Monday November 19 2012 - Top 10 Risk Management News


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Monday November 19 2012 - Top 10 Risk Management News

  1. 1. 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,Today we will start from something reallyinteresting: The compensation in financialand nonfinancial sectors before the crisis.We always try to predict thefuture, and to figure outwhen we will have the nextmarket bubble (which canalso be an opportunity).A market bubble is forming.Can we use the gap in thecompensation (togetherwith other information likethe growth to GDP ratioetc.) to learn more about it?How?I wait for your comments.We will share the best answer with all members, and we will give aCRCMP program to the winner.We will discuss something different now. The Federal Reserve willapprove dividend increases or other capital distributions only for _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  2. 2. Page |2companies whose capital plans are approved by supervisors and who areable to demonstrate sufficient financial strength to continue to operate asfinancial intermediaries under stressed macroeconomic and financialmarket scenarios, even after making the planned capital distributions.This is very interesting.On one hand, under the Basel iii rules, banks need to have more commonequity Tier 1 capital. So banks must attract investors.On the other hand, it becomes more and more difficult to pay dividends.Is it a flaw, an oxymoron? Which are your thoughts?We will share the best answer with all members, and we will give aCRCMP program to the winner.You can read more about the dividends at Number 1 below.Also…“A cyclist has made a strong start to the race.But, as it happens, he has overestimated his strength.After a while, he has to pedal harder just to avoid falling over.His energies are flagging and he is on the point of collapsing fromexhaustion.His mistake was to treat a long-distance race as a series ofever-shortening sprints.His horizon was too short; the cumulative effort is finally catching up.And yet, he struggles on.The global economy is not so different from this sportsman. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  3. 3. Page |3It gained new force from a powerful wave of globalisation and thesuppression of inflation.But the resurgence of the financial cycle made it feel, for a while, strongerthan it really was.Market participants and policymakers did not see through this illusion.And, every time that a financial boom turned to bust, they would simplytry harder, re-applying the same old nostrums.Their horizons were too short; and the cumulative impact of their effortsis catching up with them: stocks of private and sovereign debt have beengrowing beyond sustainable levels and the policy room for manoeuvre hasbeen shrinking dramatically”Who said that?Claudio Borio, from the Bank for International Settlements, in one reallygreat presentation …… where he covers economic cycles as well!He continues - at Number 3 of our list:“Our historian would go one level deeper.He would ask: “Are banking crises, like Tolstoy’s famous unhappyfamilies, all different? Or are they more like his happy ones, which are allalike?”You must read it!!!Welcome to the Top 10 list. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  4. 4. Page |4Agencies Provide Guidanceon Regulatory CapitalRulemakingsThe U.S. federal banking agencies issued three notices of proposedrulemaking in June that would revise and replace the current regulatorycapital rules.The proposals suggested an effective date of January 1, 2013.A full version of the Group of 20communique:“We, the G20 Finance Ministers and Central BankGovernors, met to assess progress on thefulfillment of the mandates given to us by ourLeaders, to promote robust growth and jobcreation and to address ongoing economic andfinancial challenges.”On time, stocks and flows: Understanding theglobal macroeconomic challengesClaudio BorioBank for International Settlements _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  5. 5. Page |5PCAOB Regulatory InitiativesJames R. Doty, ChairmanPractising Law Institute, New York, NYIntroductory statementMario Draghi, President of the ECB,Vítor Constâncio, Vice-President of the ECB,Frankfurt am MainSteven Maijoor, ESMA ChairDevelopments in European FinancialReporting Regulation andEnforcementMeet the Experts, LondonSpeech by the Chancellor of theExchequer, Rt Hon GeorgeOsborne MP(to the Royal Society) _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  6. 6. Page |6The Challenges of Understanding Labor MarketTrendsDennis Lockhart, President and Chief Executive OfficerFederal Reserve Bank of AtlantaLarge Exposure RegimeGroups of Connected Clients andConnected CounterpartiesInteresting partsAIMA ANNOUNCES AIFMDIMPLEMENTATION PROJECTThe Alternative Investment ManagementAssociation (AIMA), the global hedge fundassociation, has announced its AIFMD Implementation Project ahead ofthe release of the final implementation text of the Alternative InvestmentFund Managers Directive (AIFMD) by the European Commission. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  7. 7. Page |7Agencies ProvideGuidance onRegulatory CapitalRulemakingsThe U.S. federal banking agencies issued three notices of proposedrulemaking in June that would revise and replace the current regulatorycapital rules.The proposals suggested an effective date of January 1, 2013.Many industry participants have expressed concern that they may besubject to a final regulatory capital rule on January 1, 2013, withoutsufficient time to understand the rule or to make necessary systemschanges.In light of the volume of comments received and the wide range of viewsexpressed during the comment period, the agencies do not expect thatany of the proposed rules would become effective on January 1, 2013.As members of the Basel Committee on Banking Supervision, the U.S.agencies take seriously our internationally agreed timing commitmentsregarding the implementation of Basel III and are working asexpeditiously as possible to complete the rulemaking process.As with any rule, the agencies will take operational and otherconsiderations into account when determining appropriateimplementation dates and associated transition periods. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  8. 8. Page |8The Federal Reserve Board on Friday launched the 2013 capital planningand stress testing program, issuing instructions to firms with timelines forsubmissions and general guidelines.The program includes the Comprehensive Capital Analysis and Review(CCAR) of 19 firms as well as the Capital Plan Review (CapPR) of anadditional 11 bank holding companies with $50 billion or more of totalconsolidated assets.The aim of the annual reviews is to ensure that large, complex bankinginstitutions have robust, forward-looking capital planning processes thataccount for their unique risks, and to help ensure that institutions havesufficient capital to continue operations throughout times of economicand financial stress.Capital is important to banking organizations, the financial system, andthe broad economy because it acts as a cushion to absorb losses and helpsto ensure that any such losses are borne by shareholders, not taxpayers.Institutions in the CCAR and CapPR programs will be expected to havecredible plans that show they have sufficient capital to continue to lend tohouseholds and businesses even under severely adverse conditions, andare well prepared to meet Basel III regulatory capital standards as theyare implemented in the United States.Firms capital adequacy will be assessed against a number of quantitativeand qualitative criteria, including projected performance under the stressscenarios provided by the Federal Reserve and the institutions internalscenarios.Boards of directors of the institutions are required to review and approvecapital plans before submitting them to the Federal Reserve. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  9. 9. Page |9"The Federal Reserve has been focused--and will remain focused--onensuring the nations largest financial institutions have enough capital toweather severe, unexpected conditions and still continue lending tohouseholds and businesses," Gov. Daniel K. Tarullo said.The 19 bank holding companies in the CCAR have increased theiraggregate tier 1 common capital to $803 billion in the second quarter of2012 from $420 billion in the first quarter of 2009.The tier 1 common ratio for these firms, which compares high-qualitycapital to risk-weighted assets, has more than doubled to a weightedaverage of 10.9 percent from 5.4 percent.One part of the CCAR and CapPR reviews is an evaluation by the FederalReserve of institutions plans to make capital distributions, such asdividend payments or stock repurchases.The Federal Reserve will approve dividend increases or other capitaldistributions only for companies whose capital plans are approved bysupervisors and who are able to demonstrate sufficient financial strengthto continue to operate as financial intermediaries under stressedmacroeconomic and financial market scenarios, even after making theplanned capital distributions.In a change from prior years, following the Federal Reserves assessmentof the initial capital plans, CCAR firms will have one opportunity to makea downward adjustment to their planned capital distributions from theirinitial submissions before a final Federal Reserve decision is made.As in 2012, the Federal Reserve will release summary results for the 19CCAR firms including its projections of capital ratios, losses, andrevenues under the Federal Reserves severely adverse scenario.In 2013, the Federal Reserve will release two sets of post-stress data foreach firm. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  10. 