally too broad.As a consequence certain sectors, entities or activities should not becaptured by the definition, e.g. factoring, certain insurance activities andinvestment funds since they are already subject to regulation.On the other hand other stakeholders argued that the definition should bebroad enough to catch as many activities as possible.Many stakeholders emphasised the need for global coordination in orderto make sure that existing or future incentives for regulatory arbitrage arelimited, in particular in view of the stricter regulation for banks andinsurance entities currently under negotiation.Stakeholders stressed that an EU approach should not contradictrecommendations developed by international organisations such as FSB,Basel or IOSCO.Some stakeholders warned that the benefits coming from the shadowbanking system should be identified and conserved and they stressed theimportance of considering the negative effects posed by any newregulation on different market participants.Other stakeholders argued that any future regulation should beproportionate and focused on entities/activities posing systemic risks tothe financial system.The preference should be for enhancement of the existing legalframework instead of issuing a separate shadow banking regulationregime. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 116Part of the policy reaction should be to look at the nonhomogenoussupervisory architecture in Europe and increase the level ofharmonisation.Existing and future policy proposals should be coherent.The point was made that the interconnectedness between the bankingand the nonbanking sector was regarded as substantial.Therefore more transparency is needed in the banking sector.It was highlighted that there is a need for better information collectionprocesses, greater market transparency and regular monitoring to identifyareas of systemic risk.Question a - Do you agree with the proposed definition ofshadow banking?Although most consultation respondents agreed with the proposeddefinition and expressed general support, some concerns were raised asto whether the definition is appropriate.Those respondents raising concerns argued that the proposed term is toobroad and would therefore catch a variety of activities which should notbe related to the shadow banking debate.They argued that the proposed definition would also cover certainactivities already subject to regulation and which should not be treatedthe same way as non-regulated activities.Instead the focus should be more on systemic and potentially significantrisks related to shadow banking.It should be more specifically looking at non regulated activities.Other respondents to the consultation expressed the view that theproposed definition is a good basis mainly because it covers entities aswell as activities, which seemed to be a critical issue. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 117Some stakeholders suggested defining entities/activities that should notbe in the scope of shadow banking rather than the other way around.This would avoid that the approach becomes too broad.Others suggested that the definition should be operational, open and asbroad as possible in order to be adaptable to changing market realitiesand entities and activities that should be included.A number of respondents stressed the need for compliance with the FSBdefinition and made a strong case for using a common global definition inorder to limit the potential room for arbitrage and to ensure globalconsistency.Question b - Do you agree with the preliminary list of shadowbanking entities and activities? Should more entities and/oractivities be analysed? If so, which ones?The responses to the question were mixed.Although a number of consultation respondents expressed agreement,others raised strong concerns, in particular in view of the potentialimpacts of new regulation on certain sectors and business models.As a general remark some respondents emphasised that shadow bankingsystemic risks ought to be assessed based on activities rather than a list ofentities.It was highlighted that to come up with a conclusive list would not beoperational since there is not a "one size fits all" solution.Other consultation respondents agreed, but added that shadow bankingshould cover specific qualities of the financial system as whole, not justparticular sectors of the financial industry, thus arguing for a moreholistic approach.They argued that most entities and activities are already or should besubject to monitoring and regulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 118Ultimately the objective should be to focus on the application of "samebusiness, same rules".The point was made that the focus should be on conduits and vehicleswhich are not consolidated in the balance sheets of banks.Securities lending and repos between regulated counterparts are mostlycarried out through central counterparts.Additional entities to be scrutinised are those performing "sociallending" activities (e.g. peer-to-peer credit).Others suggested adding entities which are not only deposit-taking, e.g.treasury or risk capital funds, CCPs, securities lending and all operationsinvolving collateral re-use, although warning that not all institutionsleveraging their financial activities should be included.The insurance industry argued that insurance and reinsuranceundertakings that issue or guarantee credit products should not beclassified as shadow banking.A number of stakeholders suggested that certain activities should not bein the focus of the shadow banking debate.The argument was made, mainly by industry representatives, thatactivities for example in the area of securities lending and repo activitiesshould be considered as shadow banking only with supplementarycriteria (e.g. use of repo to gain leverage in excess of a certain hurdle).Others argued that the definition of MMF type funds within the sector ofshadow banking is not satisfactory, as it suggests a link between risk runand deposit-like characteristics.The argument was made that the risk born by MMFs stems from thediscrepancy between mark-to-market and published NAV in the specificcase of MMFs measured at a constant value (C-NAVs). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 119Another view expressed was that shadow banking should include allcredit intermediation activities that are implicitly enhanced, indirectlyenhanced or unenhanced by official guarantees.These activities include debt issued or guaranteed by government -sponsored enterprises, which benefits from an implicit credit borne by thetaxpayer; the off-balance sheet activities of depositary institutions, suchas unfunded credit card loan commitments; and, lines of credits toconduits and bank-affiliated hedge funds.A number of respondents stressed that ETFs do not constitute per seshadow banking entities, because excessive leverage is only used by asmall number of them, which seems to be already addressed by existinglegislation.The point was made that most ETFs providing credit for bankingcounterparties can be better addressed through banking regulation or theUCITS framework. Since ETFs in the shadow banking sector represent only a fraction ofinvestments funds in general, they should not be distinguished from otherinvestment funds in the treatment of shadow banking entities.Other respondents argued for a narrower approach, comprising onlyentities which are unregulated or inadequately regulated.Question c - Do you agree that shadow banking can contributepositively to the financial system? Are there other beneficialaspects from these activities that should be retained andpromoted in the future?The positions expressed by respondents to the consultation were mixedon this question.A number of stakeholders acknowledged that there are benefits createdby the shadow banking sector, e.g. the enhancement of innovation andcompetition or diversification of investments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 120They suggested that shadow banking also contributed to the widereconomy by providing credible, sound and alternative investmentopportunities and vital sources of financing for businesses.Other benefits mentioned included the following:- Shadow banking increases the number of financial firms and thus can reduce the size of market participants. In this sense it can help address the risks of ‘too big to fail’ financial institutions.- Shadow banking provides additional diversity in the financial ecosystem, helping to ensure that it does not become widely or mainly dependent on the behaviour of banks.- It is important not to create a system in which all or most of the players act like banks.- Shadow banking can provide financial services not necessarily offered by regular banks, such as market making, thereby improving market liquidity.- Shadow banking can help closing a funding gap and reinforce the stability of the financial system (a decentralised financial system avoids concentration of business; less transmission of systemic risk).- The emergence of alternative funding solutions should not be deterred by heavy regulation.Other stakeholders were more cautious in terms of the potential benefitsand expressed support only if shadow banking facilitates long-terminvestment and thus were doubtful about benefit of financial innovationto growth.On the other hand several stakeholders argued that there are no benefitsrelated to shadow banking activities, since their success appears only tobe linked to the fact that they rely on a lack of regulation and are based onunfair competition. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 121It was doubted that unregulated activities could be seen as contributingto a more stable financial system and add social welfare to the society as awhole.Some stakeholders were also concerned about access to finance forcompanies, in particular SMEs.They suggested that any new legislation should not work against theinterest and needs of firms.As regards the possible risk diversification, some respondents expressedthe view that shadow banking activities can even increase the risks for thereal economy, since it is questionable whether they can provide analternative source of funding during a period of crisis.Overall, stakeholders expressed a clear view that, notwithstanding thebenefits, the inherent risks of shadow banking justify an appropriatepolicy response.Question d - Do you agree with the description of channelsthrough which shadow banking activities are creating new risksor transferring them to other parts of the financial system?Although there was general support for the description of the channelsthrough which shadow banking systems are creating new risks, mostrespondents expressed reservations.One respondent expressed disagreement with the implicit assumptionthat institutions that facilitate or support shadow banking are doing thisonly to avoid regulatory intervention.Others argued that the description is only applicable to certain types ofshadow banking activities, since there are many other non-bank activitieswhich simply supply the market with additional liquidity, without usingexcessive leverage, e.g. asset management funds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 122In the same context, a number of respondents, mainly from the financialsector, argued that, in contrast to general assumptions, certain entities oractivities, such as investment funds, do not pose systemic risks.For example, MMFs create less liquidity transformation than banks;asset-liability maturity mismatch is very limited; credit quality is high;and, there are already high standards for liquidity risk managementensuring that redemption requests are met.The argument was made that in some areas the level of regulation isalready high, such as risk management and leverage, as covered by theUCITS and AIFM regime.In addition, fund managers can temporarily suspend redemptions or use"gates" to manage redemption requests.The high degree of existing regulation and supervision preventsinvestment funds from being used to circumvent banking regulation.Other areas of risk (for example hidden leverage, regulatory arbitrage,disorderly failures, massive sales and runs) where regarded by somerespondents as overstated or not limited to the shadow banking sectoralone, and thus specific regulation aimed at shadow banking activitieswas not regarded as the preferred response.A number of respondents expressed support for the risks mentioned inthe Green Paper and stressed that four risk groups should in particular beaddressed:(i) A more focused monitoring system should be put in place;(ii) A tighter and better coordinated regulation focussing onstability/health of financial system is needed;(iii) Convergence with other international regulatory systems, e.g. the USDodd-Frank Act, might be useful; and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 123(iv) Enhanced transparency and quantification of the impact of shadowbanking activities is necessary.Another suggestion made was to investigate the separation betweencommercial banking activities and other activities of the banking group.This would be in follow-up to the report issued by the High Level ExpertGroup chaired by Erkki Liikanen.Question e - Should other channels be considered throughwhich shadow banking activities are creating new risks ortransferring them to other parts of the financial system?A number of respondents to the consultation stated that additionalchannels should be considered.Some respondents underlined that in addition to the general size ofshadow banking, which can cause systemic risks, the reputational riskthat shadow banking may entail for regular banks should be considered.Another issue mentioned was called the “Paradox of diversification”,meaning that the more financial institutions start to behave similarly intheir diversification strategy to reduce individual risks, the more thecorrelation of assets classes will increase resulting in higher systemic risk.Also the risk of shadow banking institutions being used as instruments tohide illicit activities (e.g. tax fraud or money laundering strategies) wasmentioned.Many respondents confirmed that a significant amount of the risk islinked to the complexity and lack of transparency of products, structuresor activities in the area of shadow banking.It was mentioned that misalignments or even conflicts of interests mayarise in securitisation-based credit intermediation, which do not exist fora traditional bank lending from its own balance sheet. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 124This may result in a supply of poorly underwritten loans and structuredsecurities, which could threaten the collapse of entire markets.Complexity was mentioned by some respondents as another channelthrough which risks can be created, since the longer the chain of financialintermediation in shadow banking is, the more entities will be exposed tothe knock-on effects of dislocation at some point further up the chain.Moreover, the complexity of the links that may form between shadowbanks could have destabilising network effects.In addition, the lower the quality of the loan, the longer the chain thatmay be required to enhance the quality of the assets to the standardsneeded to sell to money market mutual funds and other end investors,thereby creating more risks.Some respondents commented that complexity reduces transparency,which can be misleading for intermediaries, investors and regulators interms of risk allocation.This may allow “risks to accumulate unnoticed and unchecked” givingrise to the possibility that, “when hidden risks suddenly becomeapparent, market participants effectively panic”.Opacity may also spawn “fraud, misconduct, and other opportunisticbehaviour”.Others suggested that the reliance of shadow banking on collateralisedwholesale market funding may amplify economic and market cycles byfacilitating leverage when asset prices are buoyant and margins andhaircuts are low.This can trigger rapid and deep deleveraging when confidence ispunctured by a shock, causing asset prices to fall and margins andhaircuts to rise.Pro-cyclicality is made worse by the interconnectedness withthe traditional banking sector, which creates negative feedback loops. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 125Question f - Do you agree with the need for stricter monitoringand regulation of shadow banking entities and activities?The majority of stakeholders agreed with the need for stricter monitoringand regulation of the shadow banking system.However, in most cases it was linked to conditions, such as:- It should be based on the principle of "same business, same rules" and has to be coherent and based on the capacity and expertise of the system of supervision;- Any new regulatory framework should not penalise the "good" side of shadow banking;- Access to finance for SMEs should not be impeded;- The opinions of FSB, ESRB, IOSCO, Basel Committee, EIOPA, ESMA, EBA should be taken into account;- It should be based on solid analysis of the real needs and the impacts;- Regulation needs to be targeted and proportionate;- Regulatory action needs to be coordinated on global level; and- The impact of on-going regulatory initiatives should be taken into account, e.g. in the area of European investment funds.In addition to stricter regulation it was mentioned that more detaileddisclosure requirements and enhanced monitoring systems could be seenas a first step for improving the understanding of the shadow bankingsector.Thus, there is no need to exclusively focus on regulation.It was suggested that a monitoring process should be put in place,including mapping, identification and detailed analysis of aspects posingsystemic risk and room for regulatory arbitrage. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 126Many respondents stressed that the EU should not miss this opportunityto demonstrate leadership and set the global agenda for future shadowbanking regulation.An EU-wide shadowing banking data gap analysis should becommissioned to complete the work already started by the ECB andshould include the input of EU practitioners, if possible.The European Commission should create a shadow banking datamanagement taskforce to aid in the development of potentialtarget-operating models to meet shadow banking policy objectives,including cost-benefit analyses.Question g Do you agree with the suggestions regardingidentification and monitoring of the relevant entities and theiractivities? Do you think that the EU needs permanentprocesses for the collection and exchange of information onidentification and supervisory practices between all EUsupervisors, the Commission, the ECB and other central banks?There was support for an EU central database building on a joint effort bypublic authorities and the financial services industry.The proposed EU permanent processes for the collection and exchangeof information should be centralised and coordinated to limit reportingburden.It was proposed to consider an exemption for entities whose activities donot exceed certain thresholds or are not of a shadow banking nature.The monitoring at national level and informal exchange of informationbetween EU supervisors was regarded as sufficient by other respondents,who argued against an exchange of information at the global level.Other comments were more critical and suggested that identification andmonitoring must be carried out on the basis of the systemic risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 127They considered that the proposed approach in the Green Paper generallydoes not achieve this; an entity/activity specific approach is necessary.Some stakeholders proposed that the ESRB should be given a mandate tocoordinate the regular monitoring of the shadow banking sector, in linewith the step by step approach followed by the FSB.Furthermore, the role of the ESRB should be clarified.For the purposes of monitoring, data and information from varioussources will be needed, both aggregate and entity-specific as well ascovering all financial sector.Question h - Do you agree with the general principles for thesupervision of shadow banking set out above?There was a large degree of support for the proposed principles (GreenPaper, page 6).However, concerns were raised that further details would be required fortheir implementation, e.g. regarding what would be deemed to be theappropriate level and proportionate, and how supervision will beintegrated within the macro prudential framework.Furthermore, some respondents referred to the consolidation rules underIFRS as an important element of supervising non-bank activities.The point was made that, in general, supervision should be carried out onEuropean level in order to get a better understanding of existing creditintermediation chains.In contrast, some respondents preferred a more national approach.Others commented that it is important to develop a mechanism thatallows for the measurement of the level of implementation andappropriateness of the suggested principles. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 128Some respondents highlighted that, since the shadow banking systemwill continue to evolve, it is important that regulation can be adapted tonew developments.Others stressed the need for regulation and principles to be deliverableand operational.In addition, new policy should only be adopted subject to EU wideconsultation and cost benefit analysis.Some respondents expressed disagreement with the principles, unless amore extensive mapping of shadow banking with an indication of thecorresponding level of risk for each activity and entity is undertaken.Furthermore a clearer definition of priorities and exemptions should bedeveloped before the principles are applied.Question I - Do you agree with the general principles forregulatory responses set out above?Stakeholders broadly agreed with the general principles for regulatoryresponses (Green Paper, page 7), but expressed some preferences andnuances to the approach:Stakeholders suggested that shadow banking entities and activities thatincur credit risk (even those that do not collect customer deposits) shouldbe subject to similar solvency and liquidity requirements as creditinstitutions once their level of activity passes a certain threshold.However, the different stages of development in different countriesshould be recalled in this context.Others warned that the extension of existing banking regulation toshadow banking entities should be carefully considered, in order todetermine whether the provisions suitable for the banking sector will havethe same effect on the shadow banking sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 129In addition there has to be clear distinction between banks and shadowbanks, so that credit institutions are not subjected to double regulation.It was suggested by some respondents that a regulatory response shouldbe appropriately calibrated, in order to carefully consider how marketactivities are performed; avoid unintended consequences; preserve thebenefits of shadow banking; and, ensure a level playing field between theregulated banking and non-regulated financial sectors performing similaractivities.Any regulatory proposal should comply with the policy recommendationsdeveloped by FSB, IOSCO or the Basel Committee.Stakeholders stressed that, in their view, the most effective approachwould be to focus on the extension or revision of existing mechanisms.They argued that any new measures would suffer from static definitionsand that indirect regulation might not sufficiently target shadow bankingconcerns.Aspects such as tax avoidance schemes should also be taken intoaccount.An approach based on economic substance and activity, rather than onfixed and narrowly-defined entities, was regarded as more effective.Instruments for addressing the links between regulated entities/activitiesand the shadow banking sector were regarded as necessary.It was suggested that for this purpose a number of micro-prudentialinstruments could be used to address macro-prudential aims, forexample:- Bank capital buffers;- Sectorial capital requirements, such as specific risk weights on intra-financial system exposures;- Large exposures and activity limits; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 130- Funding concentration limits; and- Minimum and "through the cycle" margin and haircut requirements for secured lending and financing transactions.Some respondents were concerned that the supply of "safe assets" willhave to increase in order to balance the effects of other regulatory reforms,such as the OTCD reform or the effects of the crisis, includingdeleveraging.With the current general shortage of safe assets, the shadow bankingsystem can play a role to fill this vacuum.From a regulatory perspective regard should always be had to the sourceof safe assets and the way in which they are provided (such as whetherthere is a title transfer in which ownership changes hands).Other respondents suggested that the first priority should be to establisha complete overview of the interconnectedness between all entities andactivities and the banking system and to have an understanding of theunintended consequences for access to finance for the real economy.They highlighted that there is no "one-size fits all" approach, underliningthe importance of flexibility and adaptability of new regulation todevelopments in the sector.The need for detailed impact assessments was mentioned.Other principles mentioned included safe and efficient market structures;non-distortion of competition or interference in price-buildingmechanism; and financial innovation and scrutiny of unintendedconsequences.Some stakeholders stressed the need for more consistent enforcementand a clarification of the powers of the ESRB, as well as the need for aclose coordination between macro and micro prudential authorities andconduct-of-business regulators to avoid policy confusion. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 131Others raised the issue of follow up and therefore the need for periodicassessment and review of effectiveness due to the innovative nature ofshadow banking.Question j - What measures could be envisaged to ensureinternational consistency in the treatment of shadow bankingand avoid global regulatory arbitrage?This issue was regarded by almost all stakeholders as key, in order toavoid the creation of loopholes or incentives for regulatory arbitrage at theinternational level.Most respondents therefore argued for consistent regulatory guidelinesacross countries.In particular the FSB and IOSCO were mentioned as organisations whichshould ensure international coordination.For example the adoption of an internationally-consistent definition forshadow banking systems was regarded as a crucial element.It was suggested that the EU should comply with the FSBsrecommendations as far as possible and it should establish an integratedframework for macro and micro prudential supervision alongside globalinformation and data exchange framework at global level.A regular exchange and sharing of information and data betweenauthorities could be achieved by the implementation of the Global LegalEntity Identifier (LEI).Certain respondents highlighted that the existing regulatory framework,i.e. Basel 2 and 2.5, already contain sufficient regulatory instruments thatwould allow for a stronger focus on international consistency.The important role of peer reviews was mentioned in this context. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 132Others suggested that more harmonisation through the removal ofmaterially-unjustified differences (e.g. in accounting and consolidationrules) should be achieved.They stressed that risks related to the shadow banking sector arecurrently heightened to a varying extent across the EU, not only due todifferences in regulation but also because of differences in interpretationand enforcement.To this end, a greater use of regulations instead of directives in EUlegislation and direct supervision at EU level were mentioned asappropriate measures.On the other hand, some stakeholders warned that full harmonisation andcoordination at the international level may not be achievable due to thedifferent structures of different markets, e.g. MMFs.Others were more cautious and warned that global harmonisation wouldbe unrealistic at this stage.However, they were optimistic that reliance on the FSB framework andmore extensive use of peer reviews (e.g. by the IMF FSAP and FSB) couldbe beneficial.Question k - What are your views on the current measuresalready taken at the EU level to deal with shadow bankingissues?Stakeholders summarised measures already taken at EU level, inparticular legislation in the area of AIFMD, MiFID, UCITS or CRAs.These were broadly welcomed and regarded as appropriate measures foraddressing key concerns.However, some respondents expressed concerns regarding thecumulative impact of the measures and commented that the effect on _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 133particular areas of financial markets (e.g. the sustainability ofsecuritisation market) is currently neglected.Thus, any additional regulation to address risks posed by shadow banksshould not overlap with existing regulation.Furthermore, potential existing loopholes in current legislation should beidentified.It was also mentioned that indirect regulation via the banking andinsurance sectors is a crucial element of a regulatory response to shadowbanking.However, enlarging the scope of existing regulation should be donecarefully.Others stressed the need for further evaluation of "soft rules" (Level II)developed by ESMA.One conclusion might be to make them legally binding in order toimprove consistent application.Some commentators asked for caution regarding new proposals, sincethey took the view that certain entities, e.g. MMFs and ETFs, are alreadysufficiently regulated in the EU.Concerns were also expressed regarding extending provisions of CRD IVto non-deposit taking financial companies.Question l - Do you agree with the analysis of the issuescurrently covered by the five key areas where the Commission isfurther investigating options?Stakeholders broadly agreed with the five areas mentioned (Green Paper,pages 11-13), which largely reflect the five work streams set up by the FSB. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 134Hence, most respondents stressed that the final outcome of the FSB workshould be taken into account.The following specific comments were made:(i) Banking regulationMost respondents believe that CRD/CRR IV will improve the regulationof shadow banks and will provide powers to set capital and liquidityguidance via a macro-prudential tool-kit.As regards the links between the banking and unregulated sectors,consolidation policy can play a role in ensuring the "same business, samerules" principle.Financial reporting requirements according to IFRS and capital guidanceunder CRDII/III, if applied consistently, provide a good basis formanaging risks arising from banks interaction with the shadow bankingsector.(ii) Asset management regulation issuesMost of the comments were related to MMFs and ETFs.Regarding MMFs the risks highlighted by IOSCO (runs, contagion risk,and implicit guarantee of sponsors for return of capital, constant NAVfunds, rating risk) were mentioned.Views regarding valuation (constant versus variable NAV) were mixed.Some respondents suggested that MMFs are not vulnerable to massiveredemptions and should not be considered shadow bankingentities/activities, with the exception of C-NAV MMFs.They considered that MMFs are not a source of significant maturitytransformation within Europe and represent limited risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 135Others took the opposite view and argued for a substantial revision ofMMF regulation.Other comments included a proposal to exclude certain asset classes,such as raw materials, from UCITS since they would not provide addedvalue to the society, Regarding ETFs the ESMA guidelines wereconsidered to establish a harmonized framework on the quality ofcollateral; prohibited transaction for re-use of collateral; prevention ofconflicts of interest; and liquidity of the fund, although there seemed to bea preference for making those rules binding.(iii) Securities lending and re-purchase agreementsMost stakeholders agreed with the focus in this area and suggested thatthe issue of increased leverage should be addressed directly, rather thanindirectly, through regulation of securities markets.Other respondents suggested introducing adequate measures to deal withliquidity mismatches, concentration and roll-over risks in collateralisedfunding markets.European supervisory bodies could be allowed to monitor an assetencumbrance ratio.Some suggested exploring the issue of "who owns what" in securitiesfinancing transactions and to consider different policy options to addressexisting risks notably by looking at accounting rules or the introductionof quantitative limits.One respondent expressed concerns regarding the potential confusion of"re-use" and "re-hypothecation" as synonyms when in fact there is animportant difference regarding the transfer of titles (which is the case forrepos, but not for re-hypothecation).A number of stakeholders was not in favour of minimum margin orhaircut requirements and argued that mandatory haircuts applied to thesecurities lending market are likely to increase, rather than reduce,pro-cyclicality. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 136One concern expressed was that if investment managers were not able toprotect their investors by increasing haircuts (and a mandatory minimumhaircut may in effect become a maximum), they may stop lendingaltogether to certain counterparties.Many commentators agreed with the idea of increased transparency andthe setting up of trade repositories for repos.From a macro-economic perspective, regulatory measures should behorizontal and focus on collateral management.(iv) SecuritisationOnly a few stakeholders commented on this by stating that securitisationissues are already covered by existing regulation (CRDII/III/IV, BaselTrading Book review).A renewed assessment of a need for review should wait until theimplementation is completed.Overall there was not a strong push for further regulation in this area.(v) Other shadow banking entitiesThis area is still under consideration by the FSB (work stream 3).Most respondents therefore asked for further clarification and suggestedwaiting for the outcome of the FSB work.Based on initial results of the FSB work, mapping of entities, risks andregulation was regarded as the right approach, with a clear focus onactivities and not entities.In addition to the five key areas, a number of respondents argued forimprovements regarding the overall transparency of the shadow bankingsector and in particular in the area of repos and securities lendingtransactions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 137The setting up of trade repositories was broadly supported, mainlybecause this could help tracking counterparty risk and potential conflictsof interest.However, this should ideally be pursued in parallel to harmonisedreporting and accounting requirements.Question m - Are there additional issues that should be covered?If so, which ones?Although most consultation respondents welcomed the scope and rangeof questions raised by the Green Paper, some listed a number ofadditional issues, including:- The introduction of a mandatory clearing obligation (Tri Party-Repo), as well as an obligation to trade on regulated markets for standardized outside-group transactions;- A clear focus on contingent liabilities in general, including not only those from banks, but from all potential "guarantors" and not limited to MMF-related step-in liabilities. This is because the high level of indebtedness of sovereigns and moral hazard created by government guarantees is a risk factor;- Regulators should look more into interconnections between shadow banking and the insurance sector. The core principles of Solvency II regime should be consistent withCRD IV;- Some techniques (dark pools and HFT) do not relate directly to shadow banking but they should be more in the focus, subject to monitoring and regulation if needed; and- The Prime Collateralised Securities (PCS) initiative launched at EU level in the area of securitisation should be promoted. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 138For example it could be assessed by EBA and recognised as eligible assetin the context of CRD IV.Question n - What modifications to the current EU regulatoryframework, if any, would be necessary properly to address therisks and issues outlined above?Stakeholders provided a number of ideas regarding modifications to thecurrent EU regulatory framework, including:- It should be investigated if and how current rules for bank liquidity could be extended to all non-regulated bank entities, including shadow banking entities;- More attention should be paid to naked short selling and investment in raw materials;- The own capital requirements and future liquidity requirements, foreseen under the CRR for credit institutions engaging in securities loans transactions, should also apply in cases of chain transaction when one or more intermediaries are not credit institutions;- There should be support for the development and use of effective macro prudential oversight to monitor risks emerging in the system as a whole and the targeted and proportionate use of macro prudential policy tools.- Instead of new regulation, the focus should be more on increased disclosure, transparency, data collection and monitoring systems; and- Existing and well-functioning regulation, e.g. UCITS, should remain unchanged.A number of respondents argued that there are good reasons for a reformof MMFs in the area of minimum liquidity, valuation techniques, andcredit ratings. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 139Others argued in the opposite direction, maintaining that the currentregulation of MMFs appropriately addresses inherent risks.Question o - What other measures, such as increasedmonitoring or non-binding measures should be considered?Stakeholders suggested a number of other measures that should beconsidered:- A constant reassessment of risk mapping exercise should be conducted by relevant authorities;- The regulatory system needs to be suitably dynamic in order to address new regulatory issues related to the inventiveness of shadow banking sector;- Transparency of supervisory systems can be improved by the publication of core indicators, such as supervisory personnel per employee in the financial sector etc.;- While the "single rule book" is supported, a framework should be set up allowing macro-prudential authorities some "constrained discretion" (with safeguards) in setting higher standards to deal with financial stability risks in their jurisdiction arising from SB.In addition, subject to the safeguards, it is necessary to allow for a flexibleand targeted application of macro-prudential instruments to sectors,entities and activities (including a process enabling new instruments tobe activated swiftly when need arises to address specific systemic risksconcerns);- More transparency is needed, e.g. a European trade repository for repos; and- A better exchange of data and information between supervisors and the creation of EU databases without duplication of data or overburden regulated intermediaries would be beneficial in order to reduce systemic risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 1402.2.2. General Overview of the ConsultationIn order to develop a deeper understanding of the issues, the EuropeanCommission launched a Green Paper and consultation from 19 March to15 June 2012.The key objective of the Green Paper was to consult stakeholders onshadow banking issues: definition, risks and benefits, the need for strictermonitoring and regulation, outstanding issues and possible next steps.The Commission received in total 140 contributions, of which 24 fromPublic Authorities, 47 from registered organisations and 64 fromindividual organisations.Five organisations asked for their submission to remain confidential.The largest number of responses was submitted from stakeholders in theUK, France, and Germany and from EU based firms or associations.In terms of professional background, the most submissions came by farfrom the financial sector, including financial institutions andassociations.A considerable number of submissions came from the public sector,governments, national banks and regulators. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 141 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 142 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 1432.2.3. List of participants1. National Bank of Romania2. AXA Investment Managers3. ABI Associazione Bancaria Italiana4. Confidentiality requested5. Nomura International plc6. CNMV Advisory Committee of the Spanish Securities Market Law7. Markit Inc8. EIOPA – European Insurance and Occupational Pensions Authority9. HFSB – Hedge Fund Standards Board10. MFA – Managed Funds Association11. European Network of Credit Unions12. VGF - Verband Geschlossene Fonds13. EBG - European Banking Group14. DIHK – Deutscher Industrie- und Handelskammertag e.V.15. Rolls Royce plc16. LeaseEurope AISBL17. CLLS - City of London Law Society _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 14418. IFCR - International Centre for Financial Regulation19. Confidentiality requested20. ESBG - European Savings Bansk Group21. BBA - British Bankers Association22. Dansk Aktionaerforening23. Eurofinas AISBL24. Genworth Inc25. Finance Watch AISBL26. EBF - European Banking Federation27. Government of Poland28. Central Bank of Ireland29. VÖB - Bundesverband Öffentlicher Banken Deutschlands30. VNO-NCW and MKB Netherlands31. ASF Association Française des Societes Financieres32. Tamar Joulia Paris and Casey Campbell33. Trade Union Pro Finland34. Clifford Chance35. FLA - Finance and Leasing Association36. Ministry of Finance Finland37. VVD Group – Volkspartij voor Vrijheid en Democratie38. TSI True Sale International GmbH39. MBIA UK Insurance Limited40. AFGI Association of Financial Guaranty Insurers41. GCAE - Group Consultatif Actuariel European42. ZIA - Zentraler Immobilien Ausschuss e.V.43. Lithuanian Free Market Institute44. Royal Ministry of Finance Norway45. FMA – Financial Market Authority Austria46. Groupe GTI – Gestion et Titrisation Internationales47. BdB – Bundesverband Deutscher Banken48. APB - Portuguese Banking Association49. Tiberiu Tudor Salantiu50. UniCredit Group51. ABFA – Asset Based Finance Association52. Mazars53. AMUNDI Asset Management54. BBF - Belgian Association of Factoring Companies55. Financial Services User Group _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 14556. CGPME57. Jersey Financial Services Commission58. MEDEF – Mouvement des Entreprises de France59. Sciteb60. Deutscher Factoring Verband e.V.61. NFU - Nordic Financial Unions62. BAK - Bundesarbeitskammer