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Risk and Compliance Management News June 2012


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Risk and Compliance Management News June 2012

Risk and Compliance Management News June 2012

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  • 1. International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Dear Member, We have a very interesting paper from the Bank of international Settlements that clarifies issues of the Basel ii / iii frameworks. Fundamental review of the trading book - consultative document May 2012 This consultative document sets out a revised market risk framework and proposes a number of specific measures to improve trading book capital requirements. These proposals reflect the Committees increased focus on achieving a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions. Key elements of the proposals include: A more objective boundary between the trading book and the banking book that materially reduces the scope for regulatory arbitrage - feedback is sought on two alternative approaches; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 2.  Moving from value-at-risk to expected shortfall, a risk measure that better captures "tail risk"; Calibrating the revised framework in both the standardised and internal models-based approaches to a period of significant financial stress, consistent with the stressed value-at-risk approach adopted in Basel 2.5; Comprehensively incorporating the risk of market illiquidity, again consistent with the direction taken in Basel 2.5; Measures to reduce model risk in the internal models-based approach, including a more granular models approval process and constraints on diversification; and A revised standardised approach that is intended to be more risk-sensitive and act as a credible fallback to internal models. The Committee is also proposing to strengthen the relationship between the models-based and standardised approaches by establishing a closer link between the calibration of the two approaches, requiring mandatory calculation of the standardised approach by all banks, and considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach. Furthermore, the treatment of hedging and diversification will be more closely aligned between the two approaches. Comments on this consultative document should be submitted by Friday 7 September 2012 by e-mail to Alternatively, comments may be sent by post to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments will be published on the Bank for International Settlementss website unless a commenter specifically requests confidential treatment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 3. Once the Committee has reviewed responses, it intends to release forcomment a more detailed set of proposals to amend the Basel IIIframework.In line with its normal process, the Committee will also subject suchproposals to a thorough Quantitative Impact Study.AbbreviationsCDS Credit default swapCRM Comprehensive risk measureCTP Correlation trading portfolioCVA Credit valuation adjustmentES Expected shortfallGAAP Generally Accepted Accounting PrinciplesIFRS International Financial Reporting StandardsIRC Incremental risk chargeMTM Mark-to-marketOTC Over-the-counterP&L Profit and lossPVBP Present value of a basis pointRWA Risk-weighted assetsSDR Special drawing rightsSMM Standardised measurement methodVaR Value-at-riskFundamental review of the trading bookExecutive summaryThis consultative document presents the initial policy proposalsemerging from the Basel Committee’s (“the Committee”) fundamentalreview of trading book capital requirements.These proposals will strengthen capital standards for market risk, andthereby contribute to a more resilient banking sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 4. The policy directions set out in this paper form part of the Committee’sbroader agenda of reforming bank regulatory standards to address thelessons of the financial crisis.These initial proposals build on the series of important reforms that theCommittee has already delivered through Basel III and set out the keyapproaches under consideration by the Committee to revise the marketrisk framework.These proposals also reflect the Committee’s increased focus onachieving a regulatory framework that can be implemented consistentlyby supervisors and which achieves comparable levels of capital acrossjurisdictions.The Committee’s policy orientations with regard to the trading book are avital element of the objective to achieve comparability of capital outcomesacross banks, particularly those which are most systemically important.BackgroundThe financial crisis exposed material weaknesses in the overall design ofthe framework for capitalising trading activities and the level of capitalrequirements for trading activities proved insufficient to absorb losses.As an important response to the crisis, the Committee introduced a set ofrevisions to the market risk framework in July 2009 (part of the “Basel 2.5”rules).These sought to reduce the cyclicality of the market risk framework andincrease the overall level of capital, with particular focus on instrumentsexposed to credit risk (including securitisations), where the previousregime had been found especially lacking.However, the Committee recognised at the time that the Basel 2.5revisions did not fully address the shortcomings of the framework.As a result, the Committee initiated a fundamental review of the trading _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 5. book regime, beginning with an assessment of “what went wrong”.The fundamental review seeks to address shortcomings in the overalldesign of the regime as well as weaknesses in risk measurement underboth the internal models-based and standardised approaches.This consultative paper sets out the direction the Committee intends totake in tackling the structural weaknesses of the regime, in order to solicitstakeholders’ comments before proposing more concrete revisions to themarket risk capital framework.Key areas of Committee focusThe Committee has focused on the following key areas in its review:The trading book/banking book boundaryThe Committee believes that its definition of the regulatory boundary hasbeen a source of weakness in the design of the current regime.A key determinant of the boundary is banks’ intent to trade, an inherentlysubjective criterion that has proved difficult to police and insufficientlyrestrictive from a prudential perspective in some jurisdictions.Coupled with large differences in capital requirements against similartypes of risk on either side of the boundary, the overall capital frameworkproved susceptible to arbitrage.While the Committee considered the possibility of removing theboundary altogether, it concluded that a boundary will likely have to beretained for practical reasons.The Committee is now putting forth for consideration two alternativeboundary definitions: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 6. “Trading evidence”- based boundary:Under this approach the boundary would be defined not only by banks’intent, but also by evidence of their ability to trade and risk manage theinstrument on a trading desk.Any item included in the regulatory trading book would need to bemarked to market daily with changes in fair value recognised in earnings.Stricter, more objective requirements would be used to ensure robust andconsistent enforcement.Tight limits to banks’ ability to shift instruments across the boundaryfollowing initial classification would also be introduced.Fundamental to this proposal is a view that a bank’s intention to trade –backed up by evidence of this intent and a regulatory requirement to keepitems in the regulatory trading book once they are placed there – is therelevant characteristic for determining capital requirements.In some jurisdictions, application of this type of definition of theboundary could result in regulatory trading books that are considerablynarrower than at present.Valuation-based boundary:This proposal would move away from the concept of “trading intent” andconstruct a boundary that seeks to align the design and structure ofregulatory capital requirements with the risks posed to a bank’sregulatory capital resources.Fundamental to this proposal is a view that capital requirements formarket risk should apply when changes in the fair value of financialinstruments, whether recognised in earnings or flowing directly to equity,pose risks to the regulatory and accounting solvency of banks.This definition of the boundary would likely result in a larger regulatorytrading book, but not necessarily in a much wider scope of application for _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 7. market risk models or necessarily lower capital requirements.Stressed calibrationThe Committee recognises the importance of ensuring that regulatorycapital is sufficient in periods of significant market stress.As the crisis showed, it is precisely during stress periods that capital ismost critical to absorb losses.Furthermore, a reduction in the cyclicality of market risk capital chargesremains a key objective of the Committee.Consistent with the direction taken in Basel 2.5, the Committee intends toaddress both issues by moving to a capital framework that is calibrated toa period of significant financial stress in both the internal models-basedand standardised approaches.Moving from value-at-risk to expected shortfallA number of weaknesses have been identified with using value-at-risk(VaR) for determining regulatory capital requirements, including itsinability to capture “tail risk”.For this reason, the Committee has considered alternative risk metrics, inparticular expected shortfall (ES).ES measures the riskiness of a position by considering both the size andthe likelihood of losses above a certain confidence level.In other words, it is the expected value of those losses beyond a givenconfidence level.The Committee recognises that moving to ES could entail certainoperational challenges; nonetheless it believes that these are outweighed _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 8. by the benefits of replacing VaR with a measure that better captures tailrisk.Accordingly, the Committee is proposing the use of ES for the internalmodels-based approach and also intends to determine risk weights for thestandardised approach using an ES methodology.A comprehensive incorporation of the risk of market illiquidityThe Committee recognises the importance of incorporating the risk ofmarket illiquidity as a key consideration in banks’ regulatory capitalrequirements for trading portfolios.Before the introduction of the Basel 2.5 changes, the entire market riskframework was based on an assumption that trading book risk positionswere liquid, ie that banks could exit or hedge these positions over a 10-dayhorizon.The recent crisis proved this assumption to be false.As liquidity conditions deteriorated during the crisis, banks were forcedto hold risk positions for much longer than originally expected andincurred large losses due to fluctuations in liquidity premia andassociated changes in market prices.Basel 2.5 partly incorporated the risk of market illiquidity into modellingrequirements for default and credit migration risk through theincremental risk charge (IRC) and the comprehensive risk measure(CRM).The Committee’s proposed approach to factor in market liquidity riskcomprehensively in the revised market risk regime consists of threeelements:- First, operationalising an assessment of market liquidity for regulatory capital purposes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 9. The Committee proposes that this assessment be based on the concept of “liquidity horizons”, defined as the time required to exit or hedge a risk position in a stressed market environment without materially affecting market prices. Banks’ exposures would be assigned into five liquidity horizon categories, ranging from 10 days to one year.- Second, incorporating varying liquidity horizons in the regulatory market risk metric to capitalise the risk that banks might be unable to exit or hedge risk positions over a short time period (the assumption embedded in the 10-day VaR treatment for market risk).- Third, incorporating capital add-ons for jumps in liquidity premia, which would apply only if certain criteria were met. These criteria would seek to identify the set of instruments that could become particularly illiquid, but where the market risk metric, even with extended liquidity horizons, would not sufficiently capture the risk to solvency from large fluctuations in liquidity premia.Additionally, the Committee is consulting on two possible options forincorporating the “endogenous” aspect of market liquidity.Endogenous liquidity is the component that relates to bank-specificportfolio characteristics, such as particularly large or concentratedexposures relative to the market.The main approach under consideration by the Committee to incorporatethis risk would be further extension of liquidity horizons; an alternativecould be application of prudent valuation adjustments specificallytargeted to account for endogenous liquidity.Treatment of hedging and diversificationHedging and diversification are intrinsic to the active management oftrading portfolios. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 10. Hedging, while generally risk reducing, also gives rise to basis risk thatmust be measured and capitalised.In addition, portfolio diversification benefits, whilst seeminglyrisk-reducing, can disappear in times of stress.Currently, banks using the internal models-based approach are allowedlarge latitude to recognise the risk-reducing benefits of hedging anddiversification, while recognition of such benefits is strictly limited underthe standardized approach.The Committee is proposing to more closely align the treatment ofhedging and diversification between the two approaches.In part, this will be achieved by constraining diversification benefits inthe internal models-based approach to address the Committee’s concernsthat such models may significantly overestimate portfolio diversificationbenefits that do not materialise in times of stress.Relationship between internal models-based and standardisedapproachesThe Committee considers the current regulatory capital framework forthe trading book to have become too reliant on banks’ internal modelsthat reflect a private view of risk.In addition, the potential for very large differences between standardisedand internal models based capital requirements for a given portfolio is amajor level playing field concern and can also leave supervisors without acredible option of removing model permission when model performanceis poor.To strengthen the relationship between the models-based andstandardised approaches the Committee is consulting on three proposals: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 11. - First, establishing a closer link between the calibration of the two approaches;- Second, requiring mandatory calculation of the standardised approach by all banks;- Third, considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.Revised models-based approachThe Committee has identified a number of weaknesses with riskmeasurement under the models-based approach.In seeking to address these problems, the Committee intends to(i) Strengthen requirements for defining the scope of portfolios that willbe eligible for internal models treatment; and(ii) Strengthen the internal model standards to ensure that the output ofsuch models reflects the full extent of trading book risk that is relevantfrom a regulatory capital perspective.To strengthen the criteria that banks must meet before regulatory capitalcan be calculated using internal models, the Committee is proposing tobreak the model approval process into smaller, more discrete steps,including at the trading desk level.This will allow ***model approval to be “turned-off” more easily*** thanat present for specific trading desks that do not meet the requirements.At the trading desk level, where the bank naturally has an internal profitand loss (P&L) available, model performance can be verified morerobustly.The Committee is considering two quantitative tools to measure theperformance of models. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 12. First, a P&L attribution process that provides an assessment of how well adesk’s risk management model captures risk factors that drive its P&L.Second, an enhanced daily backtesting framework for reconcilingforecasted losses from the market risk metric with actual losses.Although the market risk regime has always required backtesting ofmodel performance, the Committee is proposing to apply it at a moregranular trading desk level in the future.Where a trading desk does not achieve acceptable P&L attribution orbacktesting results, the bank would be required to calculate capitalrequirements for that desk using the standardised approach.To strengthen model standards, the Committee is consulting on limitingdiversification benefits, moving to an expected shortfall metric andcalibrating to a period of market stress.In addition, it is consulting on introducing a more robust process forassessing whether individual risk factors would be deemed as“modellable” by a particular bank.This would be a systematic process for identifying, recording andcalculating regulatory capital against risk factors deemed not to beamenable to market risk modelling.Revised standardised approachThe Committee has identified a number of important shortcomings withthe current standardised approach.A standardised approach serves two main purposes.Firstly, it provides a method for calculating capital requirements forbanks with business models that do not require sophisticatedmeasurement of market risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 13. This is especially relevant to smaller banks with limited trading activities.Secondly, it provides a fallback in the event that a bank’s internal marketrisk model is deemed inadequate as a whole or for specific trading desksor risk factors.This second purpose is of particular importance for larger or moresystemically important banks.In addition, the standardised approach could allow for a harmonisedreporting of risk positions in a format that is consistent across banks andjurisdictions.Apart from allowing for greater comparability across banks andjurisdictions, this could also allow for aggregation of risk positions acrossthe banking system to obtain a macroprudential view of market risks.With those objectives in mind the Committee has adopted the followingprinciples for the design of the revised standardised approach:simplicity, transparency and consistency, as well as improved risksensitivity; a credible calibration; limited model reliance; and a crediblefallback to internal models.In seeking to meet these objectives, the Committee proposes a “partialrisk factor” approach as a revised standardised approach.The Committee also invites feedback on a “fuller risk factor” approach asan alternative.More specifically:(a) Partial risk factor approach:Instruments that exhibit similar risk characteristics would be grouped inbuckets and Committee-specified risk weights would be applied to theirmarket value. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 14. The number of buckets would be approximately 20 across five broadclasses of instruments, though the exact number would be determinedempirically.Hedging and diversification benefits would be better captured than atpresent by using regulatory correlation parameters.To improve risk sensitivity, instruments exposed to “cross-cutting” riskfactors that are pervasive across the trading book (eg FX and interest raterisk) would be assigned to more than one bucket.For example, a foreign-currency equity would be assigned to theappropriate quity bucket and to a cross-cutting FX bucket.(b) Fuller risk factor approach:This alternative approach would map instruments to a set of prescribedregulatory risk factors to which shocks would be applied to calculate acapital charge for the individual risk factors.The bank would have to use a pricing model (likely its own) to determinethe size of the risk positions for each instrument with respect to theapplicable risk factors.Hedging would be recognized for more “systematic” risk factors at therisk factor level.The capital charge would be generated by subjecting the overall riskpositions to a simplified regulatory aggregation algorithm.The appropriate treatment of creditA particular area of Committee focus has been the treatment of positionssubject to credit risk in the trading book.Credit risk has continuous (credit spread) and discrete (default andmigration) components. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 15. This has implications for the types of models that are appropriate forcapturing credit risk.In practice, including default and migration risk within an integratedmarket risk framework introduces particular challenges and potentiallymakes consistent capital charges for credit risk in the banking andtrading books more difficult to achieve.The Committee is therefore considering whether, under a futureframework, there should continue to be a separate model for default andmigration risk in the trading book.Areas outside the scope of these proposalsThe Committee thinks it is important to note that there are two particularareas that it has considered, but are not subject to any detailed proposalsin this consultative document.Interest rate risk in the banking bookAlthough the Committee has determined that removing the boundarybetween the banking book and the trading book may be impractical, it isconcerned about the possibility of arbitrage across the banking book /trading book boundary.A major contributor to arbitrage opportunities are different capitaltreatments for the same risks on either side of the boundary.One example is interest rate risk, which is explicitly captured in thetrading book under a Pillar 1 capital regime, but subject to Pillar 2requirements in the banking book.The Committee has therefore undertaken some preliminary work on thekey issues that would be associated with applying a Pillar 1 capital chargefor interest rate risk in the banking book. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 16. The Committee intends to consider the timing and scope of further workin this area later in 2012.Interaction of market and counterparty riskBasel III introduced a new set of capital charges to capture the risk ofchanges to credit valuation adjustments (CVA).This is known as the CVA risk capital charge and will be implemented asa “stand alone” capital charge under Basel III, with a coordinated startdate of 1 January 2013.The Committee is aware that some industry participants believe that CVArisk, as the market component of credit risk, should be captured in anintegrated fashion with other forms of market risk within the market riskframework.The Committee has agreed to consider this question, but remainscautious of the degree to which these risks can be effectively captured in asingle integrated modelling approach.It observes that there is no clear market standard for the treatment of CVArisk in banks’ internal capital.Occasionally, even within individual banks, different treatments for CVArisk seem to exist.For the time being, the Committee anticipates that open questionsregarding the practicality of integrated modelling of CVA and market riskcould constrain moving towards such integration.In the meantime, the industry should focus on ensuring a high-qualityimplementation of the new stand-alone charge on 1 January 2013.This is consistent with the Committee’s broader concerns over the degreeof reliance on internal models and the over-estimation of diversificationbenefits. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 17. For this reason, this consultative document sets out initial proposals onrevisions to the capital framework for capturing market risk and does notoffer specific proposals for dealing with CVA risk.Nonetheless, stakeholders may wish to provide their views on whetherCVA risk should be incorporated into the market risk framework and, ifso, how this could be achieved in the context of the emerging revisions tothe market risk framework presented in this paper.Next stepsThe Committee welcomes comments from the public on all aspects ofthis consultative document and in particular on the questions in the text(summarised at the end of this document) by 7 September 2012 by e-mailto, comments may be sent by post to: Basel Committee onBanking Supervision, Bank for International Settlements,Centralbahnplatz 2, CH-4002 Basel, SwitzerlandAll comments will be published on the Bank for InternationalSettlements’ website unless a commenter specifically requestsconfidential treatment.Once the Committee has reviewed responses, it intends to release forcomment a more detailed set of proposals to amend the Basel IIIframework.As is its normal process, the Committee will subject such proposals to athorough Quantitative Impact Study. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 18. AnnexLessons from the academic literature and banks’ riskmanagement practicesIn its deliberations on revising the prudential regime for tradingactivities, the Trading Book Group has drawn on lessons both from theacademic literature and banks’ current and emerging risk managementpractices.1. Messages from the academic literature on risk measurementin the trading bookSelected lessons on VaR implementation:(a) There is no unique solution to the problem of the appropriate timehorizon for risk measurement.The horizon depends on characteristics of the portfolio and theeconomic purpose of measuring its risk.(b) Commonly used square-root-of-time VaR scaling rules (which ignorefuture changes in the portfolio) have been found to be an inaccurateapproximation in many studies.That said, no widely accepted alternative has emerged.(c) There are limitations of VaR models that rely on the use of continuousstochastic processes with only deterministic volatility assumptions.Introducing either stochastic volatility assumptions or stochastic jumpprocess into modelling of risk factors will help to overcome theseshortcomings.(d) Backtesting procedures that only focus on the number of VaRviolations are insufficient to determine the appropriateness of the modelassumptions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 19. The use of conditional backtesting procedures or other techniques (likethe timing of violations or the magnitude of the VaR exceptions) canimprove the backtesting process.(e) No consensus has yet emerged on the relative benefits of using actualor hypothetical results (ie P&L) to conduct backtesting exercises.Incorporating market liquidity risk:The literature distinguishes, first, between exogenous and endogenousmarket liquidity risks; and, second, between normal (or current) liquidityrisk and extreme (or stressed) liquidity risk.Portfolios may be subject to significant endogenous liquidity costs underall market conditions, depending on their size or on the risk positions ofother market participants.According to accounting standards, endogenous liquidity costs are nottaken into account in the valuation of the trading books.A first step to incorporating this risk in a VaR measure would be to take itinto account in the valuation method.In practice, the time it takes to liquidate a risk position varies, dependingon its transaction costs, the size of the risk position in the market, thetrade execution strategy, and market conditions.Some studies suggest that, for some portfolios, this aspect of liquidity riskcould also be addressed by extending the VaR risk measurement horizon.Risk measures:VaR has been criticised in the literature for lacking subadditivity. Aprominent alternative to VaR is ES, which is subadditive.Despite criticism focused on the complexity, computational burden, andbacktesting issues associated with ES, the recent literature suggests that _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 20. many issues have been resolved or have been identified as less severe thanoriginally expected. Spectral risk measures are a promising generalisationof ES that is cited in the literature.Stress testing practices for market risk:Stress testing often was implemented as an ad hoc exercise without anyestimate of scenario probability or use of a bank’s VaR risk measurementframework.More recent research advocates the integration of stress testing into therisk modelling framework.This would overcome the drawbacks of reconciling standalone stress testresults with standard VaR model output.Progress has also been achieved in theoretical research on the selection ofstress scenarios.The regulatory stressed VaR approach has not been analysed in theacademic literature.Unified versus compartmentalised risk measurement:Recently, attention has shifted towards unified approaches to riskmeasurement that consider all risk categories jointly.Theoretically, an integrated approach is needed to capture potentialcompounding effects that are ignored in traditional compartmentalisedrisk measurement approaches (eg separate measures for interest rate,market, credit and operational risk).These might underestimate risk if a portfolio cannot be cleanly dividedinto sub-portfolios along risk categories.Irrespective of the separation of assets into “books”, it is not always truethat calculating different risks for the same portfolio in a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 21. compartmentalised fashion and adding up the compartmentalisedmeasures will be a conservative estimate of the true risk.This insight is particularly important for “back-fitting packages”, such asthe IRC.Risk management and VaR in a systemic context:A number of studies criticise VaRbased capital rules as being procyclicalin nature.This may induce cyclical lending behavior by banks and exacerbate thebusiness cycle.Another criticism of VaR-based capital rules is that banks may fail toconsider system-wide endogeneity in their internal decisions.If all banks do this, they may act uniformly in booms and busts leading toinstabilities in asset markets.Unfortunately, the literature does not offer convincing alternatives.2. Key findings from a survey of industry practicesThe Trading Book Group conducted a survey of industry practices in riskmanagement, capital allocation and other measures for the trading bookthat could be used to inform the development of regulatory capitalstandards.The key findings are as follows.Length of holding period for risk assessment:For day-to-day risk management the use of one-day VaR is universalamong banks surveyed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 22. However, for internal capital adequacy and strategic risk management,banks are generally moving beyond short-horizon models (eg one-dayand 10-day VaR).It is now acknowledged that, to determine the level of capital necessary toremain in business after sustaining a large loss, risk must be assessedover a longer holding period.Shorter horizons do not address the liquidity risk for all exposures and donot capture tail events that are important for capital adequacy.Some banks are developing risk models with varying holding periods forrisk assessment across products and conditional on the market liquidityof the exposure, though validation will be difficult.Alternatives to traditional VaR models:Many banks see the need for a measure of risk for exposures that are hardto capture in traditional VaR models.Stress tests are utilised but most view that risk needs to be assessed over arange of possible scenarios because the nature of the next crisis cannot bepredicted.Consequently, more ambitious comprehensive statistical models of stressscenarios are used.Such models allow systematic assessment of risk across multiple stressscenarios beyond those present in historical data sets.These approaches are similar to reverse stress tests in that they aresensitive to the scenario to which the bank is most exposed.Alternatively, some banks recommend the use of risk sensitive add-ons torisk model outputs for exposures whose risks cannot be reliably measuredwith VaR. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 23. These banks believe that use of add-ons where complexity and modeluncertainty exist would be preferable to blunt risk-insensitivestandardised measures.The same complexity and measurement issues that are challenges forVaR models are likely to affect the robustness of standardised riskweights.Model validation:The emerging modelling approaches for assessment of exposure tostress events will present a challenge for model validation because of thepaucity of relevant historical data.In addition, models that assess risk over long holding periods such as inthe IRC model present a validation challenge because some productshave less than 10 years of historical data.In cases where historical data are not sufficient for traditionalbacktesting, several banks suggested using benchmark portfolios todiscover which models were outliers in underestimating of risk.Scaling of VaR and nonlinearities:Nonlinearities in exposures are captured in most banks’ models to somedegree albeit imperfectly.Almost all banks’ VaR models capture nonlinearities at a local level (smallprice changes) for much of their market risk exposure, but many banks’VaR models fail to capture non-linearity at a global level (large pricechanges).A common weakness in the capture of non-linearity is the use of scalingof oneday VaR to estimate exposures at longer holding periods. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 24. Such scaling only captures local non-linearity in the range of one-dayprice changes and can underestimate non-linear exposure over longerhorizons, even when full revaluation is used.To learn _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 25. _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • 26. FSB enhances its process for ongoing monitoring ofcompensation practicesThe 2011 FSB peer review on compensation indicated that good progresshas been made in implementing the FSB Principles and Standards onSound Compensation Practices (“Principles and Standards”), but thatmore work is necessary to overcome constraints to full implementation byindividual national authorities and to address concerns by firms of anuneven playing field.Following the completion of the peer review, the Financial Stability Board(FSB) was tasked by the G20 to undertake ongoing monitoring and publicreporting on further progress in compensation practices.In order to strengthen its monitoring in this area, the FSB has recentlyestablished the Compensation Monitoring Contact Group (CMCG), anetwork of national experts from member jurisdictions with regulatory orsupervisory responsibility on compensation practices.The CMCG is responsible for monitoring and reporting to the FSB onnational implementation of the Principles and Standards.In addition, the FSB has established a mechanism for nationalsupervisors from FSB member jurisdictions to bilaterally report, verifyand, if necessary, address specific compensation-related complaints byfinancial institutions that give rise to level playing field concerns.The objectives of the Bilateral Complaint Handling Process (BCHP) areto:- Address evidence-based complaints raised by firms to their home supervisors that document a competitive disadvantage as a result of the inconsistent implementation of the Principles and Standards by firms headquartered in other jurisdictions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 27. - Produce and report information to the FSB on the nature and outcomes of such complaints so as to inform the scope and intensity of the ongoing monitoring.The BCHP is intended to complement and reinforce normal bilateral ormultilateral supervisory channels that may be used by supervisors toaddress compensation issues.The outcomes of the BCHP will be reported by the CMCG to the FSB aspart of its ongoing monitoring process.Information on the FSB’s implementation monitoring activities ofcompensation practices is available on a dedicated page of the FSBwebsite that can be accessed at the following exactly is happening ?The G20 Leaders in the November 2011 Cannes Summit Declaration,called on the FSB to "undertake an ongoing monitoring and publicreporting on compensation practices focused on remaining gaps andimpediments to full implementation of these standards and carry out anongoing bilateral complaint handling process to address level playingfield concerns of individual firms".Compensation practices is one of the designated priority areas under theFSBs Coordination Framework for Implementation Monitoring(CFIM).All priority areas undergo more intensive monitoring and detailedreporting via periodic progress reports and peer reviews.The Compensation Monitoring Contact Group (CMCG) under the FSBStanding Committee on Standards Implementation (SCSI) is responsiblefor monitoring and reporting on national implementation in this area andon the results of the bilateral complaint handling process, a mechanismby which national supervisors from the FSB member jurisdictions worktogether to verify and, as needed, address specific compensation-related _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 28. complaints by financial institutions that give rise to level playing fieldconcerns.It is good to see the G20 Cannes Summit final declaration"BUILDING OUR COMMON FUTURE: RENEWEDCOLLECTIVE ACTION FOR THE BENEFIT OF ALL"1. Since our last meeting, global recovery has weakened, particularly inadvanced countries, leaving unemployment at unacceptable levels.Tensions in the financial markets have increased due mostly to sovereignrisks in Europe.Signs of vulnerabilities are appearing in emerging markets.Increased commodity prices have harmed growth and hit the mostvulnerable.Exchange rate volatility creates a risk to growth and financial stability.Global imbalances persist.Today, we reaffirm our commitment to work together and we have takendecisions to reinvigorate economic growth, create jobs, ensure financialstability, promote social inclusion and make globalization serve the needsof our people.A global strategy for growth and jobs2. To address the immediate challenges faced by the global economy, wecommit to coordinate our actions and policies.We have agreed on an Action plan for Growth and Jobs. Each of us willplay their part. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 29. Fostering Employment and Social Protection3. We firmly believe that employment must be at the heart of the actionsand policies to restore growth and confidence that we undertake underthe Framework for strong, sustainable and balanced growth.We are committed to renew our efforts to combat unemployment andpromote decent jobs, especially for youth and others who have been mostaffected by the economic crisis.We therefore decide to set up a G20 Task-Force on Employment, with afocus on youth employment, that will provide input to the G20 Labourand Employment Ministerial Meeting to be held under the MexicanPresidency in 2012.We have tasked International organizations (IMF, OECD, ILO, WorldBank) to report to Finance Ministers on a global employment outlook andhow our economic reform agenda under the G20 Framework willcontribute to job creation.4. We recognize the importance of investing in nationally determinedsocial protection floors in each of our countries, such as access to healthcare, income security for the elderly and persons with disabilities, childbenefits and income security for the unemployed and assistance for theworking poor.They will foster growth resilience, social justice and cohesion.In this respect, we note the report of the Social Protection Floor AdvisoryGroup, chaired by Ms Michelle Bachelet.5. We commit to promote and ensure full respect of the fundamentalprinciples and rights at work.We welcome and encourage the ILO to continue promoting ratificationand implementation of the eight ILO Fundamental Conventions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 30. 6. We are determined to strengthen the social dimension of globalisation.Social and employment issues, alongside economic, monetary andfinancial issues, will remain an integral part of the G20 agenda.We call on international organisations to intensify their coordination andmake it more effective.In view of a greater coherence of multilateral action, we encourage theWTO, the ILO, the OECD, the World Bank and the IMF to enhance theirdialogue and cooperation.7. We are convinced of the essential role of social dialogue.In this regard we welcome the B20 and L20 Meetings that took placeunder the French presidency and the willingness of these fora to worktogether as witnessed in their joint statement.8. Our Labour and Employment Ministers met in Paris on September26-27, 2011 to tackle these issues.We endorse their conclusions, annexed to this Declaration. We ask ourMinisters to meet again next year to review progress made on thisagenda.Building a more stable and resilient International MonetarySystem9. In 2010, the G20 committed to working towards a more stable andresilient IMS and to ensure systemic stability in the global economy,improve the global economic adjustment, as well as an appropriatetransition towards an IMS which better reflects the increased weight ofemerging market economies.In 2011, we are taking concrete steps to achieve these goals.Increasing the benefits from financial integration and resilienceagainst volatile capital flows to foster growth and development10. We agreed on coherent conclusions to guide us in the management ofcapital flows drawing on country experiences, in order to reap the benefits _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 31. from financial globalization, while preventing and managing risks thatcould undermine financial stability and sustainable growth at the nationaland global levels.11. To pursue these objectives, we adopted an action plan to support thedevelopment and deepening of local currency bond markets, scaling uptechnical assistance from different international institutions, improvingthe data base and preparing joint annual progress reports to the G20.We call on the World Bank, Regional Development Banks, IMF,UNCTAD, OECD, BIS and FSB to work together to support the deliveryof this plan and to report back by the time of our next meeting aboutprogress made.Reflecting the changing economic equilibrium and theemergence of new international currencies12. We affirm our commitment to move more rapidly toward moremarket-determined exchange rate systems and enhance exchange rateflexibility to reflect underlying economic fundamentals, avoid persistentexchange rate misalignments and refrain from competitive devaluation ofcurrencies.We are determined to act on our commitments to exchange rate reformarticulated in our Action plan for Growth and Jobs to address short termvulnerabilities, restore financial stability and strengthen themedium-term foundations for growth.Our actions will help address the challenges created by developments inglobal liquidity and capital flows volatility, thus facilitating furtherprogress on exchange rate reforms and reducing excessive accumulationof reserves.13. We agreed that the SDR basket composition should continue to reflectthe role of currencies in the global trading and financial system and beadjusted over time to reflect currencies changing role and characteristics.The SDR composition assessment should be based on existing criteria,and we ask the IMF to further clarify them. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 32. A broader SDR basket will be an important determinant of itsattractiveness, and in turn influence its role as a global reserve asset.This will serve as a reference for appropriate reforms.We look forward to reviewing the composition of the SDR basket in 2015,and earlier if warranted, as currencies meet the criteria, and call forfurther analytical work of the IMF in this regard, including on potentialevolution.We will continue our work on the role of the SDR.Strengthening our capacity to cope with crises14. As a contribution to a more structured approach, we agreed to furtherstrengthen global financial safety nets in which national governments,central banks, regional financial arrangements and international financialinstitutions will each play a role according to and within their respectivemandate.We agreed to continue these efforts to this end.We recognize that central banks play a major role in addressing liquidityshocks at a global and regional level, as shown by the recentimprovements in regional swap lines such as in East Asia.We agreed on common principles for cooperation between the IMF andRegional Financial Arrangements, which will strengthen crisis preventionand resolution efforts.15. As a contribution to this structured approach and building on existinginstruments and facilities, we support the IMF in putting forward the newPrecautionary and Liquidity Line (PLL).This would enable the provision, on a case by case basis, of increased andmore flexible short-term liquidity to countries with strong policies andfundamentals facing exogenous, including systemic, shocks.We also support the IMF in putting forward a single emergency facility toprovide non-concessional financing for emergency needs such as natural _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 33. disasters, emergency situations in fragile and post-conflict states, andalso other disruptive events.We call on the IMF to expeditiously discuss and finalize both proposals.16. We welcome the euro areas comprehensive plan and urge rapidelaboration and implementation, including of country reforms.We welcome the euro areas determination to bring its full resources andentire institutional capacity to bear in restoring confidence and financialstability, and in ensuring the proper functioning of money and financialmarkets.We will ensure the IMF continues to have resources to play its systemicrole to the benefit of its whole membership, building on the substantialresources we have already mobilized since London in 2009.We stand ready to ensure additional resources could be mobilised in atimely manner and ask our finance ministers by their next meeting towork on deploying a range of various options including bilateralcontributions to the IMF, SDRs, and voluntary contributions to an IMFspecial structure such as an administered account.We will expeditiously implement in full the 2010 quota and governancereform of the IMF.Strengthening IMF surveillance17. We agreed that effective and strengthened IMF surveillance will becrucial to the efficiency and stability of the IMS.In this context, a strengthening of multilateral surveillance and a betterintegration with bilateral surveillance will be important, as well asenhanced monitoring of interlinkages across sectors, countries andregions.Against this background, we welcome the recent improvements to theIMF surveillance toolkit including the consolidated multilateralsurveillance report and spillover reports and ask the IMF to continue toimprove upon these exercises and methodology. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 34. 