10. P a g e | 10One set will reflect the capital distribution assumptions prescribed in thestress testing rule mandated by the Dodd-Frank Wall Street Reform andConsumer Protection Act to enhance comparability of results.The other will include ratios based on each firms own planned capitalactions as proposed in their initial CCAR capital plan submissions, aswell as ratios based on any adjustments made to planned capitaldistributions.While the aims of CapPR are the same as CCAR, there are a number ofimportant distinctions.For example, the Federal Reserves assessment of capital plans underCapPR will not be based on supervisory estimates derived fromindependent supervisory models, but instead solely on an assessment ofthe firms own capital plans and internal capital planning and stresstesting practices that support them.Further, the Federal Reserve will not publish a summary of bank-specificresults for CapPR in 2013.The Federal Reserve wanted to give firms as much time as possible toprepare their submissions and therefore is issuing the instructions aheadof the release of the macroeconomic and financial market scenarios.The Federal Reserve will require institutions to use the scenarios in boththe stress tests conducted as part of their capital plans and in the stresstests that are part of the Dodd-Frank Wall Street Reform and ConsumerProtection Act.The Federal Reserve expects to release the scenarios at 4 p.m. EST onThursday, November 15. Institutions will be required to submit theircapital plans no later than January 7, 2013. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  11. 11. P a g e | 11The following is a full version of the Groupof 20 communique:1. We, the G20 Finance Ministers and CentralBank Governors, met to assess progress on thefulfillment of the mandates given to us by ourLeaders, to promote robust growth and jobcreation and to address ongoing economic and financial challenges.2. We will do everything necessary to strengthen the overall health andgrowth of the global economy.Our main focus in the period ahead will be to rebuild confidence and toreduce risks and volatility in international financial markets; contribute toa faster pace of economic recovery and job creation, and promote thefoundations for strong, sustainable, and balanced growth.We are firmly committed to open trade and investment, expandingmarkets and resisting protectionism in all its forms.3. We have made significant progress in implementing the commitmentsestablished in the Los Cabos Growth and Jobs Action Plan.Substantive measures have been adopted in Europe, including the launchof the European Stability Mechanism, the decision of the ECB onOutright Monetary Transactions, the agreement by European leaders toestablish a single supervisory mechanism for banks, the adoption andongoing implementation of the Compact for Growth and Jobs, and thereforms and fiscal consolidation carried out by a number of Europeancountries.Other countries with policy space have implemented actions to supportaggregate demand.Major central banks have taken further unconventional measures in linewith their respective mandates which are welcomed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  12. 12. P a g e | 124. Global growth remains modest and downside risks are still elevated,including due to possible delays in the complex implementation of recentpolicy announcements in Europe, a potential sharp fiscal tightening inthe United States, securing funding for this years budget in Japan,weaker growth in some emerging markets and additional supply shocksin some commodity markets.The reduction of global imbalances has not been sufficient, and in manycountries the process of necessary deleveraging by the private and publicsectors is ongoing and unemployment remains high.Complete and timely implementation of all of our policy commitments iscritical in order to continue to reduce risks and secure a durable andstrong recovery.5. We are committed to build on the policy measures taken in recentmonths.Current reform momentum in the EU on structural, fiscal and financialfields needs to be continued with the view to improving competitivenessand promoting financial stability.In this respect, we welcome the recent decision by European leaders toagree on a legislative framework by January 1st 2013 on a singlesupervisory mechanism.We look forward to the operational implementation of the singlesupervisory mechanism in the course of 2013 and to the completion of thetechnical discussions on the future of the ESM direct bankrecapitalization instrument, within a broader strategy of completing thearchitecture of the EMU.6. We will ensure our public finances are on sustainable paths, in line withthe medium-term Toronto commitments in the case of advancedeconomies.In light of the weak pace of global growth, they will ensure that the paceof fiscal consolidation is appropriate to support the recovery. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  13. 13. P a g e | 13Countries which have fiscal space will let the automatic fiscal stabilizersoperate as appropriate.Those with sufficient space stand ready to support demand as needed inthe shortrun should economic conditions deteriorate.The United States will carefully calibrate the pace of fiscal tightening toensure that public finances are placed on a sustainable long-run pathwhile avoiding a sharp fiscal contraction in 2013.In Japan further progress in medium-term fiscal consolidation is needed.By the next Summit, advanced economies agree to identify credible andambitious country-specific targets for the debt-to-GDP ratio beyond 2016,where these do not currently exist, accompanied by clear strategies andtimetables to achieve them.7. The weak pace of global growth also reflects limited progress towardssustaining and rebalancing global demand.We commit to achieving external and internal adjustment in a way thatsupports and sustains growth and leads to global rebalancing.In this regard, we reiterate our commitments to move more rapidlytoward more market-determined exchange rate systems and exchangerate flexibility to reflect underlying fundamentals, avoid persistentexchange rate misalignments and refrain from competitive devaluation ofcurrencies; to boost domestic sources of growth in surplus economies,and boost national savings in deficit economies.We reiterate that excess volatility of financial flows and disorderlymovements in exchange rates have adverse implications for economicand financial stability.We commit to the implementation of ambitious structural reforms aimedat promoting output and employment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  14. 14. P a g e | 14We have also made progress in strengthening our AccountabilityAssessment framework by agreeing on a set of measures to inform ouranalysis of our fiscal, monetary and exchange rate policies.We will consider a range of indicators and approaches to assess spillovereffects, progress towards commitments on structural reforms, and ourcollective achievement of strong, sustainable and balanced growth.8. We welcome the continuation of the process to strengthen IMFresources to safeguard global financial stability and enhance the IMFsrole in crisis prevention and resolution.Since the Los Cabos Summit, additional pledges have been received frommore members, and total commitments add up to US$461 billion.Furthermore, we welcome the formalization of the first set of bilateralborrowing agreements under the agreed modalities comprisingUS$286bn, which represent more than half of the Los Cabos 2012 pledge.We call for the finalization of the remaining bilateral agreements.9. We welcome IMF´s Executive Board decision on the use of US$2.7bnof additional resources from the windfall gold sales profits for the Fund´sPoverty Reduction and Growth Trust and call on the membership toprovide the assurances needed for this to take place.This effort reinforces the international community´s will to reducepoverty by boosting financial assistance to low income country members.10. We remain committed to the full implementation of the 2010 Quotaand Governance Reform.Although significant progress has been achieved, as of October 2012 theconditions for the entry into force of the 2010 Quota and GovernanceReform have not been fully met. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  15. 15. P a g e | 15We reaffirm the urgency of making these important reforms effective andcall on members who have yet to complete the process to do so as soon aspossible.The process of IMF reform will enhance its legitimacy, relevance andeffectiveness.11. We are committed to completing the comprehensive review of thequota formula, to address deficiencies and weaknesses in the currentquota formula, by January 2013 and to complete the next general review ofquotas by January 2014.We agree that the formula should be simple and transparent, consistentwith the multiple roles of quotas, result in calculated shares that arebroadly acceptable to the membership, and be feasible to implementbased on a timely, high quality and widely available data.We reaffirm that the distribution of quotas based on the formula shouldbetter reflect the relative weights of IMF members in the world economy,which have changed substantially in the view of a strong GDP growth indynamic emerging markets and developing countries.We reaffirm the importance of continuing to protect the voice andrepresentation of the poorest members of the IMF.We call on the IMF membership to develop the consensus needed tocomplete the review by January 2013.12. We welcome the strengthening of the IMFs surveillance frameworkthrough the adoption of the new Integrated Surveillance Decision, and wewelcome the introduction of the Pilot External Sector Report tostrengthen multilateral analysis and enhance the transparency ofsurveillance.A transparent and evenhanded framework of surveillance is key to achieveownership and traction of policy recommendations by the IMF, thusmaking surveillance more effective. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  16. 