Austria63. Confidentiality requested64. Ministry of Finance Czech Republic65. af2i – association française des investisseurs institutionnels66. ICMA - ERC European Repo Council67. ESRB – European Systemic Risk Board68. DSGV – German Savings Banks Association69. FAAN – Factoring and asset-based financing AssociationNetherlands70. Melanie L. Fein71. CNB – Czech National Bank72. UNI Europa73. Government of the Netherlands74. IFC Forum75. GDV – Gesamtverband der Deutschen Versicherungswirtschaft e.V.76. RBS Group plc77. KEPKA – Consumer Protection Centre Greece78. IMMFA – Institutional Money Market Funds Association79. Allianz SE80. HSBC Global Asset Management81. LMA - The Loan Market Association82. Veblen Institute for Economic Reforms83. Chris Barnard, Actuary, Germany84. Maria Niewiadoma, Poland85. ICISA – International Credit Insurance & Surety Association86. Jeroen Spaargaren87. ABI - Association of British Insurers88. Banco de Portugal89. CBI – Confederation of British Industry90. ICI - Investment Company Institute91. IIF – Institute of International Finance _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 14692. German Authorities – Deutsche Bundesbank, Bundesministerium derFinanzen, BaFin93. ALFI – association of the luxembourg fund industry94. AIMA – Alternative Investment Management Association95. UBS AG96. ISLA – International Securities Lending Association97. IMA – Investment Management Association98. afg – association française de la gestion financière99. NATIXIS Asset Management100. EACH – European Association of CCP Clearing Houses101. EuroFinuse – EuroInvestors – The European Federation of FinancialServices Users102. Ministry of Business and Growth Denmark103. Confidentiality requested104. OFPE – Observatoire des Fonds de Près a lEconomie105. EFAMA – European Fund and Asset Management Association106. BARCLAYS107. BVI – Bundesverband Investment und Asset Management e.V.108. IntesaSanpaolo109. EACB – European Association of Co-operative Banks110. IRSG - International Regulatory Strategy Group111. PricewaterhouseCoopers International Ltd112. Confidentiality requested113. FBF - Fédération Bancaire Française114. INVERCO - Spanish Assoc. of Collective Investment Schemes andPension Funds115. SOMO - Centre for Research on Multinational Corporations116. ICI Global117. Federated Investors Inc118. ICMA - Asset Management and Investors Council119. BNP Paribas120. HM Treasury United Kingdom121. CFA Institute122. ifia - Irish Funds Industry Association123. State Street Corporation124. afme - Association for Financial Markets in Europe125. BlackRock126. AFTE - Association Française des Trésoriers dEntreprise _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 147127. Italian Ministry of economy and finance and Italian supervisoryAuthorities128. JWG129. Fidelity Investments130. Swedish Authorities131. Insurance Europe AISBL132. French Authorities133. LSEG - London Stock Exchange Group134. Government of Ireland135. Bundesrat Germany136. Swedish Parliament137. EBA - European Banking Authority138. ECB-European Central Bank - Eurosystem139. BusinessEurope140. ESMA- European Securities and Markets Authority _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 148European Union: Financial SectorAssessment, PreliminaryConclusions by the IMF StaffA Financial Sector Assessment Program (FSAP) team led by theMonetary and Capital Markets Department of the International MonetaryFund (IMF) visited the European Union (EU) during November27–December 13, 2012, to conduct a first-ever overall EU-wide assessmentof the soundness and stability of the EU’s financial sector (EU FSAP).The EU FSAP builds on the 2011 European Financial Stability Exercise(EFFE) and on recent national FSAPs in EU member states.The mission arrived at the following preliminary conclusions, which aresubject to review and consultation with European institutions andnational authorities:The EU is facing great challenges, with continuing bankingand sovereign debt crises in some parts of the Union.Significant progress has been made in recent months in laying thegroundwork for strengthening the EU’s financial sector. Implementationof policy decisions is needed.Although the breadth of the necessary agenda is significant, the details ofthe agreed frameworks need to be put in place to avoid delays in reachingconsensus on key issues.The present conjuncture makes management of the situationparticularly difficult.The crisis reveals that handling financial system problems at the nationallevel has been costly, calling for a Europe-wide approach.Interlinkages among the countries of the EU are particularlypronounced, and the need to provide more certainty on the health ofbanks has led to proposals for establishing a single supervisorymechanism (SSM) associated with the European Central Bank (ECB),initially for the euro area but potentially more widely in the EU. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 149The mission’s recommendations include the following:Steps toward banking unionThe December 13 EU Council agreement on the SSM is a strongachievement.It needs to be followed up with a structure that has as few gaps aspossible, including with regard to the interaction of the SSM withnational authorities under the prospective harmonized resolution anddeposit guarantee arrangements.The SSM is only an initial step toward an effective BankingUnion—actions toward a single resolution authority with commonbackstops, a deposit guarantee scheme, and a single rulebook, will alsobe essential.Reinvigorating the single financial market in EuropeHarmonization of the regulatory structure across Europe needs to beexpedited.EU institutions should accelerate passage of the Fourth CapitalRequirements Directive, the Capital Requirements Regulation, thedirectives for harmonizing resolution and deposit insurance, as well asthe regulatory regime for insurance Solvency II at the latest by mid–2013,thus enabling the issuance of single rulebooks for banking, insurance,and securities.Moreover, the European Commission should increase the resources andpowers of the European Supervisory Authorities as needed tosuccessfully achieve those mandates, while also enhancing theiroperational independence.Improved and expanded stress testingEuropean stress testing needs to go beyond microprudential solvency,and increasingly serve to identify other vulnerabilities, such as liquidityrisks and structural weaknesses.Confidence in the results of stress tests can be enhanced by an assetquality review, harmonized definitions of non-performing loans, andstandardized loan classification, while maintaining a high level ofdisclosure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 150Experience suggests that the benefits of a bold approach outweigh therisks.Splitting bank and sovereign riskMeasures must be pursued to separate bank and sovereign risk,including by making the ESM operational expeditiously for bankrecapitalizations.Strong capital buffers will be important for the banks to perform theirintermediating role effectively, to stimulate growth, and so safeguardfinancial stability.Effective crisis management framework to minimize costs totaxpayersTaxpayers’ potential liability following bank failures can be reduced byresolution regimes that include statutory bail-in powers.A common deposit insurance fund, preferably financed ex ante by levieson the banking sector, could also reduce the cost to taxpayers, even if ittakes time to build up reserves.Granting preferential rights to depositor guarantee schemes in thecreditor hierarchy could also reduce costs, particularly while guaranteefunds are being built.The European Commission and member states should assess the costsand benefits of the various plans for structural measures aimed atreducing banks’ complexity and potential taxpayer liability with a viewtowards formulating a coordinated proposal.If adopted, it would be important to ensure that such measures arecomplementary to the international reform agenda, not cause distortionsin the single market, and not lead to regulatory arbitrage.Lastly, the mission would like to extend their thanks to Europeaninstitutions for close cooperation and assistance in completing this FSAPanalysis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 151European CybercrimeCentre (EC3) opens on 11JanuaryAs from 11 January the newEuropean Cybercrime Centre(EC3) will be up and running to help protect European citizens andbusinesses from cyber-crime.EU Commissioner for Home Affairs Cecilia Malmström will participatein the official opening of the Centre established at the European PoliceOffice, Europol in the Hague (the Netherlands)."The Cybercrime Centre will give a strong boost to the EUs capacity tofight cybercrime and defend an internet that is free, open and secure.Cybercriminals are smart and quick in using new technologies forcriminal purposes; the EC3 will help us become even smarter andquicker to help prevent and fight their crimes", said CommissionerMalmström."In combatting cybercrime, with its borderless nature and huge abilityfor the criminals to hide, we need a flexible and adequate response.The European Cybercrime Centre is designed to deliver this expertise asa fusion centre, as a centre for operational investigative and forensicsupport, but also through its ability to mobilise all relevant resources inEU Member States to mitigate and reduce the threat fromcybercriminals wherever they operate from", said Troels Oerting, Headof the European Cybercrime CentreInvestigations into online fraud, child abuse online and othercybercrimes regularly involve hundreds of victims at a time, andsuspects in many different parts of the world.Operations of this magnitude cannot be successfully concluded bynational police forces alone.The opening of the European Cybercrime Centre (EC3) marks asignificant shift in how the EU has been addressing cybercrime so far. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 152Above all, the approach of the EC3 will be more forward-thinking andinclusive.It will pool expertise and information, support criminal investigationsand promote EU-wide solutions.The EC3 will focus on illegal online activities carried out by organisedcrime groups, especially attacks targeting e-banking and other onlinefinancial activities, online child sexual exploitation and those crimes thataffect the critical infrastructure and information systems in the EU.The Centre will also facilitate research and development and ensurecapacity building among law enforcement, judges and prosecutors andwill produce threat assessments, including trend analyses, forecasts andearly warnings.In order to dismantle more cybercrime networks and prosecute moresuspects, the EC3 will gather and process cybercrime related data andwill provide a Cybercrime Help desk for EU countries law enforcementunits.It will offer operational support to EU countries (e.g. against intrusion,fraud, online child sexual abuse, etc.) and deliver high-level technical,analytical and forensic expertise in EU joint investigations.According to a recent Eurobarometer, Europeans remain veryconcerned about cyber security. 89% of internet users avoid disclosingpersonal information online, and 12% have already experienced onlinefraud.Around one million people worldwide fall victim to some form ofcybercrime every day. Estimates indicate that victims lose around €290billion each year worldwide as a result of cybercriminal activities(Norton, 2011).BackgroundThe Commission announced its intention to establish a EuropeanCybercrime Centre (EC3) in the EU Internal Security Strategy in Action(IP/10/1535 and MEMO/10/598), adopted on 22 November 2010 by theCommission. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 153The setting up of a (EC3) European Cybercrime Centre (IP/12/317 andMEMO/12/221) is part of a series of measures that seek to protectcitizens from online crimes.It complements legislative proposals such as the Directive on attacksagainst information systems (IP/10/1239 and MEMO/10/463) and theDirective on combating the sexual exploitation of children online andchild pornography adopted in 2011 (IP/11/1255).The official opening Ceremony of the EC3 will take place on the 11January at the headquarters of Europol in the Hague, the Netherlands.Registration for mediaPlease register for the official opening in the Hague by using the mediarequest form the names of participants, their media organisation and the typeof media organisation.Deadline for registration is 10 January 2013, 14:00.Please bring a valid ID and a press card.For further details on the programme, please see the Europol website more information _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 154Frequently asked questions: The European Cybercrime CenterECWhat are the objectives?The main task of the European Cybercrime Centre is to disrupt theoperations of organised crime networks that commit a large share of theserious and organised cybercrimes.Offences include those generating large criminal profits, those causingserious harm to their victims or those affecting our vital infrastructureand IT systems.The Centre will gather information from a variety of sources – not onlylaw enforcement authorities – to support investigations conducted byMember States authorities.This will allow the Centre to identify the most dangerous, pressingcybercrime threats and single out key cybercrime networks in the EU.The Centre will also provide an early warning system for national lawenforcement on new vulnerabilities criminals have started to exploit oron how to handle new, technically challenging cases.The Centre will further develop a common standard for cybercrimereporting so that serious cybercrime can be reported to national lawenforcement authorities in a uniform way.Information from a citizen in one Member State reporting a compromiseof his bank account could easily be linked to other citizens reportingsimilar incidents affecting the same bank in their respective countries.In such cases, the Centre will be able to immediately alert all otherMember States authorities.The Centre will also respond to queries from cybercrime investigators,prosecutors and judges as well as the private sector on specific technicaland forensic issues, and would bring together the various players incybercrime training with the aim of increasing the overall offer oftraining possibilities and expanding such courses to the judiciary.Finally, the Centre would assume the collective voice of Europeancybercrime investigators, providing a platform to develop commonpositions of Union law enforcement authorities on key issues, for _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 155example on Internet governance structures or in building trustednetworks with the private sector and non-governmental organisations,and providing the natural interface for international initiatives to curbcybercrime, such as Interpols work in this domain.How will it work?Equipped with state-of-the-art technology and a strong team of highly -qualified and specialised personnel offering a wide spectrum of services- from helping Member States analyse complex digital forensic evidenceto forecasting trends and scenarios, the European Cybercrime Centrewill become the focal point in the fight against cybercrime in the Union.How is the EC³ staffed and funded?Since the EC³ will be launched within Europol its budget will form partof the general Europol budget (which amounted to around €84 million in2012).Around 7 million euros will be available for the EC³ operational activitieswithin the Europol 2013 budget.As for the staff, 30 full time positions are already operating within theEC³ and in the course of 2013 Europol will make additionalredistributions of tasks, so as to free around 10 additional posts, bringingthe total EC³ staff to around 40 people.As for subsequent years, additional reinforcements will be necessary tomeet the increased workload of the Centre.The Commission is at work to find ways to increase Europols budgetaccordingly with the Agencys expanding mandate in the field ofcybercrime.What is the extent of the cybercrime problem?According to a recent study, Internet users remain very concerned aboutcyber security.As many as 89% of them avoid disclosing personal information onlineand 74% agree that the risk of becoming a victim of cybercrime hasincreased in the past year. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 156In fact, about one million people worldwide fall victim to some form ofcybercrime every day.Some estimate that victims lose around €290 billion2 each yearworldwide as a result of cybercriminal activities.According to a McAfee study cybercrime profits amount to 750 billion ayear, with 150.000 computer viruses in circulation every day and 148.000computers compromised dailyWhat type of operations will be carried out?In the past months, Europol has also significantly increased its practicalsupport to cybercrime investigations in Member States.Only last year and to cite only one example, Operation Icarus,coordinated by Europol, identified 273 online child sexual abusesuspects and 113 of those suspects spread across 23 countries werearrested.This is the scale and complexity of operations the European CybercrimeCentre will focus on. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 157Sebastian von Dahlen and Goetz von PeterNatural catastrophes and globalreinsurance – exploring the linkagesNatural disasters resulting in significant losseshave become more frequent in recent decades,with 2011 being the costliest year in history.This feature explores how risk is transferredwithin and beyond the global insurance sectorand assesses the financial linkages that arise in the process.In particular, retrocession and securitisation allow for risk-sharing withother financial institutions and the broader financial market.While the fact that most risk is retained within the global insurancemarket makes these linkages appear small, they warrant attention due totheir potential ramifications and the dependencies they introduce.The views expressed in this article are those of the authors and do notnecessarily reflect those of the BIS, the IAIS or any affiliated institution.We would like to thank Anamaria Illes for excellent research assistance,and Claudio Borio, Stephen Cecchetti, Emma Claggett, Daniel Hofmann,Anastasia Kartasheva, Andrew Stolfi and Christian Upper for helpfulcommentsThe physical destruction caused by severe natural catastrophes triggers aseries of adverse effects.Damaged production facilities, shattered transportation infrastructureand business interruption produce both direct losses and indirectmacroeconomic costs in the form of foregone output (von Peter et al(2012)). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 158Beyond these economic costs are enormous human suffering and a hostof longerterm socioeconomic consequences, documented by the WorldBank and United Nations (2010).By examining catastrophe-related losses over the past three decades, thisspecial feature explores the linkages that arise in the transfer of risk frompolicyholders all the way to the ultimate bearer of risk.It describes the contracts and premiums exchanged for protection, andthe way reinsurers diversify and retain risks on their balance sheets.In so doing, the feature traces how losses cascade through the systemwhen large natural disasters occur.Losses from insured property and infrastructure first affect primaryinsurers, who in turn rely on reinsurers to absorb peak risks –low-probability, high-impact events.Reinsurers, in turn, use their balance sheets and, to a lesser extent,retrocession and securitization arrangements, to manage peak risksacross time and space.[Retrocession takes place when a reinsurer buys insurance protectionfrom another entity.Securitisation refers to the transfer of insurance-related risks (liabilities)to financial markets.]This global risk transfer creates linkages within the insurance industryand between insurers and financial markets.While securitisation to financial markets remains relatively small,linkages between financial institutions produced through retrocessionhave not been fully assessed as detailed data are lacking.Further linkages can arise when reinsurers go beyond their traditionalinsurance business to engage in financial market activities such as _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 159investment banking or CDS writing; the implications of those activitiesare beyond the scope of this feature.Comprehensive information is needed to monitor the entire risk transfercascade and assess its wider repercussions in financial markets.Physical damage and financial lossesNatural catastrophes resulting in significant financial losses have becomemore frequent over the past three decades (Kunreuther andMichel-Kerjan (2009), Cummins and Mahul (2009)).The year 2011 witnessed the greatest natural catastrophe-related losses inhistory, reaching $386 billion (Graph 1, top panel).The trend in loss developments can be attributed in large measure toweather-related events (Graph 1, bottom right-hand panel).And losses have been compounded by rising wealth and increasedpopulation concentration in exposed areas such as coastal regions andearthquake-prone cities.These factors translate into greater insured losses where insurancepenetration is high.At $110 billion, insured losses in 2011 came close to the 2005 record of $116billion (in constant 2011 dollars).The reinsurance sector absorbed more than half of insured catastrophelosses in 2011.This considerable burden on reinsurers reflected the materialisation ofvarious peak risks, notably in Japan, New Zealand, Thailand and theUnited States.The level of insured losses also depends on catastrophes’ geography andphysical type. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 160The bottom panels of Graph 1 show that losses due to earthquakes(geophysical events) have been less insured on average than those fromstorms (meteorological events).The highest economic losses caused by geophysical events occurred in2011 in the wake of the Great East Japan earthquake and tsunami ($210billion), for which private insurance coverage was relatively low at 17%(lefthand panel).Droughts can be even more difficult to quantify and insure.By contrast, the right-hand panel of Graph 1 shows that meteorologicalevents produced record losses in 2005, when Hurricanes Katrina, Rita andWilma devastated a region of the US Gulf Coast having 50% or more ininsurance coverage.The volume of insured losses differs substantially across continents,depending on the availability of and demand for insurance.While overall a slight upward trend can be discerned over the past 10years, the wide dispersion in insurance density indicates that the stage ofa region’s economic development plays an important role (Graph 2,left-hand panel).Residents of North America, Oceania and Europe spend significantamounts on non-life (property and casualty) insurance, whereas manypopulous countries in Latin America, Asia and Africa hostunderdeveloped insurance markets.Poor countries typically lack the financial and technical capacity toprovide affordable insurance coverage.For example, less than 1% of the staggering economic losses due toHaiti’s 2010 earthquake were insured.The pattern of insured losses thus only partly reflects the geography ofnatural catastrophes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 161Sources: Centre for Research on the Epidemiology of Disasters EM-DAT database; MunichRe NatCatSERVICE; authors’ calculations.North America accounts for the largest insured losses associated withnatural disasters (Graph 2, right-hand panel).In 23 of the 32 years since 1980, more than half of global insured lossesoriginated in the region, though part of this volume was redistributedthrough global reinsurance companies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 162Asia, Oceania and, to a lesser extent, Latin America saw increases incatastrophe-related losses on the back of rising insurance density over thepast 10 years.Correspondingly, these three regions account for a rising share of insuredlosses.Risk transferNatural catastrophe-related losses are large and unpredictable.The insured losses shown in Graphs 1 and 2 reflect recent experience.This section describes the sequence of payments based on contractualobligations that is triggered when an insured event materialises.One can think of the insurance market as organising risk transfer in ahierarchical way. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 163Losses cascade down from insured policyholders to the ultimatebearers of risk (Graph 3).When catastrophe strikes, the extent of physical damage determines totaleconomic losses, a large share of which is typically uninsured.The insured losses, however, must be shouldered by the global insurancemarket (Graph 3, light grey area).The public sector, when it insures infrastructure, often does so directlywith reinsurers through public-private partnerships, although more datawould be necessary to pin down the exact scope worldwide.The majority of the losses relate to private entities contracting withprimary insurers, the firms that locally insure policyholders against risks.Claims for reimbursement thus first affect primary insurers.But they absorb only some of the losses, having ceded (transferred) ashare of their exposure to reinsurance companies.Reinsurers usually bear 55–65% of insured losses when a large naturaldisaster occurs.They diversify concentrated risks among themselves and pass a fractionof losses on to the broader financial market, while ultimately retainingmost catastrophe-related risk (see section below).Before disaster strikes, however, there is a corresponding premium flowin exchange for protection.Based on worldwide aggregate premium payments in 2011, policyholdersand insured entities, both private and public sector, spent $4,596 billion toreceive insurance protection.Some 43% of this global premium volume ($1,969 billion) relates tonon-life insurance and the remainder to life insurance products (IAIS(2012)). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 164Primary insurers, in turn, paid close to $215 billion to buy coverage fromreinsurers.The lion’s share, nearly $165 billion, came from primary insurers active inthe non-life business.About one third of this amount, $65 billion, was geared towardsprotection against peak risks, with $18 billion for specific naturalcatastrophe contracts.By way of comparison, life insurance companies spent 2% of theirpremium income, $40 billion, on reinsurance protection.This comparatively low degree of reinsurance protection is due to the factthat results are typically less volatile in life insurance than in non-lifeinsurance.Following any risk transfer, insurers remain fully liable vis-à-vis thepolicyholder based on the initial contractual obligations, regardless ofwhether or not the next instance pays up on the ceded risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 165Reinsurance companies, in turn, buy protection against peak risks fromother reinsurers and financial institutions.In this process of retrocession, reinsurers spent $25 billion in 2011 tomitigate their own downside risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 166The bulk of this amount represents retroceded risks transferred to otherreinsurance companies ($20 billion in premiums), while a relatively smallshare is ceded to other market participants such as hedge funds andbanks ($4 billion) and financial markets ($1 billion).An important aspect of this structure is the prefunding of insured risks.Premiums are paid ex ante for protection against an event that may ormay not materialise over the course of the contract.These payments by policyholders and insurers generate a steadypremium flow to insurers and reinsurers, respectively.Only if and when an event with the specified characteristics occurs are theclaims payments shown in Graph 3 triggered.At all other times, premium flows are accumulated in the form of assetsheld against technical reserves (see next section).Reinsurance contracts come in two basic forms which differ in the wayprimary insurers and reinsurers determine premiums and losses.Proportional reinsurance contracts share premiums and losses in apredefined ratio.Since the 1970s, non proportional contracts have increasingly been usedas a substitute.Instead of sharing losses and premiums in fixed proportions, both partiesagree on the insured risks and calculate a specific premium on that basis.The typical non-proportional contract specifies the amount beyond whichthe reinsurer assumes losses, up to an agreed upon ceiling (first limit).Depending on the underlying exposure, a primary insurer may decide tobuy additional layers of reinsurance cover, for example with otherreinsurers, on top of the first limit. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 167“Excess of loss” agreements are the most common form ofnon-proportional reinsurance cover.For natural catastrophes, these contracts are known as CatXL(catastrophe excess of loss) and cover the loss exceeding the primaryinsurer’s retention for a single event.A major earthquake, for example, is likely to affect the entire portfolio of aprimary insurer, leading to thousands of claims in different lines ofbusiness, such as motor, business interruption and private propertyinsurance.As a result, primary insurers often purchase CatXL coverage to protectthemselves against peak risks.Peak risks and the reinsurance marketA reinsurer’s balance sheet reflects its current and past acceptance ofrisks through its underwriting activity.Dealing with exposure to peak risks, which relate to natural catastrophes,is the core business of the reinsurance industry.Natural catastrophes are rooted in idiosyncratic physical events such asearthquakes.When underwriting natural catastrophe risks, reinsurers can rely to a largeextent on the fact that physical events do not correlate endogenously inthe way financial risk does.To achieve geographical diversification, reinsurers offer peak riskprotection not just for one country but ideally on a worldwide basis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 168Another form of diversification takes place over time.Premiums are accumulated over years, and claims payments are usuallypaid out over the course of months or sometimes years.Graph 4 (left-hand panel) shows the average payout profile for CatXLcontracts.Statistics on reinsurance payments show that claims are typically settledover an extended period.On average, 63% of the ultimate obligations are paid within a year and82% within two years, and it takes more than five years after a naturaldisaster strikes for the cumulative payout to reach 100%.The premium inflows not immediately used for paying out claims areinvested in various assets held for meeting expected future claims.In this way, reinsurers build specific reserves called technical provisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 169These constitute the largest block of reinsurers’ on-balance sheetliabilities (Graph 4, right-hand panel).Insured losses are met by running down assets in line with these technicalreserves.Losses in any one year typically lead to loss ratios (incurred losses as ashare of earned premium) of between 70 and 90%.To determine whether a reinsurer can withstand severe andunprecedented (yet plausible) reinsured events, regulators look forsufficient technical provisions and capital on the reinsurer’s balancesheet.The occurrence of a major natural catastrophe dents reinsurers’underwriting profitability, as reflected in the combined ratio.This indicator sets costs against premium income.A combined ratio above 100% is not sustainable for an extended period.By contrast, temporary spikes in the combined ratio are indicative of oneoff extreme events which can be absorbed by an intertemporal transfer ofrisk.The combined ratio spiked in the years featuring the most costly naturalcatastrophes to date (Graph 5, blue line): 2005, the year of majorhurricanes in the US, and 2011, following earthquakes and flooding inAsia and Oceania.Both occasions also reduced the stock of assets reserved for meetingclaims.Yet these temporary spikes in the combined ratio did not cut through toshareholder equity to any significant extent.Catastrophes affect equity only if losses exceed the catastrophe reserve. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 170Recent market developments caused shareholder equity to decrease morethan insurers’ core underwriting business ever has.During the global financial crisis of 2008–09, shareholder equity (bookvalue) declined by 15% (Graph 5, red line), and insurance companies’share prices dropped by 59% (yellow line), more than after any naturalcatastrophe to date.In contrast, shareholder equity remained resilient in 2005 and 2011, whenreinsurers weathered record high catastrophe losses.In dealing with the consequences of peak catastrophe risks, the industryhas gravitated towards a distinctive market structure.One important element is the size of reinsurance companies.Assessing and pricing a large number of different potential physicalevents involves risk management capabilities and transaction costs on alarge scale.Balance sheet size is therefore an important tool for a reinsurer to attainmeaningful physical diversification on a global scale.Partly as a result, the 10 largest reinsurance companies account for morethan 40% of the global non-life reinsurance market (Graph 6, right-handpanel). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 171In spite of the reinsurance market’s size and concentration, failures ofreinsurance companies have remained limited in scope. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 172The largest failures to date, comprising two bankruptcies in 2003, led toan essentially inconsequential reduction in available reinsurance capacityof 0.4% (Graph 6, left-hand panel).That said, any failure of a reinsurer leads to a loss of reinsurancerecoverables by primary insurers, and could cause broader markettensions in the event of a disorderly liquidation of large portfolios.In this respect, the degree of connectedness within the global insurancemarket plays an important role.Based on their business model, reinsurers enter into contracts with a largenumber of primary insurance companies, giving rise to numerous verticallinks (Graph 3).In addition, risk transfer between reinsurers leads to horizontal linkages.We estimate that 12% of natural catastrophe-related risk accepted byreinsurers is transferred within the reinsurance industry, which impliesthat the industry as a whole retains most of the risks it contracts.In 2011, reinsurers paid 3% of earned premiums to cede catastrophe riskto entities outside the insurance sector.Judging by premium volume, the global insurance market transfers asimilarly small share of accepted risk to other financial institutions andthe wider financial markets.Linkages with financial marketsArrangements designed to transfer risk out of the insurance sector createlinkages with other financial market participants.Retrocession to other financial institutions uses contractual arrangementssimilar to those between reinsurers, and commits banks and otherfinancial institutions to pay out if the retroceded risk materialises. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 173Securitisation, on the other hand, involves the issuance of insuranceliabilities to the wider financial market.The counterparties are typically other financial institutions, such ashedge funds, banks, pension funds and mutual funds.Among insurance-linked securities, catastrophe bonds are the maininstrument for transferring reinsured disaster risks to financial markets.The exogenous nature of the underlying risks supports the view thatcatastrophe bonds provide effective diversification unrelated to financialmarket risk.For these reasons, industry experts had high expectations for theexpansion of the catastrophe bond market (eg Jaffee and Russell (1997),Froot (2001)).The issuance of catastrophe bonds involves financial transactions with anumber of parties (Graph 7).At the centre is a special purpose vehicle (SPV) which funds itself byissuing notes to financial market participants.The SPV invests the proceeds in securities, mostly government bondswhich are held in a collateral trust.The sponsoring reinsurer receives these assets in case a natural disastermaterializes as specified in the contract.Verifiable physical events, such as storm intensity measured on theBeaufort scale, serve as parametric triggers for catastrophe bonds.Investors recoup the full principal only if no catastrophe occurs.In contrast to other bonds, the possibility of total loss is part of thearrangement from inception, and is compensated ex ante by a highercoupon. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 174 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 175Despite experts’ high expectations, the catastrophe bond market hasremained relatively small.Bond issuance has never exceeded $7 billion per year, limiting theoutstanding capital at risk to $14 billion (Graph 8).Very few catastrophe bonds have been triggered to date.The 2005 Gulf Coast hurricanes activated payouts from only one of ninecatastrophe bonds outstanding at the time (IAIS (2009)).Likewise, the 2011 Japan earthquake and tsunami triggered one knowncatastrophe bond, resulting in a payout of less than $300 million.Payouts to reinsurers from these bonds are small when compared to thesum of insured losses ($116 billion in 2005 and $110 billion in 2011).The global financial crisis has also dealt a blow to this market.The year 2008 saw a rapid decline in catastrophe bond issuance, reflectinggeneralised funding pressure and investor concern over the vulnerabilityof insurance entities.The crisis also demonstrated that securitisation structures introduceadditional risk through linkages between financial entities.A case in point was the Lehman Brothers bankruptcy in September 2008.Four catastrophe bonds were impaired – not due to natural catastrophes,but because they included a total return swap with Lehman Brothersacting as a counterparty.Following Lehman’s failure, these securitization arrangements were nolonger fully funded, and their market value plunged.Investors thus learned that catastrophe bonds are not immune to“unnatural” disasters such as major institutional failures. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 176A further set of financial linkages arises with other financial institutionsthrough cross-holdings of debt and equity.Insurance companies hold large positions in fixed income instruments,including bank bonds.At the same time, other financial entities own bonds and stocks ininsurance companies.For instance, the two largest reinsurance companies stated in their latest(2011) annual reports that Warren Buffett and his companies (BerkshireHathaway Inc, OBH LLC, National Indemnity Company) own votingrights in excess of the disclosure threshold (10% in one case and 3.10% inanother).Additional shareholders with direct linkages to the financial sector havebeen disclosed by a number of reinsurance companies.The ramifications of such linkages in this part of the market are difficultto assess.ConclusionThe upward trend in overall economic losses in recent decades highlightsthe global economy’s increasing exposure to natural catastrophes.This development has led to unprecedented losses for the globalinsurance market, where they cascade from the policyholders via primaryinsurers to reinsurance companies.Reinsurers cope with these peak risks through diversification, prefundingand risk-sharing with other financial institutions.This global risk transfer creates linkages within the insurance industryand between insurers and financial markets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 177While securitisation to financial markets remains relatively small,linkages between financial institutions arising from retrocession have notbeen fully assessed.It is important for regulators to have access to the data needed formonitoring the relevant linkages in the entire risk transfer cascade, as nocomprehensive international statistics exist in this area. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 178Morten Bech, Todd KeisterOn the liquidity coverage ratio andmonetary policy implementation(Important Parts)Basel III introduces the first global framework forbank liquidity regulation.As monetary policy typically involves targetingthe interest rate on interbank loans of the most liquid asset – centralbank reserves – it is important to understand how this new requirementwill impact the efficacy of current operational frameworks.We extend a standard model of monetary policy implementation in acorridor system to include the new liquidity regulation.Based on this model, we find that the regulation does not impair centralbanks’ ability to implement monetary policy, but operational frameworksmay need to adjust.In response to the recent global financial crisis, the Basel Committee onBank Supervision (BCBS) published a new international regulatoryframework, known as Basel III, in December 2010 (BCBS (2010)).In addition to strengthening the existing bank capital rules, Basel IIIintroduces – for the first time – a global framework for liquidityregulation.A key part of the framework is the liquidity coverage ratio (LCR), whichrequires banks to hold a sufficient stock of highly liquid assets to survive a30-day period of market stress.The LCR is scheduled to be implemented in January 2015. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 179The new liquidity regulation is likely to impact the process through whichcentral banks implement monetary policy.In many jurisdictions, this process involves setting a target for the interestrate at which banks lend central bank reserves to one another, typicallyovernight and on an unsecured basis.Because these reserves are part of banks’ portfolio of highly liquid assets,the regulations will potentially alter banks’ demand for reserves, changingthe relationship between market conditions and the resulting interestrate.Central banks will need to take these changes into account when decidingon monetary policy operations.In this special feature, we study the interactions that may arise betweenliquidity regulation and monetary policy implementation.Our discussion is based on a standard economic model for analysing theprocess of implementing monetary policy, which we extend toincorporate a liquidity requirement in the form of an LCR.The key takeaway from our analysis is that, while the LCR will not impaircentral banks’ ability to implement monetary policy, the process wherebythis is done may need to adjust.Once the LCR is in place, central banks will need to consider not onlyhow the size of an open market operation affects interest rates, but alsohow the structure of the operation affects bank balance sheets.In certain circumstances, central banks may choose to adjust theiroperational frameworks to better fit the new environment.At a minimum, they will need to monitor developments that materiallyaffect the LCR of the banking system – just as they have traditionallymonitored other factors that affect reserve markets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 180We begin with a short primer on the LCR – including its definition and abrief discussion of how far the banking system currently is from meetingthe regulatory threshold.We also touch on how both interbank and lending facility borrowingsaffect a bank’s LCR.We then present a simple version of the textbook model of monetarypolicy implementation, followed by an extended version that includes anLCR requirement.Finally, we discuss how different types of open market operations affectbank balance sheets and the LCR calculations before offering someconcluding remarks.A primer on the liquidity coverage ratioAs stated by the Group of Central Bank Governors and Heads ofSupervision, “[t]he aim of the Liquidity Coverage Ratio is to ensure thatbanks, in normal times, have a sound funding structure and holdsufficient liquid assets such that central banks are asked to perform aslenders of last resort and not as lenders of first resort.”The LCR builds on traditional liquidity “coverage” methodologies usedinternally by banks to assess exposure to stress events.The LCR requires that a bank’s stock of unencumbered high-qualityliquid assets (HQLA) be larger than the projected net cash outflows(NCOF) over a 30-day horizon under a stress scenario specified bysupervisors:High-quality liquid assets include central bank reserves, debt securitiesissued (or guaranteed) by public authorities, and highly ratednon-financial corporate bonds and covered bonds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 181Total expected cash outflows are calculated by multiplying thesize of various types of liabilities and off-balance sheet commitments bythe rates at which they are expected to run off or be drawn down in thestress scenario.For example, unsecured interbank loans are assumed to run offcompletely if they come due during the stress scenario, whereas depositsare assumed to run off by 5 or 10%, depending on the characteristics ofthe deposit.The denominator of the LCR is on a “net” basis, as contractual inflowscan be deducted from outflows, subject to a cap.The impact of the new regulation will depend in part on how close banksare to the LCR threshold once the regulation is implemented.If most banks satisfy the LCR requirement by a comfortable margin, theregulation’s effect on their behavior – and hence on the process ofmonetary policy implementation – will be fairly minor.If, however, many banks fall short of the new standards, the impact ismore likely to be significant.Insofar as meeting the LCR requirement is costly for banks, it isconceivable that some banks may not exceed the regulatory threshold bya considerable margin, which could allow the LCR to impact theimplementation of monetary policy.However, before we can address this issue, we need to understand howinterbank loans and borrowing from the central bank affect thecalculation of the LCR.ConclusionsThe introduction of the liquidity coverage ratio will influence banks’liquidity management procedures and, hence, their demand for funds inthe interbank market. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 182Central banks that conduct monetary policy by setting a target for theinterest rate in this market will, therefore, need to take this change intoaccount.In this feature, we analyse how the introduction of an LCR affects theprocess of monetary policy implementation in the context of a simple,well known model of banks’ reserve management.This analysis points to three basic conclusions.First, the LCR will not impair the ability of central banks to implementmonetary policy, but the process by which they do so may change.Second, correctly anticipating an open market operation’s effect oninterest rates will require central banks to consider not only the size of theoperation, but also the way the operation is structured and how it impactson bank balance sheets.Finally, the LCR may increase the steepness of the very short end of theyield curve by introducing an additional premium for interbank loans thatextend beyond 30 days. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 183EIOPA – Risk DashboardSystemic risks and vulnerabilitiesOn the basis of observed market conditions, data gathered fromundertakings, and expert judgment, EIOPA assesses the main systemicrisks and vulnerabilities faced by the European insurance industry overthe coming quarters to be:• Macro risks:Recessionary pressure in a number of economies in the EU exemplify themacro-economic risks which are still at an elevated level.Although several important steps have been taken recently both at theEuropean and national level, uncertainty remains with regard to anyremaining implementation risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 184In addition, the combination of austerity measures, rising unemploymentand a prolonged period of subdued growth could have negative effects oninsurance demand.• Credit and market risk:The trend of decreasing CDS spreads has continued.However, this development certainly is also driven by excess liquidity, thedifficult global financial investment environment and investors’ riskappetite striving for an appropriate balance of yield versus risk.Recent changes in asset allocation of European insurers rather hint at areduced risk appetite concerning credit investments.They tend to shift investments towards less riskier counterparties,reducing their European sovereign and banking exposure.This indicates a continuation of a negative outlook/perception on thatcredit category.Market risks are still dominated by the low yield environment with 10 yearswap rates in Western Europe having again reached new lows in the pastmonths.• Stabilisation in life insurance business:The declining trend in life gross written premiums has been reversed,however growth rates are still rather subdued.Lapse rates in the sample have improved from their peak in Q4 2011 andremained stable since last quarter. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 185Use of expert judgmentUse of expert judgment after the mechanical aggregation:• Macro risk:Slightly upwards due to high heterogeneity in growth figures across EUcountries and general uncertainty about the medium term growthpotential and its implications for the demand of insurance products.In addition, implementation risks around the various crisis managementtools used in the sovereign debt crisis are non negligible.• Credit risk:Slightly upwards as the observed decrease of the mechanistic score isconsidered too large given the uncertain macro outlook, potentiallydistorted bond prices as a result of excess liquidity while at the same timeinvestors have limited alternatives to substantially reduce their credit riskexposure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 186• Market risk:Slightly upwards due to the severe consequences a prolonged low yieldenvironment could have on the profitability and solvency of the insurancesector.Improvements in other indicators, e.g. equity risk, are not considered tomake up the effects of recently observed new historic lows in 10_yearswap rates, given the on average small equity investments of insurers.• Liquidity&funding:Slightly downwards as the increase of the mechanistic score is solelydriven by low issuance volume of cat bonds in Q3 which is seasonallydriven and is already picking up substantially in October and November.Other indicators remained stable.• Insurance risk:Slightly upwards due to reduced buffers of reinsurers for catastrophelosses after Hurricane Sandy and potential price hikes in upcomingrenewals, which are not reflected in Q3 figures yet.In addition, insurers’ business model might be impacted in a low yieldenvironment when lower investment returns cannot counter balancepotential underwriting losses. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 187 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 188 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 189Sovereign risk – a world withoutrisk-free assetsPanel comments by Mr Patrick Honohan,Governor of the Central Bank of Ireland, atthe BIS Conference on “Sovereign risk – aworld without risk-free assets”, Basel, 8January 2013.What’s new about sovereign risk since thecrisis began?Conceptually, not so much, I would suggest – and nothing that cannot befully explained within standard models of finance.But in practice, and in particular in the euro area, two linked elementsthat were always potentially present or implicit have leapt intoprominence in a way and to an extent that was not foreseen.The first is that markets have begun to price default risk in a sovereign’shome-currency;The second is the contamination of the functioning and economiceffectiveness of banks by the weak credit rating of their sovereigns (aswell as vice versa).I have to admit to the possibility that my remarks may be subject to someprofessional deformation here, in that my perspective on these matters islikely coloured by my pre-occupation with the situation in Ireland.Ireland has certainly displayed these two elements in a dramatic way, butthey are evidently present in half a dozen other euro area countries alsoand to an extent which has had implications for the functioning of theEurosystem as a whole, and therefore on the global financial system.Let me take these two points in turn. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 190First the pricing-in of sovereign default risk in “home currency”.Why did the default premium suddenly emerge?Evidently, even though everyone understood the rules, no such pricing-inoccurred for the first decade of the Eurosystem (Figure 1).Risk appetite was high for much of that period, but the market’sperception of sovereign risk must also have remained low.(Perhaps, despite Treaty prohibitions, market participants assumed thatany sovereign that got into trouble would be bailed-out).Indeed, sovereign spreads in the euro area were almost totally insensitiveto credit ratings before the crisis (Figure 2).One often-heard interpretation of what happened during that decade isthat the complacent market environment relaxed the budget constraint oneuro-area sovereigns and led them to borrow recklessly.Actually this story doesn’t fit the facts very well.After all, although sovereign debt ratios in most of the Eurosystem did notfall as much as they could and should have on the good years, at least theydid not increase dramatically before the crisis (Figure 4).(Private debt ratios, and in particular the size of the bank and near-banksystems did increase, but that is a somewhat different story, to which Iwill turn shortly).It’s possible alternatively that there was a multiple equilibrium here, withthe “good” or low interest equilibrium (with a self-fulfilling degree ofconfidence in the creditworthiness of all the sovereigns) being selected bythe market at the start of the euro, and events during the financial crisis –not least those associated with Greece – having tripped the system intothe “bad” or high interest equilibrium with default risk premia moving anumber of sovereigns into a more challenging debt sustainabilityposition. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 191Most likely, what we have seen is a combination of factors:(i) a sharp reduction in risk appetite resulting in even little-changed debtratios, as in Italy, looking more challenging and in need of arisk-premium; and in addition (for most countries)(ii) a sharp increase in debt ratios as governments reacted to the crisis(including, but not at all confined to, the socialisation in most countries ofsome private banking losses through their assumption by governments)(Figure 4 again).The increased sensitivity of sovereign spreads to ratings, and theincreased range of ratings themselves – both illustrated in Figure 2 –suggest that both factors are at work.(As spreads widened in stressed countries, their fluctuations – whichwould not concern hold-to-maturity investors – added a risk factor forothers and probably ratcheted up the average level of the spreads.)In the specific case of Ireland, the depth of the recession and theremarkably high elasticity of tax revenues and the Government deficit tothe downturn, combined with the unfortunate decision to lock-in a verycomprehensive bank guarantee before the potential scale of the bankinglosses could at all be appreciated, meant that Ireland’s actual andprospective general government debt made a shocking turnaround fromabout 25 per cent of GDP in 2007 to 117 per cent just five years later.Historians will debate the exact triggers for the market’s loss ofconfidence in the Irish sovereign.Even as late as April 2010, after the first sampling indicated the scale ofthe banking losses, sovereign spreads were little more than 1 per cent.By November of that year (just a few weeks after the Deauville statementwhich persuaded the markets that private sector holders of euro sovereigndebt would not be immune from loss-sharing) large banking outflows andspreads exceeding five per cent made recourse to official assistanceinevitable. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 192(Figure 3 shows the plot with some relevant news stories flagged).Perhaps the most significant take-away from the sequence of spikes andtroughs is the fact that some of them clearly relate to news that iscountry-specific, some of them to euro area general news.The same is doubtless true for all of the stressed sovereigns.Default risk vs. devaluation risk vs. redenomination riskIt’s worth pausing to recall that raw sovereign spreads such as we areseeing today in the euro area are not remotely unprecedented in pre-eurohistory.On the contrary, they were the norm as is illustrated by Figure 1.The difference is that these spreads reflected a combination of defaultrisk and currency risk.During the last fiscal crisis of the 1980s Irish sovereign spreads balloonedout also.But that was for local currency denominated debt.Eurobond borrowing by the Irish Government remained at fairly tightspreads despite the high overall debt ratio (higher than today), and thefact that almost half of the national debt was denominated in foreigncurrency.The high spreads reflected devaluation expectations and currency riskgenerally.And there were devaluations, though less than was baked into the spreads– by between 250 and 300 basis points on average during the last ten yearsof that ill-fated regime, the narrow-band EMS.It is not that default and devaluation are close substitutes; not at all, andfor several reasons. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 193For one thing, default has potential reputational consequences for theissuer qualitatively different to those of devaluation.In addition, though, devaluation affects not only the international value ofthe Government’s debt promises, but also that of all other contractsdenominated in local currency; as a result, depending on the speed ofprice-resetting (pass-through) it can affect competitiveness throughoutthe economy.These differences have not been sufficiently emphasised, I feel, in recentdiscussion.As an example, I could mention the Irish devaluation of August 1986.The main goal of this important action was restoration of wagecompetitiveness, not a lowering of the real value of the localcurrency-denominated debt.(Indeed, I recall that some domestic policymakers were confused on thispoint and thought that the debt burden would actually increase as a resultof translation effect on the foreign currency debt!)Such currency risk can be so extreme as to make it impossible for thesovereign to issue any sizable amount of local-currency denominateddebt to international lenders.In the literature, such countries – all in the developing world (and notincluding Ireland, cf. Figure 5) – were said to suffer from “Original Sin”.Happily, the number of countries suffering “Original Sin” has beendiminishing in recent years.Instead, we have to acknowledge the emergence in market pricing of anew phenomenon, “redenomination risk”.How can we recognise redenomination risk? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 194This is not straightforward, not least because the term could refer to anumber of different scenarios.One suggested way of approaching the question is to use econometricestimates of the cross-sectional determinants of sovereign spreads forforeign currency-denominated borrowing to predict current spreads instressed euro area countries: a positive residual might suggest aredenomination risk premium.Comparisons of current spreads of euro area sovereigns in euro and inforeign currency-denominated borrowings provides for an alternativeapproach.My own favourite approach is to look at the co-movement in the timeseries of euro area country spreads.Some of this co-movement can be attributed to fluctuations in marketrisk-appetite; the remainder could be interpreted as a system-wideredenomination premium.This brief summary already suggests the complexity and ambiguity ofsome of the concepts involved and their measurement.Evidently, redenomination risk, as imagined by market commentators,combines default and currency risk in a novel way not contemplated bythe Treaty that established the euro area.The ECB has made clear its determination to do what is necessary topreserve the euro and remove unfounded euro break-up premia insovereign yields.The OMT, designed as a backstop to inhibit negative self-fulfillingmarket dynamics, provides the necessary tools to deliver on thatcommitment.The programme does not go overboard in the direction of removing theincentive for governments to manage their finances in such a way as torecover and retain the confidence of the market, but it will ensure that _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 195disciplined governments will not have to pay spreads that could onlyreflect market concerns about a system break-up.As announced, the ECB will only buy bonds at the shorter end of thematurity spectrum, but the OMT can be expected to have an influencetransmitted by market forces throughout the yield curve, and indeedspreads have tightened right across all maturities since the OMT wasannounced.Still, it is not to be expected that the OMT will by itself restore the tightuniformity of spreads that prevailed for the first decade of the euro.Forcing such a tight uniformity would not be generally considered safeabsent more reliable alternative mechanisms for ensuring disciplinedfiscal policy in the countries concerned.More likely would be a potentially extended period of sovereign spreadsthat, albeit narrower than at their worst, remain material.Sovereign spreads and the banksThat being so, we need to ask what are the consequences of these spreadsfor the rest of the economy, and in particular for the operation of thebanking system.Regardless of the condition of the balance sheet and the profit and lossaccount of the banks, experience shows how hard it is for banks in ajurisdiction where the sovereign is under stress to access the moneymarkets on the finest terms.In essence, the market fears that a stressed sovereign could in extremisreach to the banks as a source of last resort financing – if necessary usingnational legislation to do so.From such a perspective, providers of funds to banks will tend to price-inthe possibility that, at the margin, they could end up as indirect providersof funds to a stressed sovereign. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 196There are many examples in history of this happening, and theconsequences for bank funding costs have often been severe.In other words, while we have all become sensitised to the pressure whichsocialized banking losses can place on the sovereign, markets are alsoacutely aware of the potential damaging links in the other direction.Either way, there are consequences for the funding costs of both thesovereign and the banks.Given the scale of banking in the euro area, even a relatively smalldifference in funding costs can be consequential.Once again, the Irish situation dramatises what can happen when thetwo-way feedback loop between banks and sovereign causes a loss ofaccess to risk-free rates.As is well known, the Irish banks have suffered severe loan losses in theaftermath of the bursting of the property price and construction bubblewhich they had so enthusiastically financed.Very sizable capital injections (about 50 per cent of GNP from theIrish Government alone – a sum which proved too great to be financedwithout the protection of an IMF programme) have ensured that the Irishbanks more than satisfy regulatory requirements once again, but theirfuture profitability is constrained by the emergence and likely persistenceof the sovereign spreads, and the knock-on effect of the spreads on thebanks’ funding costs.Euro-area risk-free rates are not now the most relevant indicator of themarginal cost of funds to the Irish banking sector.It is, of course, true that the Irish banks (like those in other stressedcountries) have been drawing heavily on ECB refinancing facilitiesduring the crisis, especially following the huge outflow of funds thatoccurred in early 2009 and again in the last few months of 2010.This access to refinancing has been vital to the continuing operation _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 197of the banking system, and it has come at the policy rate.(Let me mention as an aside a curious feature of the current monetarypolicy environment in the euro area.The two key ECB rates – the main refinancing operations rate and thedeposit rate – are 75 basis points and zero, respectively.Access to both the refinancing and deposit facilities are both close toall-time highs.But in practice, the bulk of the refinancing is going to banks in thestressed countries, while the bulk of the deposits are placed by banks innon-stressed countries.To the extent that the stressed countries have tended to have weakereconomic performance during the crisis, this pattern might be consideredparadoxical.But it is of course a reflection and semi-automatic consequence of thefragmentation which has developed in the euro area.To be sure, the ECB policy rate is clearly below the marginal cost of fundsin the stressed countries.)But access to ECB funds at the policy rate is limited by the availability ofeligible collateral and the haircuts that are applied to such collateral(despite the relaxation of eligibility criteria).About 20 per cent of the total financing of the three going concern Irishcontrolled banks comes from this source at present (16 per cent of thebalance sheet total).Competition for deposits therefore remains strong and rates high.It’s not just that higher bank funding costs will now be passed on to newborrowers, adding headwinds to the economic recovery, though that iscertainly a factor. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 198Indeed, the lower policy interest rates set by the ECB since the crisisbegan have only been partly transmitted to borrowers in Ireland and inthe other stressed euro area countries (Figure 6).(As is seen by the results of a recursive regression exercise, thepass-through from policy rate to Irish residential mortgage SVR rates hashalved since the start of the crisis – Figure 7.)Some of this can be rationalised as reflecting a higher credit risk-premiumbeing charged by the banks, but some is also due to the higher marginalcost of funds.Worse still for the health of the banks, and their ability to contribute to theeconomic recovery, is the fact that they are still coping with theconsequences of their marginal cost of funds having delinked so sizablyfrom the ECB policy rate.These consequences arise because of the long-term mortgage contractsthe banks made when they assumed that their marginal cost of fundswould always remain close to the (risk-free) policy rate.Suffice it to say that a large block of residential mortgages was granted atinterest rates which track the ECB policy rate plus a very low spread.These tracker mortgages, many of which have an average remainingmaturity of 15–20 years or more, yield less than the marginal cost of funds(Figure 8 which is drawn on the assumption, not strictly valid, that theaverage spread of the trackers over policy rate was unchanged over time).In effect, by assuming that their cost of funds would not deviate muchfrom the ECB policy rate, the banks exposed themselves to a very large“basis risk”.In principle, they could escape this trap if there were a willing purchaser(public or private) with access to funding at a cost that is notcontaminated by the sovereign stress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 199Until such a purchaser comes forward, the banks will have to continue tofund this portfolio at a loss, even on performing mortgages, whose effectswill spill over onto their customers and their owners (not least the State).ConclusionIrish Sovereign spreads may no longer be bloated by redenomination risk,but at 300 basis points at the long-end, they do seem to reflect a credit riskpremium that is poor reward, so far, for what has been a sizable fiscaladjustment effort.Reflecting on where we have got to, it seems that there are distinctparallels with the fiscal crisis of the EMS period.As I mentioned, spreads (then reflecting devaluation risk) exceeded whatwould have been needed ex post to compensate for actual exchange ratemovements by almost the same amount (250–300 basis points).Those spreads were transmitted to the banking system then also.The Irish financial situation is relatively extreme, and as such illustratesclearly some of the key problems that have been faced also in otherstressed parts of the euro area.While it has delivered a much lower inflation rate, the euro is no longerinsulating financial markets from the impact of excessive debt in membercountries.The early insulation of the monetary transmission mechanism from fiscalproblems of participating countries has worn through.The pernicious feedback loop from banks to sovereign and fromsovereign to banks that re-emerged in the crisis remains strong anddamaging.Getting back to the “good” equilibrium will require a healing processwhich removes the market’s fear of default. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 200It is inevitably a protracted process needing not only firm adherence toconsistently disciplined policies but also the creation of institutions thatcan prevent future crises, or at least cope with them better if they cannotbe avoided. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 201 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 202 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 203 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 204 _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 205Certified Risk and Compliance Management Professional(CRCMP) distance learning and online certification program.Companies like IBM, Accenture etc.consider the CRCMP a preferredcertificate. You may find more if yousearch (CRCMP preferred certificate)using any search engine.The all-inclusive cost is $297.What is included in the price:A. The official presentations we usein our instructor-led classes (3285 slides)The 2309 slides are needed for the exam, as all the questions arebased on these slides. The remaining 976 slides are for reference.You can find the course synopsis Up to 3 Online ExamsYou have to pass one exam.If you fail, you must study the officialpresentations and try again, but you do not need to spend money. Upto 3 exams are included in the price.To learn more you may Personalized Certificate printed in full colorProcessing, printing, packing and posting to your office or home. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • P a g e | 206D. The Dodd Frank Act and the newRisk Management Standards (976slides, included in the 3285 slides)The US Dodd-Frank Wall Street Reformand Consumer Protection Act is themost significant piece of legislationconcerning the financial servicesindustry in about 80 years.What does it mean for risk andcompliance management professionals?It means new challenges, new jobs, newcareers, and new opportunities.The bill establishes new riskmanagement and corporate governanceprinciples, sets up an early warningsystem to protect the economy from future threats, and brings moretransparency and accountability.It also amends important sections of the Sarbanes Oxley Act. Forexample, it significantly expands whistleblower protections under theSarbanes Oxley Act and creates additional anti-retaliationrequirements.You will find more information _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)