18. We call on the IMF to make further progress towards a moreintegrated, even-handed and effective IMF surveillance, taking intoaccount the Independent Evaluation Office report on surveillance,covering in particular financial sector, fiscal, monetary, exchange ratepolicies and an enhanced analysis of their impact on external stability.We call on the IMF to regularly monitor cross-border capital flows andtheir transmission channels and update capital flow managementmeasures applied by countries.We also call on the IMF to continue its work on drivers and metrics ofreserve accumulation taking into account country circumstances, and,along with the BIS, their work on global liquidity indicators, with a viewto future incorporation in the IMF surveillance and other monitoringprocesses, on the basis of reliable indicators.We will avoid persistent exchange rate misalignments and we asked theIMF to continue to improve its assessment of exchange rates and topublish its assessments as appropriate.19. While continuing with our efforts to strengthen surveillance, werecognize the need for better integration of bilateral and multilateralsurveillance, and we look forward to IMF proposals for a new integrateddecision on surveillance early next year.20. We agreed on the need to increase the ownership and traction of IMFsurveillance, which are key components of its effectiveness.We agreed to ensure greater involvement of Ministers and Governors, byproviding greater strategic guidance through the IMFC.To increase the transparency of IMF surveillance, we reaffirm theimportance of all IMF members to contribute to improve data availability,support the Managing Directors proposal to publish multilateralassessments of external balances, and we recommend timely publicationof surveillance reports.We welcome the publication of Art. IV reports by most members of theG20 and look forward to further progress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 35. Next steps21. Building a more stable and resilient IMS is a long-term endeavor.We commit to continue working to ensure systemic stability in the globaleconomy and an appropriate transition towards an IMS which betterreflects the increased weight of emerging market economies.In 2012, we will continue to take concrete steps in this direction.Implementing and deepening Financial sector reforms22. We are determined to fulfill the commitment we made in Washingtonin November 2008 to ensure that all financial markets, products andparticipants are regulated or subject to oversight as appropriate to theircircumstances in an internationally consistent and non-discriminatoryway.Meeting our commitments notably on banks, OTC derivatives,compensation practices and credit rating agencies, andintensifying our monitoring to track deficiencies23. We are committed to improve banks resilience to financial andeconomic shocks.Building on progress made to date, we call on jurisdictions to meet theircommitment to implement fully and consistently the Basel II risk-basedframework as well as the Basel II-5 additional requirements on marketactivities and securitization by end 2011 and the Basel III capital andliquidity standards, while respecting observation periods and reviewclauses, starting in 2013 and completing full implementation by 1 January2019.24. Reforming the over the counter derivatives markets is crucial to builda more resilient financial system.All standardized over-the-counter derivatives contracts should be tradedon exchanges or electronic trading platforms, where appropriate, andcentrally cleared, by the end of 2012; OTC derivatives contracts should be _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 36. reported to trade repositories, and non-centrally cleared contracts shouldbe subject to higher capital requirements.We agree to cooperate further to avoid loopholes and overlappingregulations.A coordination group is being established by the FSB to address some ofthese issues, complementing the existing OTC derivatives workinggroup.We endorse the FSB progress report on implementation and ask the CPSSand IOSCO to work with FSB to carry forward work on identifying datathat could be provided by and to trade repositories, and to defineprinciples or guidance on regulators and supervisors access to data heldby trade repositories.We call on the Basel Committee on Banking Supervision (BCBS), theInternational Organization for Securities Commission (IOSCO) togetherwith other relevant organizations to develop for consultation standards onmargining for non-centrally cleared OTC derivatives by June 2012, and onthe FSB to continue to report on progress towards meeting ourcommitments on OTC derivatives.25. We reaffirm our commitment to discourage compensation practicesthat lead to excessive risk taking by implementing the agreed FSBprinciples and standards on compensation.While good progress has been made, impediments to full implementationremain in some jurisdictions.We therefore call on the FSB to undertake an ongoing monitoring andpublic reporting on compensation practices focused on remaining gapsand impediments to full implementation of these standards and carry outan on-going bilateral complaint handling process to address level playingfield concerns of individual firms.Based on the findings of this ongoing monitoring, we call on the FSB toconsider any additional guidance on the definition of material risk takersand the scope and timing of peer review process. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 37. 26. We reaffirm our commitment to reduce authorities and financialinstitutions reliance on external credit ratings, and call on standardsetters, market participants, supervisors and central banks to implementthe agreed FSB principles and end practices that rely mechanistically onthese ratings.We ask the FSB to report to our Finance Ministers and Central BankGovernors at their February meeting on progress made in this area bystandard setters and jurisdictions against these principles.27. We agree to intensify our monitoring of financial regulatory reforms,report on our progress and track our deficiencies.To do so, we endorse the FSB coordination framework forimplementation monitoring, notably on key areas such as the Baselcapital and liquidity frameworks, OTC derivatives reforms, compensationpractices, G-SIFI policies, resolution frameworks, and shadow banking.This work will build on the monitoring activities conducted by standardsetting bodies to the extent possible.We stress the need to report the results of this monitoring to the publicincluding on an annual basis through a traffic lights scoreboard preparedby the FSB.We welcome its first publication today and commit to take all necessaryactions to progress in the areas where deficiencies have been identified.Addressing the too big to fail issue28. We are determined to make sure that no financial firm is "too big tofail" and that taxpayers should not bear the costs of resolution.To this end, we endorse the FSB comprehensive policy framework,comprising a new international standard for resolution regimes, moreintensive and effective supervision, and requirements for cross-bordercooperation and recovery and resolution planning as well as, from 2016,additional loss absorbency for those banks determined as globalsystemically important financial institutions (G-SIFIs). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 38. The FSB publishes today an initial list of G-SIFIs, to be updated eachyear in November.We will implement the FSB standards and recommendations within theagreed timelines and commit to undertake the necessary legislativechanges, step up cooperation amongst authorities and strengthensupervisory mandates and powers.29. We ask the FSB in consultation with the BCBS, to deliver a progressreport by the G20 April Finance meeting on the definition of themodalities to extend expeditiously the G SIFI framework to domesticsystemically important banks.We also ask the IAIS to continue its work on a common framework for thesupervision of internationally active insurance groups, call on CPSS andIOSCO to continue their work on systemically important marketinfrastructures and the FSB in consultation with IOSCO to preparemethodologies to identify systemically important non-bank financialentities by end-2012.Filling in the gaps in the regulation and supervision of thefinancial sector30. Bank-like activities.The shadow banking system can create opportunities for regulatoryarbitrage and cause the build-up of systemic risk outside the scope of theregulated banking sector.To this end, we agree to strengthen the regulation and oversight of theshadow banking system and endorse the FSB initial elevenrecommendations with a work-plan to further develop them in the courseof 2012, building on a balanced approach between indirect regulation ofshadow banking through banks and direct regulation of shadow bankingactivities, including money markets funds, securitization, securitieslending and repo activities, and other shadow banking entities.We ask Finance Ministers and Central Bank Governors to review theprogress made in this area at their April meeting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 39. 31. Markets.We must ensure that markets serve efficient allocation of investments andsavings in our economies and do not pose risks to financial stability.To this end, we commit to implement initial recommendations by IOSCOon market integrity and efficiency, including measures to address therisks posed by high frequency trading and dark liquidity, and call forfurther work by mid-2012.We also call on IOSCO to assess the functioning of credit default swap(CDS) markets and the role of those markets in price formation ofunderlying assets by our next Summit.We support the creation of a global legal entity identifier (LEI) whichuniquely identifies parties to financial transactions.We call on the FSB to take the lead in helping coordinate work among theregulatory community to prepare recommendations for the appropriategovernance framework, representing the public interest, for such a globalLEI by our next Summit.32. Commodity markets.We welcome the G20 study group report on commodities and endorseIOSCOs report and its common principles for the regulation andsupervision of commodity derivatives markets.We need to ensure enhanced market transparency, both on cash andfinancial commodity markets, including OTC, and achieve appropriateregulation and supervision of participants in these markets.Market regulators and authorities should be granted effective interventionpowers to address disorderly markets and prevent market abuses.In particular, market regulators should have, and use formal positionmanagement powers, including the power to set ex-ante position limits,particularly in the delivery month where appropriate, among other powersof intervention. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 40. We call on IOSCO to report on the implementation of itsrecommendations by the end of 2012.33. Consumer protection.We agree that integration of financial consumer protection policies intoregulatory and supervisory frameworks contributes to strengtheningfinancial stability, endorse the FSB report on consumer financeprotection and the high level principles on financial consumer protectionprepared by the OECD together with the FSB.We will pursue the full application of these principles in our jurisdictionsand ask the FSB and OECD along with other relevant bodies, to report onprogress on their implementation to the upcoming Summits and developfurther guidelines if appropriate.34. Other regulatory issues.We are developing macro-prudential policy frameworks and tools to limitthe build-up of risks in the financial sector, building on the ongoing workof the FSB-BIS-IMF on this subject.We endorse the joint report by FSB, IMF and World Bank on issues ofparticular interest to emerging market and developing economies and callinternational bodies to take into account emerging market anddeveloping economies specific considerations and concerns in designingnew international financial standards and policies where appropriate.We reaffirm our objective to achieve a single set of high quality globalaccounting standards and meet the objectives set at the London summitin April 2009, notably as regards the improvement of standards for thevaluation of financial instruments.We call on the IASB and the FASB to complete their convergence projectand look forward to a progress report at the Finance Ministers andCentral Bank governors meeting in April 2012.We look forward to the completion of proposals to reform the IASBgovernance framework. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 41. Tackling tax havens and non-cooperative jurisdictions35. We are committed to protect our public finances and the globalfinancial system from the risks posed by tax havens and non cooperativejurisdictions.The damage caused is particularly important for the least developedcountries.Today we reviewed progress made in the three following areas:- In the tax area, the Global Forum has now 105 members. More than 700 information exchange agreements have been signed and the Global Forum is leading an extensive peer review process of the legal framework (phase 1) and implementation of standards (phase 2). We ask the Global Forum to complete the first round of phase 1 reviews and substantially advance the phase 2 reviews by the end of next year. We will review progress at our next Summit. Many of the 59 jurisdictions which have been reviewed by the Global Forum are fully or largely compliant or are making progress through the implementation of the 379 relevant recommendations. We urge all the jurisdictions to take the necessary action to tackle the deficiencies identified in the course of their reviews, in particular the 11 jurisdictions whose framework does not allow them at this stage to qualify to phase 2. We underline in particular the importance of comprehensive tax information exchange and encourage competent authorities to continue their work in the Global Forum to assess and better define the means to improve it. We welcome the commitment made by all of us to sign the Multilateral Convention on Mutual Administrative Assistance in Tax _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 42. Matters and strongly encourage other jurisdictions to join this Convention. In this context, we will consider exchanging information automatically on a voluntary basis as appropriate and as provided for in the convention;- In the prudential area, the FSB has led a process and published a statement to evaluate adherence to internationally agreed information exchange and cooperation standards. Out of 61 jurisdictions selected for their importance on several economic and financial indicators, we note with satisfaction that 41 jurisdictions have already demonstrated sufficiently strong adherence to these standards and that 18 others are committing to join them. We urge the identified non-cooperative jurisdictions to take the actions requested by the FSB;- In the anti-money laundering and combating the financing of terrorism area, the FATF has recently published an updated list of jurisdictions with strategic deficiencies. We urge all jurisdictions and in particular those identified as not complying or making sufficient progress to strengthen their AML/CFT systems in cooperation with the FATF.36. We urge all jurisdictions to adhere to the international standards in thetax, prudential and AML/CFT areas.We stand ready, if needed, to use our existing countermeasures to dealwith jurisdictions which fail to meet these standards.The FATF, the Global Forum and other international organizationsshould work closely together to enhance transparency and facilitatecooperation between tax and law enforcement agencies in theimplementation of these standards. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 43. We also call on FATF and OECD to do further work to prevent misuse ofcorporate vehicles.Strengthening the FSB capacity resources and governance37. The FSB has played a key role in promoting development andimplementation of regulation of the financial sector.38. To keep pace with this growing role, we agreed to strengthen FSBscapacity, resources and governance, building on its Chairs proposals.These include:- the establishment of the FSB on an enduring organizational footing: we have given the FSB a strong political mandate and need to give it a corresponding institutional standing, with legal personality and greater financial autonomy, while preserving the existing and well-functioning strong links with the BIS;- the reconstitution of the steering committee: as we move into a phase of policy development and implementation that in many cases will require significant legislative changes, we agree that the upcoming changes to the FSB steering committee should include the executive branch of governments of the G20 Chair and the larger financial systems as well as the geographic regions and financial centers not currently represented, in a balanced manner consistent with the FSB Charter;- the strengthening of its coordination role vis-à-vis other standard setting bodies (SSB) on policy development and implementation monitoring, avoiding any functional overlaps and recognizing the independence of the SSBs.39. We call for first steps to be implemented by the end of this year andwill review the implementation of the reform at our next Summit.Addressing Food Price Volatility and Increasing AgricultureProduction and Productivity _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 44. 40. Increasing agricultural production and productivity is essential topromote food security and foster sustainable economic growth.A more stable, predictable, distortion free, open and transparent tradingsystem allows more investment in agriculture and has a critical role toplay in this regard.Mitigating excessive food and agricultural commodity price volatility isalso an important endeavour.These are necessary conditions for stable access to sufficient, safe andnutritious food for everyone.We agreed to mobilize the G20 capacities to address these key challenges,in close cooperation with all relevant international organisations and inconsultation with producers, civil society and the private sector.41. Our Agriculture Ministers met for the first time in Paris on 22-23 June2011 and adopted the Action Plan on Food Price Volatility andAgriculture.We welcome this Action Plan, annexed to this Declaration.42. We have decided to act on the five objectives of this Action Plan:(i) Improving agricultural production and productivity,(ii) Increasing market information and transparency,(iii) Reducing the effects of price volatility for the most vulnerable,(iv) Strengthening international policy coordination and(v) Improving the functioning of agricultural commodity derivativesmarkets.43. We commit to sustainably increase agricultural production andproductivity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 45. To feed a world population expected to reach more than 9 billion peopleby 2050, it is estimated that agricultural production will have to increaseby 70% over the same period.We agree to further invest in agriculture, in particular in the poorestcountries, and bearing in mind the importance of smallholders, throughresponsible public and private investment. In this regard, we decide to:- Urge multilateral development banks to finalise their joint action plan on water, food and agriculture and provide an update on its implementation by our next Summit;- Invest in research and development of agricultural productivity. As a first step, we support the "International Research Initiative for Wheat Improvement" (Wheat Initiative), launched in Paris on September 15, 2011 and we welcome the G20 Seminar on Agricultural Productivity held in Brussels on 13 October 2011 and the first G20 Conference on Agricultural Research for Development, held in Montpellier on 12-13 September 2011, designed to foster innovation-sharing with and among developing countries.44. We commit to improve market information and transparency in orderto make international markets for agricultural commodities moreeffective.To that end, we launched:- The "Agricultural Market Information System" (AMIS) in Rome on September 15, 2011, to improve information on markets. It will enhance the quality, reliability, accuracy, timeliness and comparability of food market outlook information. As a first step, AMIS will focus its work on four major crops: wheat, maize, rice and soybeans. AMIS involves G20 countries and, at this stage, Egypt, Vietnam, Thailand, the Philippines, Nigeria, Ukraine and Kazakhstan. It will be managed by a secretariat located in FAO; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 46. - The "Global Agricultural Geo-monitoring Initiative" in Geneva on September 22-23, 2011. This initiative will coordinate satellite monitoring observation systems in different regions of the world in order to enhance crop production projections and weather forecasting data.45. We recognize that appropriately regulated and transparentagricultural financial markets are a key for well-functioning physicalmarkets and risk management.We welcome IOSCO recommendations on commodity derivativesendorsed by our Finance Ministers.46. We commit to mitigate the adverse effects of excessive price volatilityfor the most vulnerable through the development of appropriaterisk-management instruments.These actions are detailed in the development section of this finalDeclaration.47. According to the Action Plan, we agree to remove food exportrestrictions or extraordinary taxes for food purchased for non-commercialhumanitarian purposes by the World Food Program and agree not toimpose them in the future.In this regard, we encourage the adoption of a declaration by the WTO forthe Ministerial Conference in December 2011.48. We have launched a "Rapid Response Forum" in Rome on September16, 2011 to improve the international communitys capacity to coordinatepolicies and develop common responses in time of market crises.49. We welcome the production of a report by the internationalorganizations on how water scarcity and related issues could beaddressed in the appropriate fora.50. We commend the joint work undertaken by FAO, OECD, The WorldBank Group, IFAD, UNCTAD, WFP, WTO, IMF, IFPRI and the UN _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 47. HLTF to support our agenda and we request that they continue workingclosely together.51. We will keep progress on the implementation of the Action Plan onFood Price Volatility and Agriculture.Improving the functioning of Energy Markets52. We stress the importance of well-functioning and transparent physicaland financial energy markets, reduced excessive price volatility, improvedenergy efficiency and better access to clean technologies, to achievestrong growth that is both sustainable and inclusive.We are committed to promote sustainable development and green growthand to continue our efforts to face the challenge of climate change.53. We commit to more transparent physical and financial energymarkets. Commodity derivatives are being addressed as part of ourfinancial regulation reform agenda.We have made progress and reaffirm our commitment to improve thetimeliness, completeness and reliability of the JODI-Oil database as soonas possible.We also commit to support the IEF -- JODI work in order to improve thereliability of JODI-Oil and look forward to receiving theirrecommendations.We will regularly review and assess progress made on this front.54. We welcome the IEF Charters commitment to improve dialoguebetween oil producer and consumer countries, as well as the holding onJanuary 24, 2011 of the Riyadh Symposium on short, medium and longterm outlook and forecasts for oil markets.We call for those meetings to be held on an annual basis and for the IEF,the IEA and OPEC to release a joint communiqué and a reporthighlighting their outcomes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 48. 55. We note the new JODI-Gas database and commit to work oncontributing to it on the basis of the same principles as the JODI-Oildatabase.We also call for annual symposiums and communiqués on short, mediumand long term outlook and forecasts for gas and coal.We call for further work on gas and coal market transparency and ask theIEA, IEF and OPEC, to provide recommendations in this field bymid-2012.56. Recognizing the role of Price Reporting Agencies for the properfunctioning of oil markets, we ask IOSCO, in collaboration with the IEF,the IEA and OPEC, to prepare recommendations to improve theirfunctioning and oversight to our Finance Ministers by mid-2012.57. We reaffirm our commitment to rationalise and phase-out over themedium term inefficient fossil fuel subsidies that encourage wastefulconsumption, while providing targeted support for the poorest.We welcome the country progress reports on implementing strategies forrationalizing and phasing out inefficient fossil fuel subsidies, as well asthe joint report from the IEA, OPEC, OECD and the World Bank onfossil fuels and other energy support measures.We ask our Finance Ministers and other relevant officials to press aheadwith reforms and report back next year.Protecting Marine Environment58. We decide to take further action to protect the marine environment, inparticular to prevent accidents related to offshore oil and gas explorationand development, as well as marine transportation, and to deal with theirconsequences.We welcome the establishment of a mechanism to share best practicesand information on legal frameworks, experiences in preventing andmanaging accidents and disasters relating to offshore oil and gas drilling,production and maritime transportation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 49. We ask the Global Marine Environment Protection working group, incooperation with the OECD, the International Regulators Forum andOPEC, to report next year on progress made and to establish thismechanism in order to disseminate these best practices by mid-2012, atwhich point it will be reviewed.We also commit to foster dialogue with international organisations andrelevant stakeholders.Fostering Clean energy, Green Growth and SustainableDevelopment59. We will promote low-carbon development strategies in order tooptimize the potential for green growth and ensure sustainabledevelopment in our countries and beyond.We commit to encouraging effective policies that overcome barriers toefficiency, or otherwise spur innovation and deployment of clean andefficient energy technologies.We welcome the UN Secretary Generals "Sustainable Energy for All"initiative. We support the development and deployment of clean energyand energy efficiency (C3E) technologies.We welcome the assessment of the countries current situation regardingthe deployment of these technologies as well as the on-going exercise ofsharing best practices, as a basis for better policy making.60. We are committed to the success of the United Nations Conference onSustainable Development in Rio de Janeiro in 2012."Rio + 20" will be an opportunity to mobilize the political will needed toreinsert sustainable development at the heart of the international agenda,as a long term solution to growth, job creation, poverty reduction andenvironment protection.A green and inclusive growth will create a broad spectrum ofopportunities in new industries and in areas such as environmental _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 50. services, renewable energy and new ways to provide basic services to thepoor.Pursuing the Fight against Climate Change61. We are committed to the success of the upcoming Durban Conferenceon Climate Change on 28 November - 9 December 2011.We support South Africa as the incoming President of the Conference.We call for the implementation of the Cancun agreements and furtherprogress in all areas of negotiation in Durban.62. We stand ready to work towards operationalization of the GreenClimate Fund as part of a balanced outcome in Durban, building uponthe report of the Transitional Committee.63. Financing the fight against climate change is one of our mainpriorities.In Copenhagen, developed countries have committed to the goal ofmobilizing jointly USD 100 billion per year from all sources by 2020 toassist developing countries to mitigate and adapt to the impact of climatechange, in the context of meaningful mitigation actions andtransparency.We discussed the World Bank -- IMF -- OECD -- regional developmentbanks report on climate finance and call for continued work taking intoaccount the objectives, provisions and principles of the UNFCCC byinternational financial institutions and the relevant UN organizations.We ask our Finance Ministers to report to us at our next Summit onprogress made on climate finance.64. We reaffirm that climate finance will come from a wide variety ofsources, public and private, bilateral and multilateral, includinginnovative sources of finance.We recognize the role of public finance and public policy in supportingclimate-related investments in developing countries. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 51. We underline the role of the private sector in supporting climate-relatedinvestments globally, particularly through various market-basedmechanisms and also call on the MDBs to develop new and innovativefinancial instruments to increase their leveraging effect on private flows.Avoiding protectionism and reinforcing the Multilateral TradingSystem65. At this critical time for the global economy, it is important tounderscore the merits of the multilateral trading system as a way to avoidprotectionism and not turn inward.We reaffirm our standstill commitments until the end of 2013, as agreed inToronto, commit to roll back any new protectionist measure that mayhave risen, including new export restrictions and WTO-inconsistentmeasures to stimulate exports and ask the WTO, OECD and UNCTADto continue monitoring the situation and to report publicly on asemi-annual basis.66. We stand by the Doha Development Agenda (DDA) mandate.However, it is clear that we will not complete the DDA if we continue toconduct negotiations as we have in the past.We recognize the progress achieved so far.To contribute to confidence, we need to pursue in 2012 fresh, credibleapproaches to furthering negotiations, including the issues of concern forLeast Developed Countries and, where they can bear fruit, the remainingelements of the DDA mandate.We direct our Ministers to work on such approaches at the upcomingMinisterial meeting in Geneva and also to engage into discussions onchallenges and opportunities to the multilateral trading system in aglobalised economy and to report back by the Mexico Summit.67. Furthermore, as a contribution to a more effective, rules-based tradingsystem, we support a strengthening of the WTO, which should play a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 52. more active role in improving transparency on trade relations and policiesand enhancing the functioning of the dispute settlement mechanism.68. We look forward to welcoming Russia as a WTO member by the endof the year.Development: Investing for Global Growth69. As part of our overall objective for growth and jobs, we commit tomaximise growth potential and economic resilience in developingcountries, in particular in Low-Income Countries (LICs).Development is a key element of our agenda for global recovery andinvestment for future growth.It is also critical to creating the jobs needed to improve peoples livingstandards worldwide.Recognizing that development is a concern and duty to all G20 countries,our Ministers met for the first time on Development in Washington onSeptember 23, 2011.70. We support the report of the Development Working Group, annexedto this Declaration, implementing the G20s Seoul DevelopmentConsensus for Shared Growth, and call for prompt implementation of ourMulti-Year Action Plan.71. We take actions to overcome the most critical bottlenecks andconstraints hampering growth in developing countries.In this regard, we decided to focus on two priorities, food security andinfrastructure, and to address the issue of financing for development.72. The humanitarian crisis in the Horn of Africa underscores the urgentneed to strengthen emergency and long-term responses to foodinsecurity.In accordance with our Multi-Year "Action Plan on Food Price Volatilityand Agriculture", we: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 53.  