16. P a g e | 1613. We note the World Bank and other International Organizations (IOs)progress report on implementation of the G20 action plan to support thedevelopment of local currency bond markets.We look forward to full implementation of the action plan in 2013 toensure a broad ownership of the diagnostic tool among potential users,and further reporting on progress by the World Bank.We welcome ongoing regional initiatives to promote local currency bondmarkets.We will deepen work on these issues under Russia´s Presidency.14. We acknowledge the importance of long term financing, particularlyfor infrastructure investment, recognizing that work on this subject willfoster an environment more conducive to long-term investment,effectively helping to boost jobs and growth.We ask that the World Bank, IMF, OECD, FSB, UN and relevant IOsundertake further diagnostic work to assess factors affecting long-terminvestment financing including its availability.We look forward to receiving this work in early 2013 to provide a soundbasis for any future G20 work.15. We remain committed to the full, timely and consistentimplementation of the financial regulation agenda, and discussed thelatest FSB reports on the progress in implementation of agreed reforms.We endorse the conclusions and recommendations of the fourth progressreport on the implementation of the G20 commitments to OTCderivatives reforms and the BCBS report on implementation of Basel III.We agree to put in place the legislation and regulation for OTCderivatives reforms promptly and act by end-2012 to identify and addressconflicts, inconsistencies and gaps in our respective national frameworks,including in the cross-border application of rules. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  17. 17. P a g e | 17We agree to take the measures needed to ensure full, timely and effectiveimplementation of Basel II, 2.5 and III and its consistency with theinternationally agreed standards.We look forward to receiving for our April meeting the BCBS report onthe consistency of measurement of risk-weighted assets.We endorse the Charter for the Regulatory Oversight Committee whichwill act as the governance body for the global Legal Entity Identifiersystem to be launched in March 2013.16. We acknowledge progress made in the design and implementation ofpolicy measures to strengthen the resilience of the financial system andreduce systemic risks.In particular, we welcome the publication by the FSB of an updated list ofglobal systemically important banks, the BCBS framework for dealingwith domestic systemically important banks, and the InternationalAssociation of Insurance Supervisors (IAIS) consultation paper on policymeasures for global systemically important insurance companies.We commit to make the necessary changes to resolution regimes toenable authorities to resolve SIFIs.We welcome the initial integrated set of policy recommendations tostrengthen the oversight and regulation of shadow banking together withexpanded data monitoring.We call for finalized policy measures by the St. Petersburg Summit foroversight and regulation for shadow banking that can be peer-reviewed.17. We also welcome the recommendations to increase the intensity andeffectiveness of SIFI supervision, and the FSBs roadmap to accelerateimplementation of the FSB Principles for Reducing Reliance on CreditRating Agency Ratings. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  18. 18. P a g e | 18We encourage further work to enhance transparency of and competitionamong credit rating agencies and ask IOSCO to provide a report onongoing work at our meeting in April.We support measures to strengthen the transparency of financialinstitutions and recognize the contribution of the Enhanced DisclosureTask Force.Recognizing the need for adequate statistical resources, we endorse theprogress report of the FSB and the IMF on closing information gaps, andin particular look forward to the implementation of the data reportingtemplates for global systemically important financial institutions.We are concerned about the slow progress achieved toward a single set ofhigh quality accounting standards.We encourage the International Accounting Standards Board (IASB) andFinancial Accounting Standards Board (FASB) to complete workpromptly, and report to our next meeting.In relation to LIBOR, EURIBOR and other financial benchmarks, wewelcome actions taken and ongoing reviews to identify measures toaddress weaknesses and restore confidence in benchmark and indexsetting practices and welcome the coordinator role of the FSB as agreed.We ask IOSCO to provide by our April meeting a report on the next stepson the functioning of credit default swaps markets.We expect the FSB to continue monitoring, analyzing and reporting onthe unintended consequences of regulatory reforms on EMDEs.18. We welcome the FSBs progress in implementing the measuresendorsed at Los Cabos to strengthen its capacity, resources andgovernance.We look forward to its establishment as a legal entity by our next meetingand its full implementation by September 2013. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  19. 19. P a g e | 19We call on the FSB to report back on how it intends to keep under reviewthe structure of its representation.19. We welcome the observed increase in jurisdictions adherence tointernational regulatory and supervisory cooperation and informationexchange standards, as stated in the FSB status report, and call for furtherprogress.20. We remain committed and encourage the FATF to continue to pursueall its objectives, and notably to continue to identify and monitorhigh-risk jurisdictions with strategic Anti-Money Laundering/Counter-Terrorist Financing (AML/CFT) deficiencies.We look forward to the completion in 2013 of the revision of the FATFassessment process.We encourage all countries to adapt their legal framework with a view tocomplying with the revised FATFs Recommendations, in particular thenecessity to identify the beneficial owner of corporate vehicles, and welook forward to the assessment of the effectiveness of the measurescountries take and their compliance with the global standards in the nextround of Mutual Evaluations.21. We commend the signings of the Multilateral Convention in CapeTown and further progress made towards transparency as reported by theGlobal Forum whose membership has increased.We look forward to a progress report by the Global Forum on theeffectiveness of information exchange practices by April 2013.We welcome and endorse the improved OECD standard with respect toinformation requests on a group of taxpayers and encourage all countriesto adopt it when appropriate.We will continue to implement practices of automatic exchange ofinformation and call on the OECD to analyze the safeguards,mechanisms and milestones necessary to increase its use and efficientimplementation in a multilateral context. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  20. 20. P a g e | 20We also welcome the work that the OECD is undertaking into theproblem of base erosion and profit shifting and look forward to a reportabout progress of the work at our next meeting.22. We welcome the work stated in the final 2012 Global Partnership forFinancial Inclusion (GPFI) progress report on implementing the fiverecommendations set out in 2011 and the progress on implementing theG20 Principles for Innovative Financial Inclusion, including throughconcrete actions by developing and emerging countries to meet theircommitments to the Maya Declaration.We commend the additional commitments to the Maya Declaration madein Cape Town in 2012, and encourage countries to measure progressthrough national data collection efforts.We welcome the decision to establish the Alliance for Financial Inclusion(AFI) as a permanent network for knowledge creation, exchange andpolicy dialogue.23. We welcome the first GPFI Conference on Standard-Setting Bodiesand Financial Inclusion as a substantial demonstration of growingcommitment among Standard Setting Bodies (SSBs) to provide guidanceand to engage with the GPFI to explore the linkages among financialinclusion, financial stability, financial integrity and financial consumerprotection.We also commend the work done to continue improving SMEs financingand their environment.24. Together with the implementing partners, we look forward to updateson the G20 Financial Inclusion Peer Learning Program and encouragethe commitment to other initiatives that promote Financial Inclusion.25. For advancing the financial consumer protection agenda, weacknowledge the work done by the International Financial ConsumerProtection Network (FinCoNet) to support the exchange of best practicesand look forward for a progress report by the G20 Summit in St.Petersburg in 2013. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  21. 21. P a g e | 21We also welcome the implementation of the action plan by the G20OECD Task Force on Financial Consumer Protection and progressachieved in Cartagena, including in the field of national strategies andfinancial education for women, by the OECD International Network onFinancial Education (INFE).26. We welcome the number of proposals received in response to the 2012Mexico Financial Inclusion Challenge: Innovative Solutions forUnlocking Access.We congratulate the finalists and the winner.27. In Los Cabos, Leaders recognized that excessive commodity pricevolatility has significant implications for countries, increasing uncertaintyin the economy, and endorsed the conclusions of a report on themacroeconomic impacts of excessive commodity price volatility ongrowth.Ahead of the 2013 Summit, we will report progress on the G20scontribution to facilitate better functioning of commodity markets,considering possible areas for further work outlined in the report.28. We reaffirm our commitment to improve transparency andfunctioning of commodity markets.We welcome the progress made in the implementation of the AgriculturalMarket Information System (AMIS) which will provide moretransparency on physical markets for agricultural commodities.We welcome the IEFs recommendations to improve the reliability of theJODI-Oil database.We welcome the report prepared by the IEA, the IEF and the OPEC onincreasing transparency in international gas and coal markets and askthese organizations to propose practical steps by mid-2013 that G20countries could take to implement them. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  22. 22. P a g e | 22We welcome progress on the JODI-Gas database and look forward toworking with it in 2013.We welcome the report on recommendations to improve the functioningand oversight of oil Price Reporting Agencies, and ask IOSCO to liaisewith the IEA, IEF and OPEC to assess the impact of the principles onphysical markets and report back.We also ask IOSCO to report progress on the implementation of theprinciples in 2013.We reaffirm our commitment to enhance transparency and appropriateregulation in financial commodity markets, and thus we welcomeIOSCOs report on the implementation of its Principles for theRegulation and Supervision of Commodities Derivatives Markets.29. In Los Cabos, Leaders highlighted that green growth and sustainabledevelopment policies have strong potential to stimulate long termprosperity.We will voluntarily self-report again in 2013 on our efforts to incorporategreen growth and sustainable development policies into structural reformagendas, taking into account the outcome of the UN Conference onSustainable Development (Rio+20).We will report back to our leaders on the progress made to rationalize andphase-out over the medium-term inefficient fossil fuel subsidies thatencourage wasteful consumption, while providing targeted support forthe poorest.We will develop a voluntary peer review process on such fossil fuelsubsidies and present a report on the outcomes to our Leaders in 2013.We welcome the OECD report on pension funds financing greeninitiatives.30. Recognizing that the UNFCCC is the forum for climate changenegotiations and decisionmaking at the international level, we _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  23. 23. P a g e | 23acknowledge that climate finance is a relevant issue to be discussedamongst G20 Finance Ministers and Central Bank Governors.We welcome the progress report by the G20 Climate Finance Study Groupon ways to effectively mobilize resources for climate finance.We will continue working towards building a better understanding of theunderlying issues among G20 members taking into account theobjectives, provisions and principles of the UNFCCC, and report back toour Leaders in 2013.31. We recognize that disaster risk financing policies are necessary for anoverall Disaster Risk Management (DRM) strategy.We appreciate and welcome the combined efforts made by the WorldBank and the OECD, with the support of the United Nations, to broadenthe participation in the discussion on DRM by highlighting the centralrole that financial policymakers play to support other areas ofGovernment and civil society in dealing with disasters.We welcome the G20/OECD voluntary framework for disaster riskassessment and risk financing which provides a detailed guideline thataims to facilitate the implementation of more effective DRM strategies.We encourage further efforts by the World Bank and OECD incooperation with other relevant international organizations to leveragethe voluntary framework in order to address remaining challenges.32. We commend Mexico for chairing the G20 in 2012 and look forward toRussias presidency in 2013.The Finance TrackThe Finance Track in the G20 focuses on financial and economic issues;these include providing solutions to the current economic problems,economic stabilization and structural reforms, increasing internationalcoordination for crisis prevention, correction of external, fiscal and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  24. 24. P a g e | 24financial imbalances, providing resources to increase global liquidity, andstrengthening the international financial system.The Finance Track is composed of all G20 Finance Ministers and Centralbank Governors who meet regularly during the year to discuss the currenteconomic global problems and take coordinated actions towards theirsolutions; these meetings are attended also by InternationalOrganizations such as the IMF, World Bank, OECD or the FinancialStability Board.Organizationally, the track operates with working groups formallyestablished within the G20 but also through close cooperation withinternational financial entities.Currently the Finance Track of the G20 is organized in the followingmajor areas:I. Framework for Strong, Sustainable and Balanced Growth WorkingGroup (Co-chaired by Canada and India)II. Financial RegulationIII. Financial Inclusion, Financial Education and Consumer ProtectionIV. International Financial Architecture Working Group (Co-chaired byAustralia and Turkey)V. Energy and Commodities Markets Working Group (Co-chaired byIndonesia and United Kingdom)a. Commodities Markets Subgroup (Co-chaired by Brazil and UnitedKingdom)b. Energy and Growth Subgroup (Co-chaired by Korea and United States)VI. Disaster Risk ManagementVII. Climate Finance Study Group (Co-chaired by France and SouthAfrica)The G20 has been a very effective forum of international coordination andcooperation for crisis mitigation and to foster economic growth andstrengthen financial regulation.It has also increased its scope to other relevant economic issues such asfinancial inclusion and education, disaster risk management, greengrowth or climate finance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  25. 25. P a g e | 25Under the Mexican presidency, the Finance track launched the 2012 G20Agenda on December 13-14th 2011 with a seminar in Mexico City.In preparation to the Leaders Summit in Los Cabos in June, FinanceMinisters and Central Bank Governors have met on February and April todiscuss current relevant economic problems and have taken coordinatedactions for their solution. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  26. 26. P a g e | 26On time, stocks and flows:Understanding the globalmacroeconomic challengesClaudio BorioBank for International SettlementsIntroductionIt wasn’t meant to be like this.The financial crisis that began in 2007shattered the illusion of uninterrupted prosperity that had prevailed inmuch of the Western world.It was not the first time that this had happened.Doubtless, it will not be the last.Five years on, much of the advanced country world is still struggling toreturn to robust, sustainable growth.And the crisis has kept morphing before our eyes; it has now engulfedsovereigns too.The euro area is the new epicentre.But will the tremors stop there?In what follows, I will seek to provide a broad framework for thinkingthese issues through.How did we get here? Why? Where might we go from here? How mightwe extricate ourselves from our predicament? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  27. 27. P a g e | 27These are hard questions.No one really knows the answers.But all of us have a perspective and a narrative that goes with it.This is just another one – one that draws heavily on work done at the BIS.I will try to look below the busy and at times chaotic surface of the worldeconomy.The idea is to identify what one might call the shifts in its “tectonicplates” – those deep forces that, slowly but cumulatively, canfundamentally reshape what we see on the surface and that economistscall “economic regimes”.I will highlight three such forces: financial liberalisation, theestablishment of credible anti-inflation monetary frameworks, and theglobalisation of the real side of the world economy.Each of them, taken in isolation, is undoubtedly a good thing.All of them together are worth having and fighting for.Yet I will argue that a failure of policy to adjust to them has played animportant role in the crisis and its aftermath.It has given rise to the re-emergence of powerful financial cycles, whosebooms and busts have caused havoc in the economy and have left uswhere we are today.But what is the link between all this and the title of my remarks? In fact,the title highlights two key aspects of the story.First, time. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  28. 28. P a g e | 28As the three deep forces gained full strength from the mid-1980s, theyshaped an environment where, in Burns and Mitchell’s terminology,economic time has slowed down relative to calendar time.That is, the macroeconomic developments that matter take much longerto unfold.The length of the financial cycle is much longer that of the traditionalbusiness cycle, of the order of 16 to 20 years or more compared with up toeight years.Yet the planning horizons of market participants and policymakers havenot adjusted accordingly – indeed, if anything, they have shrunk.This is a critical reason why the current problems have arisen and why ithas proved so hard to solve them.And it has major implications for the sustainability of growth, for financialregulation, for fiscal policy and for monetary policy.We then come to stocks and flows.In the new environment, stocks have come to dominate economicdynamics, in particular the large stocks of assets and, above all, debt.Stocks build up above trend during financial booms, as credit and assetprices grow beyond sustainable levels, and generate stubborn overhangsonce the boom turns to bust. Stocks raise serious policy challenges.In the presence of policy responses that react too little to booms and toomuch to busts – in jargon, that are asymmetric – stocks grow overconsecutive business cycles.It takes longer to deal with them.And doing so is also politically more difficult, because of the seriousimpact on income and wealth distribution, both within and acrossgenerations. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  29. 29. P a g e | 29This is true of both private and public debt.Failure to deal with stocks effectively could entrench instability in thesystem.If this diagnosis is right, the remedy is not hard to find, although it maybe extraordinarily difficult to implement.In a nutshell, it is to lengthen policy horizons, to put in place moresymmetrical policies, and to tackle the debt problems head-on.Much of my discussion will seek to make these guidelines more concrete.The ultimate risk of a failure to adjust is that of yet anotherepoch-defining shift in the tectonic plates – the risk of a reversal that willtake us back to an era of financial and trade protectionism as well asinflation.The structure of my remarks is as follows.The first section lays out the broad canvas.It considers the changing character of economic fluctuations,highlighting the role of the financial cycle and its link to structuralinstitutional arrangements, policy decisions and horizons.The second section turns to the policy challenges.It begins with a brief summary of the current situation, seen through thelens of the financial cycle.It then explores, in turn, the immediate or more conjunctural challenge ofhow to return to self-sustaining and sustainable growth and then thelonger-term or more structural challenge of how to adjust policyframeworks to address the financial cycle – not to be interpretedsequentially, though. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  30. 