welcome the initiative of the Economic Community of Western African States (ECOWAS) to set up a targeted regional emergency humanitarian food reserve system, as a pilot project, and the "ASEAN+3" emergency rice reserve initiative; Urge multilateral development banks to finalise their joint action plan on water, food and agriculture and provide an update on its implementation by our next Summit; Support, for those involved, the implementation of the LAquila Food Security Initiative and other initiatives, including the Global Agriculture and Food Security Program; Launch a platform for tropical agriculture to enhance capacity-building and knowledge sharing to improve agricultural production and productivity; Foster smallholder sensitive investments in agriculture and explore opportunities for market inclusion and empowerment of small producers in value chains; Support risk-management instruments, such as commodity hedging instruments, weather index insurances and contingent financing tools, to protect the most vulnerable against excessive price volatility, including the expansion of the Agricultural Price Risk-Management Product developed by the World Bank Group (IFC). We ask international organisations to work together to provide expertise and advice to low-income countries on risk-management and we welcome the NEPAD initiative to integrate risk management in agricultural policies in Africa; Encourage all countries to support the Principles of Responsible Agricultural Investment (PRAI) to ensure sustained investment in agriculture; Confirm our commitment to scaling-up nutrition through a combination of direct nutrition interventions and the incorporation of nutrition in all relevant policies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 54. 73. Investing in infrastructure in developing countries, especially in LICsand, whilst not exclusively, with a special emphasis on sub-SaharanAfrica, will unlock new sources of growth, contribute to the achievementof the Millennium Development Goals and sustainable development. Wesupport efforts to improve capacities and facilitate the mobilization ofresources for infrastructure projects initiated by public and privatesectors.74. We commissioned a High Level Panel (HLP), chaired by Mr TidjaneThiam, to identify measures to scale-up and diversify sources of financingfor infrastructure and we requested the MDBs to develop a joint actionplan to address bottlenecks.We welcome both the HLPs report and the MDB Action Plan. In thisregard, we support the following recommendations to :- Support the development of local capacities to improve supply and quality of projects and make them bankable and enhance knowledge sharing on skills for employment in low income countries. In this regard, we welcome the High Level Panel fellowship program and MDBs efforts to develop and strengthen regional public-private partnerships practitioners networks;- Increase quality of information available to investors, through the establishment of online regional marketplace platforms to better link project sponsors and financiers, such as the "Sokoni Africa Infrastructure Marketplace", and the extension of the Africa Infrastructure Country Diagnosis, which aim at benchmarking infrastructure data;- Prioritize project preparation financing, encouraging the MDBs to dedicate a greater share of their funds to preparation facilities that can operate on a revolving basis and call on MDBs to improve effectiveness of the existing preparation facilities;- Contribute to building an enabling environment for private and public infrastructure financing, especially for regional projects. We support increased transparency in the construction sector, the review of the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 55. Debt Sustainability Framework taking into account the investment-growth nexus. We call on MDBs to harmonize their procurement rules and practices and we support move towards mutual recognition of procedures and eligibility rules;- Improve access to funding, notably through the strengthening of local intermediaries and financial markets, more effective use of MDBs capital, including through use of credit enhancement and guarantee instruments.75. We commissioned the HLP to establish criteria to identify exemplaryinvestment projects in cooperation with multilateral development banks.We highlight the 11 projects mentioned in the HLP report annexed to thisDeclaration, which have the potential to have a transformational regionalimpact by leading to increased integration and access to global markets,with due consideration to environmental sustainability.We call on the MDBs, working with countries involved and in accordancewith regional priorities (in particular the Program for InfrastructureDevelopment in Africa), to pursue the implementation of such projectsthat meet the HLP criteria and to prioritize project preparation financing,notably the NEPAD Infrastructure Projects Preparation Facility.76. We stress the importance of following-up on these concrete actionsand invite MDBs to provide regular updates on the progress achieved.77. Recognizing that economic shocks affect disproportionately the mostvulnerable, we commit to ensure a more inclusive and resilient growth.We therefore decide to support the implementation and expansion ofnationally-designed social protection floors in developing countries,especially low income countries.We will work to reduce the average cost of transferring remittances from10% to 5% by 2014, contributing to release an additional 15 billion USDper year for recipient families.78. Recognizing that 2.5 billion people and millions of Small and MediumEnterprises (SMEs) throughout the world lack access to formal financial _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 56. services, and the crucial importance for developing countries to overcomethis challenge, we launched in Seoul an ambitious Global Partnership forFinancial Inclusion (GPFI). We commend the ongoing work by the GPFIto foster the development of SME finance and to include financialinclusion principles in international financial standards.We endorse the five recommendations put forward in its report, annexedto this Declaration, and commit to pursue our efforts under the MexicanPresidency.79. We welcome the presentation of the report by Mr Bill Gates onfinancing for development.We recognize the importance of the involvement of all actors, both publicand private, and the mobilisation of domestic, external and innovativesources of finance.80. Consistent with the Multi-Year Action Plan agreed in Seoul, westrongly support developing countries mobilization of domesticresources and their effective management as the main driver fordevelopment.This includes technical assistance and capacity building for designingand efficient managing of tax administrations and revenue systems andgreater transparency, particularly in mineral and natural resourceinvestment.We urge multinational enterprises to improve transparency and fullcompliance with applicable tax laws.We welcome initiatives to assist developing countries, on a demand-ledbasis, in the drafting and implementation of their transfer pricinglegislation.We encourage all countries to join the Global Forum on Transparencyand exchange of information in tax purposes.81. We stress the pivotal role of ODA. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 57. Aid commitments made by developed countries should be met.Emerging G20 countries will engage or continue to extend their level ofsupport to other developing countries.We welcome the emphasis on ensuring that poor countries benefit rapidlyfrom innovation and technological advances, and agree to encouragetriangular partnerships to drive priority innovations forward.We commit to raise the quality and efficiency of aid by concentrating onthe highest impact interventions and increase the focus on concreteresults and overall impact on development.82. We agree that, over time, new sources of funding need to be found toaddress development needs.We discussed a set of options for innovative financing highlighted by MrBill Gates, such as Advance Market Commitments, Diaspora Bonds,taxation regime for bunker fuels, tobacco taxes, and a range of differentfinancial taxes.Some of us have implemented or are prepared to explore some of theseoptions.We acknowledge the initiatives in some of our countries to tax thefinancial sector for various purposes, including a financial transaction tax,inter alia to support development.83. We welcome the upcoming 4th High-Level Forum on aideffectiveness to be held in Busan, Korea (29 November-1st December2011).The Forum will be an opportunity to establish a more inclusivepartnership to address development effectiveness.84. We look forward to a successful replenishment of the AsianDevelopment Fund and of the International Fund for AgricultureDevelopment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 58. Intensifying our Fight against Corruption85. Corruption is a major impediment to economic growth anddevelopment. We have made significant progress to implement the G20Anti-Corruption Action Plan.We endorse our experts report, annexed to this Declaration, whichoutlines the major steps taken both by individual countries and the G20collectively, and sets out further actions required to ensure that G20countries continue to make positive progress against the Action Plan.86. In this context:- We welcome the ratification by India of the United Nations Convention against Corruption (UNCAC). We also welcome the decision made by Russia to join the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. We commit to accelerate the ratification and implementation of UNCAC and to have a more active engagement within the OECD Working Group on Bribery on a voluntary basis. We further commend the member countries which are taking steps in the spirit of the Action Plan;- We commend the first reviews on the implementation of UNCAC. We commit to lead by example in ensuring the transparency and inclusivity of UNCAC reviews by considering the voluntary options in accordance with the Terms of Reference of the Mechanism, notably with regards to the participation of civil society and transparency;- We support the work of the Financial Action Task Force (FATF) to continue to identify and engage those jurisdictions with strategic Anti-Money Laundering/Counter-Financing of Terrorism (AML/CFT) deficiencies and update and implement the FATF _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 59. standards calling for transparency of cross-border wires, beneficial ownership, customer due diligence and enhanced due diligence;- We agree on a work program which includes a framework for asset recovery, building on the World Banks Stolen Asset Recovery (StAR) Initiative, whistle-blowers protection, denial of entry to corrupt officials and public sector transparency, including fair and transparent public procurement, with concrete results by the end of 2012.87. We welcome initiatives aimed at increasing transparency in therelationship between private sector and government, including voluntaryparticipation in the Extractive Industries Transparency Initiative (EITI).We also acknowledge the steps taken by some of us to request companiesin the extractive industry to publish what they pay in countries ofoperation and to support the Construction Sector Transparency Initiative(CoST).88. We commend the enhanced engagement of the private sector to fightagainst corruption. We welcome the commitments by the B20 to build onour Action Plan and urge them to take concrete action.89. We hold ourselves accountable for our commitments and will reviewprogress at our next Summit.Governance90. We welcome the report of UK Prime Minister David Cameron onglobal governance.91. As our premier Forum for international economic cooperation, theG20 is unique in bringing together the major economies, advanced andemerging alike, to coordinate their policies and generate the politicalagreement necessary to tackle the challenges of global economicinterdependence. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 60. It is a Leader-led and informal group and it should remain so. The G20 ispart of the overall framework of international governance.92. We agree that, in order to strengthen its ability to build and sustain thepolitical consensus needed to respond to challenges, the G20 must remainefficient, transparent and accountable.To achieve this, we decide to:- Maintain our focus on the broad global economic challenges;- Bolster our ability to deliver our agenda and work program effectively. We decide to formalise the Troika, made of past, present and future Presidencies to steer the work of the G20 in consultation with its members. We ask our Sherpas to develop working practices for the G20 under the Mexican Presidency;- Pursue consistent and effective engagement with non-members, regional and international organisations, including the United Nations, and other actors, and we welcome their contribution to our work as appropriate. We also encourage engagement with civil society. We request our Sherpas to make us proposals for the next meeting.93. We reaffirm that the G20s founding spirit of bringing together themajor economies on an equal footing to catalyse action is fundamentaland therefore agree to put our collective political will behind oureconomic and financial agenda, and the reform and more effectiveworking of relevant international institutions.94. On December 1st. 2011, Mexico will start chairing the G20. We willconvene in Los Cabos, Baja California, in June 2012, under theChairmanship of Mexico. Russia will chair the G20 in 2013, Australia in2014 and Turkey in 2015.We have also agreed, as part of our reforms to the G20, that after 2015,annual presidencies of the G20 will be chosen from rotating regional _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 61. groups, starting with the Asian grouping comprising of China, Indonesia,Japan and Korea.95. We thank France for its G20 Presidency and for hosting the successfulCannes Summit. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 62. Long-term Investing Can Be Severely Distorted by Inaccurate, Short-term Focus Kai Bucher, Associate Director, Inaccurate measurement of investment values, returns, risks and liabilities can create substantial distortions to long-term investment strategies and drive long-term investors to adopt a short-term orientation, according to the Measurement, Governance and Long-term Investing report, released by the World Economic Forum. Since long-term capital can play an important role in helping to drive economic growth, stabilize financial markets, and provide financial returns to fund pensions, education and other social goods, the report focuses on the often overlooked, yet increasing number of measurement - related challenges that can hinder long-term investing. Among such challenges: Mark-to-market rules require long-term illiquid portfolios to be evaluated relative to a public market benchmark, however, short-term variations in the value of assets held for the long term can lead to shifts in investment policy or execution that hinder success in long-term investing. Poor risk measurements or an inadequate understanding of risk can lead institutions to hold riskier (or less risky) assets than they should otherwise. Staff evaluation and compensation schemes may create a framework that rewards staff for acting against the stated long-term interests of the institution. The report argues that without effective governance, measurement schemes can distort decisions regarding the choice of investments and the time frame over which they are held. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 63. And the lack of meaningful, intuitive measurements for performance andrisk over long-time horizons adds more complexity to long-term investingand the governance of such efforts.