30. P a g e | 30The discussion covers financial (specifically prudential) regulation andsupervision, fiscal and monetary policies.While my focus is on the global economy, I will also note the specificitiesof the European situation.I. The broad canvasStylised facts: an economic historian’s perspectiveImagine a future economic historian looking back at the bigmacroeconomic trends from the first oil shock of the early 1970s to ourpresent day.What would he see as he cast his gaze over a longer historical timespan?Consider, in turn, the most salient outcomes, the intellectual backdrop,the features of banking crises, and institutional setups.In terms of outcomes, he would no doubt be struck by the major shift inthe behaviour of inflation: from high and variable to low and stable, withthe inflexion point around the early 1980s.At the same time, he would also note a major increase in financial crises,especially banking crises, with serious macroeconomic consequences, inboth advanced and emerging market economies.Reading the contemporary economic texts to understand the intellectualbackdrop, he would surely find it ironic that the view prevailing at thetime had regarded price stability as a guarantee of macroeconomicstability.And that, in much of the West during the early 2000s, there had even beentalk of a so-called Great Moderation: a golden age of stable output andlow inflation.This conviction had hardly been dented by the banking crises that had hitemerging market economies and even some advanced ones during the1980s and 1990s, not least the Nordic countries and Japan. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  31. 31. P a g e | 31To paraphrase Reinhart and Rogoff, what seemed to be at work was notjust the “this-time-is-different” syndrome but the no less insidious“we-are-different” syndrome.It had taken the Great Financial Crisis, as contemporaries had quicklycalled it, which had erupted in 2007 to shake this complacency.The historian would also note that the experience of those years had beenby no means unique.Similar economic fluctuations, where low inflation had coexisted withoccasional banking crises, had been quite common in the Gold Standarddays, when countries had pegged their currencies to gold.Indeed, a long economic boom with low and stable inflation had usheredin that other defining moment in economic history – the GreatDepression in the United States in the early 1930s.Then, just as later on, there had been talk of permanent prosperity, of anend to the tyranny of the business cycle.Our historian would then go one level deeper.He would ask: “Are banking crises, like Tolstoy’s famous unhappyfamilies, all different? Or are they more like his happy ones, which are allalike?”It is all too easy, he would note, to spot the idiosyncratic features of acrisis.Structured products, for instance, had not existed in the early 1930s.Or, to take just another example, the crises in Japan and Nordic countrieshad caused havoc in bank-based financial systems; by contrast, thesubsequent Great Financial Crisis had originated in the United States,with its securitisation-intensive, capital markets-based financial system. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  32. 32. P a g e | 32Or, again, the crisis in Finland had followed the collapse of its maintrading partner, the Soviet Union; but no obvious external shock had beenat work in 2007.And he could go on.Yet, he would quickly realise that focusing on idiosyncrasies would meanfalling victim to the “we-are-different” syndrome in another guise.A fuller understanding of crises requires a focus on what they have incommon, not on how they differ.Only then can one find reliable remedies.After all, had not the Japanese bank-based financial system been hailed assuperior ahead of the country’s banking crisis?And had not much the same been said of the US market-based financialsystem ahead of its own meltdown?Our historian would then look for common patterns.Soon enough, an obvious one would leap out at him: crises tend to bepreceded by major financial booms and followed by protracted busts thatleave deep scars in the economic tissue.In other words, they are closely associated with peaks in the financialcycle.The joint behaviour of credit and asset prices, in particular propertyprices, capture these cycles remarkably well.And since banking crises are rare events in any given country, it is naturalfor these cycles to be very long.Their order of magnitude is between 15 and 20 years. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  33. 33. P a g e | 33As he read further, our historian would realise that the close associationbetween crises and financial booms and busts had, in fact, beenrecognised early on in the economics profession, as far back as the 19thcentury.During the post-war period, economists such as Kindleberger andMinsky had kept the concept alive at the margins of the field.Their work had inspired policy-oriented research ahead of the GreatFinancial Crisis.But it had gone largely unheeded, drowned in the contagious enthusiasmfor the Great Moderation.Memories are short; hubris long.But our historian’s intellectual curiosity could not stop there. He hasestablished that financial cycles foment banking crises, with damagingmacroeconomic consequences.He has also noted that financial cycles were a common feature both of thegold standard era and of the period running from the mid-1980s to ourpresent day.Could the two periods have yet more in common?“Yes”, would be our historian’s answer.And this conclusion would refer to the tectonic plates of the globaleconomy – to the institutions that embody its “economic regimes”.The two eras had seen the coexistence of monetary policy frameworksthat delivered reasonable price stability with liberalised financial marketsand highly integrated markets for goods, capital and labour.In fact, they had come to be known as the first and second waves ofglobalisation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  34. 34. P a g e | 34The successful fight against inflation dated back to the early 1980s, andhad gradually spread across the world thereafter.By the mid-1980s policymakers had largely liberalised domestic financialmarkets, and by the end of that decade, in the words of Padoa-Schioppaand Saccomanni, the global financial system had turned fromgovernment-led to market-led.The integration of goods and factor markets had started much earlier inthe post-war period, but it had taken a quantum leap in the 1990s, whenthe former communist countries had entered the capitalist productionsystem.As Thomas Friedman had put it, the world had become flat – once again,he should have added.Stylised facts: an interpretationIs this similarity between deep structures and economic outcomes just acoincidence?I would suggest not.But now it is best to part company with our economic historian, as wemove further away from the realm of stylised facts to that of (we hope)informed conjectures and their policy implications.It stands to reason that the three powerful forces have interacted so as todeeply shape economic fluctuations.Their conjunction has made economies more vulnerable to large andprolonged financial booms and busts – financial cycles – that can inflictsevere damage on the economy.During the boom “financial imbalances” develop: (private sector)balance sheets become overextended on the back of aggressiverisk-taking. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  35. 35. P a g e | 35The imbalances sow the seeds of their own destruction, and hence ofeconomic weakness, unwelcome disinflation and financial strains downthe road.The boom can turn to bust either because incipient inflation eventuallydoes emerge, forcing the central bank to tighten or, more often, becausethe imbalances collapse under their own weight.One may call this property of the economy “excess elasticity”.The analogy is with an elastic band, which one can stretch further andfurther until at some point it snaps.These financial booms and busts necessarily take a long time to unfold.As they emerge, they slow down economic time relative to calendar time.How might the tectonic forces interact to produce this outcome?First, financial liberalisation makes it more likely for financial factors ingeneral, and booms and busts in credit and asset prices in particular, todrive economic fluctuations.Rather than being tightly bound by cash flow constraints, the economy ispropelled by loosely anchored perceptions of asset values and risks,critically supported by easier credit availability.Indeed, the link between financial liberalisations and subsequent creditand asset price booms is well documented.Second, the establishment of regimes yielding low and stable inflation,underpinned by central bank credibility, can make it less likely for signsof unsustainable economic expansion to show up first in rising inflationand more likely for them to emerge first as unsustainable increases incredit and asset prices (the “paradox of credibility”). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  36. 36. P a g e | 36After all, stable expectations make prices and wages less sensitive toeconomic slack: this is precisely what policymakers and economists haveexpected all along.Finally, the globalisation of the real economy has given a major boost toglobal potential growth – what economists would call a sequence ofpervasive positive “supply shocks” or an outward shift in the globaleconomy’s production possibility frontier.Think of the huge boost to production capacity as China and other formercommunist countries joined the world trading system.By the same token, however, it has surely helped to keep inflation downand provided fertile ground for credit and asset price booms.Policy and horizons: pre-crisis roleSo much for the big picture – the tectonic plates, so to speak. But whatabout the role of decisions made by the policymakers who wereconfronted with these forces?With hindsight at least, it has become clear that policymakersinadvertently added fuel to the fire ahead of the Great Financial Crisis.They put too much faith in markets’ ability to self-correct.They failed to fully understand that the changing landscape called foradjustments in policy frameworks.And, even when they did understand, they found it too hard to changecourse: too much reputational capital was at stake and, anyway, why fixwhat ain’t broken?Consider, in turn, prudential, monetary and fiscal authorities.Prudential authorities converged on frameworks that concentrated toomuch on the safety and soundness of individual institutions and too little _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  37. 37. P a g e | 37on that of the system as a whole – frameworks in which themacroeconomy and the financial cycle hardly figured.They focused too much on individual trees and too little on the wood.In current jargon, they had too much of a “microprudential” focus, asopposed to a “macroprudential” one.Monetary authorities, still burnt by the Great Inflation experience,focused narrowly on stabilising near-term inflation.They could not justify raising interest rates if inflation was low and stable,let alone falling, even if financial imbalances were building up.As a result, the imbalances proceeded to grow unchecked.And fiscal authorities failed to realise that financial booms were hugelyflattering the fiscal accounts and that the busts would at some pointpresent them with a huge bill – a burden over and above the better known,but just as intractable, one resulting from ageing populations.Underlying these failings was a natural tendency to overestimatesustainable output and growth.The notion that inflation was the sole harbinger of unsustainability wasespecially insidious.Financial factors, again, did not figure in this picture.That was the relentless message of the prevailing intellectualmacroeconomic paradigm, both a reflection of the Zeitgeist and acontributor to it.Short policy horizons played a key role in all this.Much of macroeconomic policy centres on the notion of the businesscycle. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  38. 38. P a g e | 38As conceived and measured, the business cycle has a duration of eightyears at most.And yet we have seen that the financial cycle lasts at least twice as long.Since the financial cycle’s booms and busts have major consequences foreconomic activity, not taking them into account can create serious biasesin policymaking.It is as if, on the open sea, sailors successfully rode out the smaller wavesbut remained blissfully unaware of the tsunami rolling beneath them – awave that would surge and crash only once it reached the shore.To illustrate this, consider the experience of several advanced economiesin the mid-1980s to early 1990s and in the period 2001–07.In both episodes, policymakers reacted strongly to collapses in equityprices – the global stock market crashes of 1987 and 2001 that ushered ineconomic slowdowns or actual recessions.They cut policy rates and, to a varying and smaller degree, loosened thefiscal reins.In both episodes, however, credit and property prices – the most relevantindicators of the financial cycle – continued to increase, as if getting theirsecond wind.Financial imbalances built up further.And a few years later, the credit and property price booms collapsed, inturn, causing serious financial damage and dragging down the economywith them.This is what happened to Japan in the first episode and to the UnitedStates and United Kingdom in both. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  39. 39. P a g e | 39From a medium-term perspective, consistent with the length of thefinancial cycle, the slowdowns or contractions in 1987 and 2001 can thusbe regarded as “unfinished recessions”.The initial “over-reaction” to short-term macro-economic developments,followed by an under-reaction to the further build-up of financialimbalances, caused more serious problems down the road.But short horizons are not just an issue for policymakers. They are aneven bigger one for the private sector, especially for financial marketparticipants.Here, traders’ horizons may be as short as a day, or minutes or evenmicroseconds. More generally, horizons rarely extend beyond one year,constrained by the rhythm of financial reporting conventions.Moreover, they have, if anything, been shrinking: technology has beensurging ahead; the spread of fair value accounting has telescoped theindefinite future into the ephemeral present; tighter monitoring has cometo mean more frequent monitoring.These short horizons are embedded in risk measurement tools, such asvalue-at-risk, in common trading strategies, such as momentum trading,and in credit techniques, such as securitisation.For instance, risk models rely on extraordinarily short data histories,hardly ever extending beyond a few years, and they project outcomes overa very short future, mostly days and at the very most one year.Short horizons are probably best captured by the famous words of ChuckPrince, then CEO of Citigroup, to the effect that “as long as the music isplaying, you have to get up and dance”.This was just before the crisis broke.The end result is that market participants’ expectations, once embeddedin market prices, appear highly extrapolative: they follow the trend until itis too late. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  40. 40. P a g e | 40Hence what one might call the “paradox of financial instability”: thefinancial system looks strongest precisely when it is most vulnerable.Credit growth and asset prices are unusually strong, leverage measured atmarket prices is artificially low, and risk premia and volatilities sag torock-bottom levels precisely when risk is at its highest.What looks like low risk is, in fact, a sign of aggressive risk-taking.The recent crisis has simply confirmed this all over again.A vicious cycle has set in.The interaction between market participants’ instincts, the relentless24/7 media razzmatazz and the response of policymakers becomes everstronger; as a result, horizons become ever shorter.So, the search for the culprits for the Great Financial Crisis brings verymuch to mind Agatha Christie’s famous thriller, Murder on the OrientExpress.Who was the murderer then? As it turns out, all the passengers on thetrain were.Who is the culprit now?As it turns out, we all are.II. Post-crisis challengesThe legacy of the crisis: a balance sheet recessionThe foregoing analysis casts light on the recession that followed thefinancial crisis.Not all recessions are born equal.The typical postwar recession was triggered by tighter monetary policy tostop rising inflation or a balance of payments crunch. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  41. 41. P a g e | 41By contrast, a post-financial crisis recession is a balance sheet recession,linked to a financial bust against the backdrop of low and stable inflation.This means that the preceding expansion is much longer, the subsequentdebt and sectoral capital stock overhangs much larger, and the damage tothe financial sector much greater.It also means that the policy room for manoeuvre is very limited: unlesspolicy has actively leaned against the financial boom, policy buffers willbe depleted.The capital and liquidity cushions of financial institutions will rupture;gaping holes will open up in the fiscal accounts; and policy interest rateswill sag to near zero.Think of Japan in the 1990s.A growing body of evidence suggests that balance sheet recessions areparticularly costly.They tend to be deeper, to give way to weaker recoveries, and to result inpermanent output losses: output may return to its previous long-termgrowth rate but not to its previous growth path.Several factors are no doubt at work here: the overestimation of bothpotential output and growth during the boom; the misallocation ofresources, notably the capital stock but also labour, during that phase; theoppressive effect of the debt and capital overhangs during the bust; andthe disruptions to financial intermediation once financial strains emerge.A full five years after the beginning of the financial crisis, the symptoms ofa balance sheet recession are all too evident.Banks in Europe and, to a lesser extent, the United States remain weak–although in the United States it is Government Sponsored Enterprises(GSEs) that are more exposed to the mortgage market.To be sure, banks have significantly beefed up their capital ratios. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  42. 42. P a g e | 42But their credit default swaps, gauges of perceived creditworthiness, havereturned to levels that are not that far away from those that prevailed whenLehman Brothers collapsed.Meanwhile, their shares have lost ground against the rest of the stockmarket, and they have incurred downgrades across the board in bothstandalone and all-in ratings.Private sector debt-to-GDP ratios, a measure of aggregate leverage, arestill very high. Sovereign debt has ballooned and sovereigns have beendowngraded.The policy rates of leading economies languish at their effective zerolower bound while the balance sheets of their central banks have swelledenormously.Globally, though, there are significant differences between countries.Those that have experienced domestic financial booms and busts havefaced serious strains in both non-financial sector and bank balancesheets; to varying degrees, they are seeing deleveraging in both sectors.Clear examples are the United States, the United Kingdom, Spain andIreland.Those whose financial institutions were exposed to financial boomselsewhere have also seen serious strains in their banks, but theirnon-financial private-sector debt-to-GDP ratios have typically risenfurther on the back of credit expansion.Notable examples are Germany, France and Switzerland.Indeed, in Switzerland a strong and possibly unsustainable housingboom is under way, despite rather weak economic growth.Those whose banks were not directly exposed to the financial busts inmature economies, after a brief slowdown, have proved very resilient; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  43. 43. P a g e | 43many of them have continued to see financial booms, sometimes eerilyreminiscent of the pre-crisis ones in mature economies.These include several emerging market economies and somecommodity-based advanced countries, among others.The situation is particularly worrying in the euro area.It is there that the perverse feedback loop between the weaknesses in thebalance sheets of banks and sovereigns has been most intense.An obviously incomplete economic and monetary union has brought itinto the open and exacerbated it.That said, one should not confuse the symptoms with the disease.Markets can and do lull policymakers into a false sense of security.They are far too slow to react and, when they do, they react violently.There are other major countries whose underlying fiscal positions arehardly more sustainable than those in the euro area.And yet bond markets seem to be oblivious, at least for now.The immediate policy challenge: returning to self-sustainingand sustainable growthThe immediate global policy challenge is to return to self-sustaining andsustainable growth.Seen through the lens of the financial cycle, this raises different issuesacross countries, depending on their specific situation.At one end, for those largely spared by the crisis, and that have beenseeing signs of unsustainable financial booms, the challenge is to containthese excesses and to avoid overestimating the strength of fiscalpositions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  44. 44. P a g e | 44Where the cycle might have turned already, it is to contain the damage.At the other end, for those that were at the epicentre of the crisis and haveexperienced a domestic financial boom and bust, the challenge is to dealwith twin weaknesses in the financial and non-financial sector balancesheets.Somewhere in between, for those whose banks have suffered from losseson exposures to financial busts elsewhere, the challenge is to solve thebanks’ problems, even as the non-financial sector may be in the process ofleveraging up further.For all, the challenge is to ensure that the sovereign remains creditworthyor regains its lost creditworthiness.In what follows, I will leave it to the reader to draw implications forspecific countries.Instead, I will focus on the general challenges that balance sheetrecessions raise, ie on how to address financial busts.I will then discuss how to address booms in the following sub-section,which considers the longer-term challenge of how to adjust policyframeworks: how to address booms is by now better understood andrequires less elaboration.The main policy challenge in a balance sheet recession is to prevent astock problem from morphing into a long-lasting flow problem, weighingdown on income, output and expenditures.It is therefore critical to distinguish two phases, crisis management andcrisis resolution, which differ in terms of their priorities.In crisis management, the priority is to prevent the implosion of thefinancial system, so as to ward off the threat of a self-reinforcingdownward spiral in economic activity.Restoring confidence is essential. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  45. 45. P a g e | 45If there is scope to do so, policies should be deployed aggressively.This is the phase historically linked to central banks’ lender-of-last resortfunction; together with interest rate cuts, such a course of action can beespecially helpful in boosting confidence.In crisis resolution, by contrast, the priority is balance sheet repair, so asto lay the basis for a self-sustaining recovery.Here it is essential to tackle the debt overhang head-on.And policies need to be adjusted accordingly.Consider, sequentially, the roles of prudential, fiscal and monetary policyin this phase.The priority for regulation and supervision should be to induce thethorough repair of banks’ balance sheets and to support banks’ return tosustainable profitability.This means:Enforcing full recognition of losses (writedowns);Recapitalising institutions (subject to tough tests), including possibly viatemporary public ownership;Sorting institutions according to their viability;Dealing with bad assets (including through disposal);Reducing excess capacity in the financial system; and promotingoperational efficiencies.This is precisely what the Nordic countries did when they faced theirbanking crises in the early 1990s; and it is what Japan failed to do aroundthe same time. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  46. 46. P a g e | 46This difference was no doubt a key factor behind their divergenteconomic performance subsequently.Before the recent crisis, the response of the Nordic countries to theircrisis was universally regarded as the right way to go.Such a policy would have several benefits.It would restore confidence in the banking system.At present, for instance, market-to-book values are well below 1 and thereis little uncollateralised funding on offer to banks, especially for Europeanones.Such a policy would also unblock interbank markets and relieve pressureon central banks – just think of the Eurosystem’s extraordinary long-termunconditional liquidity support to banks.And it would restore incentives for allocating credit properly and avoidinginappropriate risk-taking.It is hardly a coincidence that volatile trading profits have been the mainsource of income since the crisis and that one global bank has recentlymade sizeable trading losses on its credit portfolio.Unless losses are fully recognised, viable institutions are recapitalised andunviable ones induced to exit, the incentives will stay in place for banks totake on the wrong risks at the expense of the good ones, and toovercharge healthy borrowers to the benefit of unhealthy ones.When the level of debt in an economy is too high and must be cut back toset the scene for a self-sustaining recovery, the allocation of credit is moreimportant than its overall amount.The priority for fiscal policy should be to create the scope for using thepublic sector balance sheet to support the repair of private sector balancesheets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  47. 47. P a g e | 47This applies to the balance sheets of financial institutions, throughinjections of public sector money (capital) subject to strict conditionalityon loss recognition and possibly through temporary public ownership.But it applies also to the balance sheets of the non-financial sectors, suchas households, including through various forms of debt relief.Such a prescription contrasts sharply with a widespread view amongmacroeconomists, who would regard pump-priming (increases inexpenditures or tax cuts) as more effective during slumps.That view, however, assumes that people wish to borrow and cannot.But if they have already taken on too much debt, they are more likely towish to cut that burden.Debt repayment would take priority over more spending.If so, even the short-term effect of untargeted fiscal expansion (theso-called “fiscal multiplier”) is likely to be small.Rather than jump-starting the economy, it could end up building bridgesto nowhere, as the Japanese experience suggests.By contrast, the targeted use of the fiscal room for manoeuvre to supportthe balance sheet repair of the financial and non-financial sectors, asneeded, could remove a key obstacle to a self-sustaining recovery.Moreover, as an owner or co-owner, the sovereign could actually makecapital gains in the longer term, as was the case in some Nordiccountries.Importantly, this is not a passive strategy, but a very active one.It inevitably substitutes public sector debt for private sector debt. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  48. 48. P a g e | 48It requires a forceful approach to addressing the conflicts of interestsbetween borrowers and lenders, between managers, shareholders anddebt holders, and so on.And it raises tricky distributional questions.It is not pure fiscal policy in the traditional macroeconomic sense: it callsfor a broader set of measures, including legal adjustments, supported bythe public purse.But what if the country is already facing a sovereign crisis? My sense isthat, even where immediate fiscal consolidation is necessary, this use ofpublic money is critical.The Nordic countries did it, even as they cut elsewhere.One way of alleviating the trade-offs is to obtain targeted externalsupport.There is a clear potential for that option in the euro area, especially as partof a well sequenced and comprehensive shift towards a more completeeconomic union.And even as short-term steps are taken, a long-term horizon is essential.The evidence indicates that any contractionary effects of fiscal policydissipate over time.And restoring the creditworthiness of the sovereign is paramount.The sovereign is the ultimate backstop for the financial system and theeconomy.There cannot be lasting financial and macroeconomic stability if publicfinances remain on an unsustainable path.What about monetary policy? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  49. 49. P a g e | 49The priority is to recognise its limitations and to avoid overburdening it.Monetary policy is likely to be less effective in a balance sheet recession.This applies as much to changes in short-term interest rates and guidanceabout future rates (“interest rate policy”) as it does to an aggressive use ofthe central bank balance sheet, such as through large-scale assetpurchases and liquidity support (“balance sheet policy”).Overly indebted agents unwilling to borrow and a banking system unableto function blunt the impact of such policies on expenditure.As a result, as policymakers press harder on the gas pedal, the engine revsup without traction.And this exacerbates any side effects that policy may have in the crisisresolution stage.Several possible side effects may arise from a long period ofextraordinarily accommodative monetary policy.First, easing can mask underlying balance sheet weaknesses.It makes it easier to underestimate the private and public sector’s abilityto repay in more normal conditions and delays the recognition of losses(eg evergreening).Second, it can blur incentives to reduce excess capacity in the financialsector and even encourage betting for resurrection.Third, it can undermine the earnings capacity of financial intermediaries,by compressing banks’ interest margins and sapping the strength ofinsurance companies and pension funds.This, in turn, weakens the balance sheets of non-financial corporations,households and the sovereign. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  50. 50. P a g e | 50It is no coincidence that Japan’s insurance companies came underserious strain a few years after its banks did.Fourth, it can atrophy markets and mask market signals, as central bankstake over financial intermediation functions.Interbank markets tend to shrink and risk premia become unusuallycompressed as policymakers become large-scale asset buyers.Fifth, while it can help repair balance sheets by weakening the currency,this may be unwelcome elsewhere, as it may be seen as having abeggar-thy-neighbour character – a point to which I will return later.Finally, over time it may compromise the operational autonomy of thecentral bank, as political economy considerations loom ever larger.This is especially important for central banks’ balance sheet policy,because of its quasi-fiscal nature.The key risk is that central banks become overburdened and a viciouscircle develops.Monetary policy can gain time, but it can also make it easier to wastetime, because of the incentives it generates.As the policy fails to produce the desired effects and adjustment isdelayed, central banks come under growing pressure to do more.An “expectations gap” yawns open, between what central banks areexpected to deliver and what they can deliver.All this makes the eventual exit more difficult and may ultimately threatenthe central bank’s credibility.One may wonder whether some of these forces have not been at play inJapan, a country where the central bank has not yet been able to exit. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  51. 51. P a g e | 51Recent evidence squares broadly with the view that macroeconomicpolicies are less effective in balance sheet recessions.BIS colleagues find that, when considering recessions and thesubsequent recoveries, monetary policy has a smaller impact on output ifrecessions are linked to financial crises.Moreover, in normal recessions, a more accommodative monetary policyin the downturn is followed by a stronger recovery, but this relationship isno longer apparent if a financial crisis occurs.In addition, the same study finds that in balance sheet recessions a fasterpace of debt reduction ushers in a strongerrecovery.And it concludes that, when used to alleviate a balance sheet recession,fiscal policy has limitations that are similar to those of monetary policy.The longer-term policy challenge: adjusting frameworksThe longer-term policy challenge is to adjust frameworks to fully reflectthe implications of the financial cycle.The financial cycle unfolds over a much longer horizon than the one thatnormally underpins policy decisions concerning output and inflation.Addressing its implications, therefore, requires lengthening the horizonand shifting the focus from period-by-period flows to their cumulativecrystallisation in stocks.Let’s first consider national policy frameworks and then broaden the viewto the global context.The overall strategy for national policy frameworks would be to ensurethe build-up of buffers in the boom phase of the financial cycle so as todraw them down in the bust phase.The buffers would make the economy more resilient to a downturn. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  52. 52. P a g e | 52And by acting as a kind of dragging anchor they could also curb theboom’s intensity.Put differently, the strategy would make policy less procyclical by makingit less asymmetric with respect to the boom and bust phases of thefinancial cycle.For prudential policy, it would mean strengthening the systemic ormacroprudential orientation of the frameworks, by adjusting instruments,such as capital standards or loan to value ratios, to reduce procyclicality.For monetary policy, it would mean providing for the option to tighteneven if near-term inflation appears under control whenever financialimbalances show signs of building up.And for fiscal policy, it would mean extra caution when assessing fiscalstrength during financial booms and taking remedial action.Post-crisis, policies have indeed moved in this direction, but to varyingdegrees.Prudential policy is furthest ahead.Basel III, in particular, has introduced a countercyclical capital buffer forbanks as part of a broader trend to put in place macroprudentialsafeguards.Monetary policy has shifted somewhat.It is now generally recognised that price stability is no guarantee offinancial stability, and a number of central banks have been adjustingtheir frameworks to incorporate the option of tightening during booms.A key element has been to lengthen policy horizons.That said, no consensus exists as yet on the desirability of suchadjustments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  53. 53. P a g e | 53And the side effects of prolonged and aggressive easing after the bustremain controversial.Fiscal policy is probably furthest behind.There is so far little recognition of the need to incorporate the impact ofthe financial cycle in assessments of fiscal sustainability or to explore thelimitations of expansionary fiscal policy in balance sheet recessions.The main risk is that policies that fail to recognise the financial cycle willbe too asymmetric, thus generating a serious bias over time.Failing to tighten policy in a financial boom but strong, if notoverwhelming, incentives to loosen it during the bust would erode boththe economy’s defences and the authorities’ room for manoeuvre.In the end, policymakers would be left with a much bigger problem ontheir hands and without the ammunition to deal with it.This is what economists call a “time inconsistency” problem.The root cause here is horizons that are too short and a failure toappreciate the cumulative impact of flows on stocks.This would entrench instability in the system.There are all-too-evident symptoms that this has been happening.Banks’ pre-crisis capital and liquidity buffers have proved woefullyinadequate; post-crisis, there have been calls not to raise them and todelay the implementation of the new regulatory standards.Sovereign debt levels have reached record peace-time highs; the crisisand countermeasures have left a gaping hole in fiscal positions, whichwere already gradually deteriorating.No less worrying, most of the costs arising from ageing populations stillloom ahead of us. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  54. 54. P a g e | 54And monetary policy has been far from immune.In many advanced economies interest rates are now effectively at zero; inboth advanced and emerging market economies, central banks’ balancesheets have expanded to record highs.At the global level, policy rates, even adjusted for inflation, have beentrending down for decades, even as the trend growth of the worldeconomy – a common yardstick to gauge their appropriate level – haspicked up.Likewise, more refined yardsticks that seek to take into account outputand inflation – so-called “Taylor rules” – indicate that policy rates areglobally unusually low.And partly as a result of purchases at the long end of the yield curve andforeign exchange intervention, bond yields have never been as low as theyare now.This brings us to the global implications of national policies. In a highlyintegrated world, any tendencies in national policies can easily spreadworldwide through a variety of channels, including other countries’responses.In the case of monetary policy, exchange rates are a critical channel.Pre-crisis, easy monetary policy in the mature economies, notably in theUnited States, spread elsewhere, especially to emerging marketeconomies such as China, partly through resistance to exchange rateappreciation.These other countries kept interest rates low or else intervened in theforeign exchange market and invested the proceeds in the countries withinternational currencies, in turn putting further downward pressure onyields there.Post-crisis, if anything, the same process has intensified. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  55. 55. P a g e | 55This raises tough issues.Economically, the risk is that monetary conditions for the world as awhole end up being too loose.Signs that financial imbalances have been building up, especially inseveral emerging market economies, are a source of concern, particularlywhen large mature economies have not yet returned to self-sustaininggrowth.The world remains unbalanced.Politically, one obvious risk is that countries might revert to themodern-day equivalent of the competitive devaluations of the interwaryears, which proved so divisive.Worryingly, post-crisis the term “currency wars” has been all too often onpolicymakers’ lips.But the bigger risk is that yet another epoch-defining shift in the globaleconomy’s tectonic plates might take place.As historians such as Niall Ferguson and Harold James keep remindingus, such shifts often occur quite abruptly and when least expected.So far, institutional setups have proved remarkably resilient to the hugeshock of the Great Financial Crisis and its tumultuous aftermath.But there are also troubling signs that globalisation may be in retreat, asstates struggle to come to grips with the de facto loss of sovereignty.This is true both globally and regionally.It is simply most visible in Europe, where a more ambitious historicalexperiment with greater integration has reached a watershed.Meanwhile, the consensus on the merits of price stability is fraying at theedges. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  56. 56. P a g e | 56As memories of the costs of inflation fade, the temptation to get rid of thehuge debt burdens through a combination of inflation and financialrepression grows.Taking all these hard-won gains for granted is the surest way of losingthem.The future is not pre-determined; far from it. But we should notunderestimate the challenges ahead.ConclusionA cyclist has made a strong start to the race.But, as it happens, he has overestimated his strength.After a while, he has to pedal harder just to avoid falling over.His energies are flagging and he is on the point of collapsing fromexhaustion.His mistake was to treat a long-distance race as a series ofever-shortening sprints.His horizon was too short; the cumulative effort is finally catching up.And yet, he struggles on.The global economy is not so different from this sportsman.It gained new force from a powerful wave of globalisation and thesuppression of inflation.But the resurgence of the financial cycle made it feel, for a while, strongerthan it really was.Market participants and policymakers did not see through this illusion. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)