“Long-term patient capital is vital to promote sustainable growth, createjobs and solve problems plaguing the global economy today.Yet, as this important paper highlights, a short-term orientation in termsof performance measurement, leadership, media focus and regulatoryconstraints threatens to obstruct long-term investment and deprivesociety of the critical benefits it can provide,” stated Scott Kalb, ChiefInvestment Officer, Korea Investment Corporation (KIC), and Chair ofthe World Economic Forum’s Global Agenda Council on Long-termInvesting.The central conclusion and recommendation of this study is thatgoverning bodies and other external stakeholders need to act on theunderstanding that the performance of long-term investments unfoldsover time periods longer than the quarter or the year, even whenshort-term measurements are used.Such metrics should be placed in context, lest long-term strategies beabruptly and unfortunately revised.“In this report, we consider the impact of different types of measurementsand how, combined with thoughtful governance approaches, institutionscan think more carefully about measuring and supporting their long-termstrategies,” observed Josh Lerner, Jacob H. Schiff Professor ofInvestment Banking, Harvard Business School, and the lead researcherfor the report.“Having a long horizon accentuates the importance of governancemodels, and long-term investors can play a critical role in fosteringleading governance practices, both within their own institutions and forthe companies that they invest in,” remarked Mark Wiseman, ExecutiveVice-President, Investments, Canada Pension Plan Investment Board. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 64. “For long-term investors, good governance that includes a qualifiedboard with a solid long-term orientation and commitment is integral toensuring that they are able to stay the course through economic andinvestment cycles.This report makes the case that without appropriate board oversight onrisk assessment, valuation metrics or compensation structures, investorscan easily lose sight of long-term gains and focus instead on short-termmetrics.”“Although there are numerous metrics for the short-term assessment oflong-term investments, none are without limitations.Good governance therefore is critical to ensure sound decision-makingaround which investments are chosen and for how long they are held,”said Michael Drexler, Senior Director, Head of Investors Industries,World Economic Forum USA.The report was developed by the World Economic Forum in collaborationwith a research team led by Josh Lerner of Harvard Business School.Guidance was provided by the World Economic Forum’s Global AgendaCouncil on Long-term Investing.Leadn _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 65. Basel III – the big issuesSpeech by Andrew Bailey, Director of UK Banks & Building Socieities atthe Seventh City of London Swiss Financial RoundtableThank you for inviting me to speak thismorning.Firstly I do want to take this opportunity to markthe stalwart service that Angela has given to theBritish Bankers’ Association (BBA) over the lastfive years.None of your predecessors can have faced such a difficult task, which youhave carried out with great fortitude.I want to spend my time this morning on the big issues that lie behind thesubject of Basel III and national finishes.Why are we undertaking such wide-ranging reforms?The simple answer, because we have had a major crisis, is not goodenough as an explanation – it explains the timing of the reforms, but thesubstance of them requires more explanation.Let me put forward a number of principles on which I want to focus thismorning.First, achieving a stable financial system will in turn enable thedevelopment of a strong, competitive system, and likewise will foster thestrength of financial centres.Financial stability and competitiveness are not fundamentally in conflict;rather, the former is a necessary but not sufficient condition of the latter,much as stable low inflation is a condition of sustainable economicgrowth. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 66. The key point here is that our respective objectives of stability andcompetitiveness are fundamentally not at odds.Second, the other key objective of the reforms is to achieve the stability ofthe financial system without recourse to public money as the buttress –both implicit dependence and in bad states of the world explicitdependence.This objective has a number of profound consequences, includingplacing the resolution of banks and its planning at the heart of banksupervision.Again, I think this objective of resolvability is fundamentally consistentwith the objective of having a competitive financial system.The reason I believe this strongly is that with well-established resolutiontools and plans, the incentives for governments to want to intervene in theoperations of banks will be reduced.Likewise, as supervisors we should be less interventionist for a bank thatcan be resolved.Of course, resolution is never costless, and this should guide ourinterventions, but other things equal we will be less intrusive where we aremore assured of resolvability.As an example of that approach, I think that with a robust resolution planin place – which can be quite simple for small banks – we should be moreopen to allowing new entrants to start-up, and then sink or swim.This is important because we will only foster more competition if weenable banks to leave the scene if their business model does not work.So, again, an objective of resolvability for banks does support theobjective of competitiveness.The third principle on which I want to focus concerns clarity in theobjectives of supervision. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 67. Put simply, it does not support an effective regime to create unnecessaryuncertainty on the ultimate objectives of prudential supervision – ie howlarge should the capital and funding buffers held by banks eventually be.Lack of clarity in this respect is not in my view conducive to awell-functioning market economy.There are at least two complications here.First, quite sensibly we want supervision to be judgemental, in otherwords to embody sensible flexibility.Likewise, we think that exercising judgement is in large part aboutapplying the Basel III framework on a forward-looking basis in order toassess the vulnerability of institutions to big risks.Indeed, the big switch here was arguably from the Basel I to Basel IIframeworks, which introduced judgement into the capital adequacyframework by allowing firms to use approved models to measure risk.These models are by their nature inherently judgemental tools for bothfirms and supervisors – the question is not whether the model is right inan absolute sense (it won’t be) but whether it helps to form an acceptableview of prudent capital requirements.But, the use of judgement in this way inevitably creates uncertainty onhow it will be applied in the future.The second complication in terms of clarity around the objectives ofsupervision is that we are applying the Basel III changes as a transitionover a number of years.This is wise in terms of the consequences of the change and their impacton the real economy, but it prompts uncertainty over how Augustinianauthorities may be in their approach to transition.Clearly, I think it is fair enough to say that the UK and Switzerland do notlook to be particularly Augustinian in their approaches.I think the key point here for me is to minimise uncertainty and thus tosupport a functioning market economy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 68. I am not a supporter of a system which leaves people guessing what wewill eventually want from banks.Looking at the UK arrangements, it is in my view helpful that a consensusis building around the Independent Commission on Banking’srecommendations of 17% primary loss-absorbing capacity measured on arisk-weighted assets basis, with a core tier one capital or common equitycomponent within that of 10%.All of this should be measured on a Basel III basis, and supported by aleverage ratio, as the ICB recommended.And, there should be clear liquidity standards.Switching to the Basel III capital standard will require a transition wherebanks do restructure their balance sheets and retain more earnings whilethey transition.Providing the objectives are well understood, I believe the banks canmake this transition.But I do accept the challenge that the process needs to be wellunderstood – markets are more likely to give banks credit for theirprudential buffers of capital and liquid assets if they understand theend-points and the ways in which we as supervisors will exercise ourjudgement.An important example of this use of judgement is that when we ask banksto hold prudential buffers we treat them just like that – ie as protectionwhich can be used, and where the response of the supervisor to a firmgoing into a buffer is to require a sensible plan to correct the use of abuffer over a reasonable period of time.To conclude, supervision needs to support banks operating in a marketeconomy.This means earning a sensible rate of return calculated on a basis thatappropriately factors in the amount of risk taken. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 69. I do believe that Basel III is correct to raise prudential requirements; thatis the crucial lesson of the crisis.We are also right in my view to end the dependence on public moneythrough effective resolution techniques.Here, by the way, we should thank a Swiss bank, Credit Suisse, forproviding much of the early thinking to support the notion of bail-in asthe way to end the dependence on public money.But, as policymakers, we need to enable our judgements and standards tobe understood and appropriately predicted so that we support theoperation of banks in a market economy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 70. Remarks by SecretaryGeithner at the OpeningCeremony of the 2012Strategic and EconomicDialogue (S&ED)BEIJING, CHINA - I wouldlike to express our appreciationto President Hu, Vice PremierWang, Councilor Dai, and theircolleagues for welcoming us toBeijing.I would particularly like tothank Vice Premier Wang. TheVice Premier combines a broadstrategic perspective with awell-deserved reputation as ahighly effective problem solver-- a rare combination. He is a fierce defender of China’s interests anddedicated to building a positive, cooperative, and comprehensive bilateraleconomic relationship with the United States.We convened the first Strategic & Economic Dialogue three years ago inthe depth of the most serious threat to the global economy and financialsystem in decades.We worked together to put out the fires of the global financial crisis, andtoday the world is better for it.We have worked to address the inevitable problems in our economicrelationship in a constructive manner and with mutual respect.And both of our nations are better for it. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 71. The diversity of the economic issues we address in this Dialogue reflectsthe breadth and importance of our relationship.We don’t always agree, but we share strong common interests, and werecognize that promoting these common interests requires cooperationand commitment from both sides.As two of the world’s largest trading nations, we both depend on an openglobal trading system in which workers and companies compete on alevel playing field.We have a common interest in promoting productivity growth throughresearch and innovation, by protecting intellectual property and openmarkets.We have a mutual interest in building a global financial system that ismore stable and less prone to crisis.Because of the size and importance of our two economies, we also have ashared responsibility for the global economy.As we have worked to promote economic reforms in the United States andChina, we have worked together to strengthen and reform the IMF andthe World Bank and to mobilize more resources to support developmentin the world’s poorest countries.We have worked together to support Europe’s efforts to better manage itsfinancial crisis.We have worked to build new mechanisms for cooperation oninternational economic and financial issues in the G-20 and the FinancialStability Board.We meet at a time of risk and challenge in the global economy, and weboth face considerable economic challenges at home. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 72. In the United States, we are making progress in repairing the damagefrom the financial crisis and putting in place a stronger foundation forfuture economic growth.We are putting in place a comprehensive program of economic reforms toimprove education, increase investments in scientific research andinnovation, improve incentives for private investment, and reform thefinancial system.And we are working to legislate a comprehensive program of reforms torestore fiscal sustainability, building on tough, 10-year spending cuts weput in place last summer.While there is still a long way to go to recover from the financial crisis, theeconomic expansion in the United States is now more broad based andresilient, and we are significantly more advanced than are the other majordeveloped economies in addressing the imbalances that helped cause ourcrisis.In China, you are in the process of exploring the next frontier of economicreforms, recognizing as your predecessors did more than 30 years ago,that future economic growth will require another fundamental shift ineconomic policy.These new reforms recognize the new reality that China must rely moreon domestic consumption rather than exports, and more on innovation byprivate companies rather than capacity expansion by state ownedenterprises, with an economy more open to competition from foreignfirms, and with a more modern financial system.The United States has a strong interest in the success of these reforms, asdoes the rest of the world.As we begin this next round of our Strategic and Economic Dialogue, Iwant to reaffirm our commitment to continue to work closely with Chinato build a stronger economic relationship and to build a stronger _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 73. framework for cooperation on global economic issues that can balancethe interests of the two largest economies in the world.China and the United States are both now sources of strength for theglobal economy, and we are moving toward the more balanced, andcomplementary growth strategies that are so important for the world.I hope we are able to make progress during these next two days on therange of issues before us.As President Obama made clear at our first meeting in Washington threeyears ago, we are nations with different political values and traditions,different political and economic systems, and as we recognize thosedifferences, it is important that we are able to talk to each other openlyand make progress on issues that benefit both the Chinese and Americanpeople.We will approach these issues with appreciation for the challenges youface in China and with confidence that China is strong enough toembrace the reforms we seek. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 74. Very InterestingNEW CODE OF CORPORATEGOVERNANCESingapore, 2 MAY 2012Principle:1 Every company should be headed by aneffective Board to lead and control thecompany.The Board is collectively responsible for the long-term success of thecompany.The Board works with Management to achieve this objective andManagement remains accountable to the Board.Guidelines:1.1 The Boards role is to:(a) Provide entrepreneurial leadership, set strategic objectives, andensure that the necessary financial and human resources are in place forthe company to meet its objectives;(b) Establish a framework of prudent and effective controls which enablesrisks to be assessed and managed, including safeguarding ofshareholders interests and the companys assets;(c) Review management performance;(d) Identify the key stakeholder groups and recognise that theirperceptions affect the companys reputation; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 75. (e) Set the companys values and standards (including ethical standards),and ensure that obligations to shareholders and other stakeholders areunderstood and met; and(f) Consider sustainability issues, e.g. environmental and social factors, aspart of its strategic formulation.1.2 All directors must objectively discharge their duties andresponsibilities at all times as fiduciaries in the interests of the company.1.3 The Board may delegate the authority to make decisions to any boardcommittee but without abdicating its responsibility. Any such delegationshould be disclosed.1.4 The Board should meet regularly and as warranted by particularcircumstances, as deemed appropriate by the board members.Companies are encouraged to amend their Articles of Association (orother constitutive documents) to provide for telephonic andvideo-conference meetings.The number of meetings of the Board and board committees held in theyear, as well as the attendance of every board member at these meetings,should be disclosed in the companys Annual Report.1.5 Every company should prepare a document with guidelines settingforth:(a) The matters reserved for the Boards decision; and(b) Clear directions to Management on matters that must be approved bythe Board.The types of material transactions that require board approval under suchguidelines should be disclosed in the companys Annual Report. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 76. 1.6 Incoming directors should receive comprehensive and tailoredinduction on joining the Board.This should include his duties as a director and how to discharge thoseduties, and an orientation program to ensure that they are familiar withthe companys business and governance practices.The company should provide training for first-time director1 in areas suchas accounting, legal and industry-specific knowledge as appropriate.It is equally important that all directors should receive regular training,particularly on relevant new laws, regulations and changing commercialrisks, from time to time.The company should be responsible for arranging and funding thetraining of directors.The Board should also disclose in the companys Annual Report theinduction, orientation and training provided to new and existingdirectors.1.7 Upon appointment of each director, the company should provide aformal letter to the director, setting out the directors duties andobligations.Principle:2 There should be a strong and independent element on the Board, whichis able to exercise objective judgement on corporate affairsindependently, in particular, from Management and 10% shareholders.No individual or small group of individuals should be allowed todominate the Boards decision making.Guidelines: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 77. 2.1 There should be a strong and independent element on the Board, withindependent directors making up at least one-third of the Board.2.2 The independent directors should make up at least half of the Boardwhere:(a) The Chairman of the Board (the "Chairman") and the chief executiveofficer (or equivalent) (the "CEO") is the same person;(b) The Chairman and the CEO are immediate family members;(c) The Chairman is part of the management team; or(d) The Chairman is not an independent director.2.3 An "independent" director is one who has no relationship with thecompany, its related corporations, its 10% shareholders or its officers thatcould interfere, or be reasonably perceived to interfere, with the exerciseof the directors independent business judgement with a view to the bestinterests of the company.The Board should identify in the companys Annual Report each directorit considers to be independent.The Board should determine, taking into account the views of theNominating Committee ("NC"), whether the director is independent incharacter and judgement and whether there are relationships orcircumstances which are likely to affect, or could appear to affect, thedirectors judgement.Directors should disclose to the Board any such relationship as and whenit arises.The Board should state its reasons if it determines that a director isindependent notwithstanding the existence of relationships orcircumstances which may appear relevant to its determination, includingthe following: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 78. (a) A director being employed by the company or any of its relatedcorporations for the current or any of the past three financial years;(b) A director who has an immediate family member who is, or has beenin any of the past three financial years, employed by the company or anyof its related corporations and whose remuneration is determined by theremuneration committee;(c) A director, or an immediate family member, accepting any significantcompensation from the company or any of its related corporations for theprovision of services, for the current or immediate past financial year,other than compensation for board service;(d) A director:(i) Who, in the current or immediate past financial year, is or was; or(ii) Whose immediate family member, in the current or immediate pastfinancial year, is or was, a 10% shareholder of, or a partner in (with 10% ormore stake), or an executive officer of, or a director of, any organisation towhich the company or any of its subsidiaries made, or from which thecompany or any of its subsidiaries received, significant payments ormaterial services (which may include auditing, banking, consulting andlegal services), in the current or immediate past financial year.As a guide, payments aggregated over any financial year in excess ofS$200,000 should generally be deemed significant;(e) A director who is a 10% shareholder or an immediate family memberof a 10% shareholder of the company; or(f) A director who is or has been directly associated with a 10%shareholder of the company, in the current or immediate past financialyear. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 79. The relationships set out above are not intended to be exhaustive, and areexamples of situations which would deem a director to be notindependent.If the Board wishes, in spite of the existence of one or more of theserelationships, to consider the director as independent, it should disclosein full the nature of the directors relationship and bear responsibility forexplaining why he should be considered independent.2.4 The independence of any director who has served on the Boardbeyond nine years from the date of his first appointment should besubject to particularly rigorous review.In doing so, the Board should also take into account the need forprogressive refreshing of the Board.The Board should also explain why any such director should beconsidered independent.2.5 The Board should examine its size and, with a view to determining theimpact of the number upon effectiveness, decide on what it considers anappropriate size for the Board, which facilitates effective decisionmaking.The Board should take into account the scope and nature of theoperations of the company, the requirements of the business and the needto avoid undue disruptions from changes to the composition of the Boardand board committees.The Board should not be so large as to be unwieldy.2.6 The Board and its board committees should comprise directors whoas a group provide an appropriate balance and diversity of skills,experience, gender and knowledge of the company.They should also provide core competencies such as accounting orfinance, business or management experience, industry knowledge, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 80. strategic planning experience and customer-based experience orknowledge.2.7 Non-executive directors should:(a) Constructively challenge and help develop proposals on strategy; and(b) Review the performance of Management in meeting agreed goals andobjectives and monitor the reporting of performance.2.8 To facilitate a more effective check on Management, non-executivedirectors are encouraged to meet regularly without the presence ofManagement.Principle:3 There should be a clear division of responsibilities between theleadership of the Board and the executives responsible for managing thecompanys business.No one individual should represent a considerable concentration ofpower.Guidelines:3.1 The Chairman and the CEO should in principle be separate persons,to ensure an appropriate balance of power, increased accountability andgreater capacity of the Board for independent decision making.The division of responsibilities between the Chairman and the CEOshould be clearly established, set out in writing and agreed by the Board.In addition, the Board should disclose the relationship between theChairman and the CEO if they are immediate family members.3.2 The Chairman should: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 81. (a) Lead the Board to ensure its effectiveness on all aspects of its role;(b) Set the agenda and ensure that adequate time is available fordiscussion of all agenda items, in particular strategic issues;(c) Promote a culture of openness and debate at the Board;(d) Ensure that the directors receive complete, adequate and timelyinformation;(e) Ensure effective communication with shareholders;(f) Encourage constructive relations within the Board and between theBoard and Management;(g) Facilitate the effective contribution of non-executive directors inparticular; and(h) Promote high standards of corporate governance.The responsibilities set out above provide guidance and should not betaken as a comprehensive list of all the duties and responsibilities of aChairman.3.3 Every company should appoint an independent director to be the leadindependent director where:(a) The Chairman and the CEO is the same person;(b) The Chairman and the CEO are immediate family members;(c) The Chairman is part of the management team; or(d) The Chairman is not an independent director.The lead independent director (if appointed) should be available toshareholders where they have concerns and for which contact through the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 82. normal channels of the Chairman, the CEO or the chief financial officer(or equivalent) (the "CFO") has failed to resolve or is inappropriate.3.4 Led by the lead independent director, the independent directorsshould meet periodically without the presence of the other directors, andthe lead independent director should provide feedback to the Chairmanafter such meetings.BOARD MEMBERSHIPPrinciple:4 There should be a formal and transparent process for the appointmentand re-appointment of directors to the Board.Guidelines:4.1 The Board should establish a NC to make recommendations to theBoard on all board appointments, with written terms of reference whichclearly set out its authority and duties.The NC should comprise at least three directors, the majority of whom,including the NC Chairman, should be independent.The lead independent director, if any, should be a member of the NC.The Board should disclose in the companys Annual Report the names ofthe members of the NC and the key terms of reference of the NC,explaining its role and the authority delegated to it by the Board.4.2 The NC should make recommendations to the Board on relevantmatters relating to:(a) The review of board succession plans for directors, in particular, theChairman and for the CEO; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 83. (b) The development of a process for evaluation of the performance of theBoard, its board committees and directors;(c) The review of training and professional development programs for theBoard; and(d) The appointment and re-appointment of directors (including alternatedirectors, if applicable).Important issues to be considered as part of the process for the selection,appointment and re-appointment of directors include composition andprogressive renewal of the Board and each directors competencies,commitment, contribution and performance (e.g. attendance,preparedness, participation and candour) including, if applicable, as anindependent director.All directors should be required to submit themselves for re-nominationand re-appointment at regular intervals and at least once every threeyears.4.3 The NC is charged with the responsibility of determining annually,and as and when circumstances require, if a director is independent,bearing in mind the circumstances set forth in Guidelines 2.3 and 2.4 andany other salient factors.If the NC considers that a director who has one or more of therelationships mentioned therein can be considered independent, it shallprovide its views to the Board for the Boards consideration.Conversely, the NC has the discretion to consider that a director is notindependent even if he does not fall under the circumstances set forth inGuideline 2.3 or Guideline 2.4, and should similarly provide its views tothe Board for the Boards consideration.4.4 When a director has multiple board representations, he must ensurethat sufficient time and attention is given to the affairs of each company. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 84. The NC should decide if a director is able to and has been adequatelycarrying out his duties as a director of the company, taking intoconsideration the directors number of listed company boardrepresentations and other principal commitments.Guidelines should be adopted that address the competing timecommitments that are faced when directors serve on multiple boards.The Board should determine the maximum number of listed companyboard representations which any director may hold, and disclose this inthe companys Annual Report.4.5 Boards should generally avoid approving the appointment of alternatedirectors.Alternate directors should only be appointed for limited periods inexceptional cases such as when a director has a medical emergency.If an alternate director is appointed, the alternate director should befamiliar with the company affairs, and be appropriately qualified.If a person is proposed to be appointed as an alternate director to anindependent director, the NC and the Board should review and concludethat the person would similarly qualify as an independent director, beforehis appointment as an alternate director.Alternate directors bear all the duties and responsibilities of a director.4.6 A description of the process for the selection, appointment andre-appointment of directors to the Board should be disclosed in thecompanys Annual Report.This should include disclosure on the search and nomination process.4.7 Key information regarding directors, such as academic andprofessional qualifications, shareholding in the company and its relatedcorporations, board committees served on (as a member or chairman), _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 85. date of first appointment as a director, date of last re-appointment as adirector, directorships or chairmanships both present and those held overthe preceding three years in other listed companies, and other principalcommitments, should be disclosed in the companys Annual Report.In addition, the companys annual disclosure on corporate governanceshould indicate which directors are executive, non-executive orconsidered by the NC to be independent.The names of the directors submitted for appointment or re-appointmentshould also be accompanied by details and information to enableshareholders to make informed decisions.Such information, which should also accompany the relevant resolution,would include:(a) Any relationships including immediate family relationships betweenthe candidate and the directors, the company or its 10% shareholders;(b) A separate list of all current directorships in other listed companies;and(c) Details of other principal commitments.BOARD PERFORMANCEPrinciple:5 There should be a formal annual assessment of the effectiveness of theBoard as a whole and its board committees and the contribution by eachdirector to the effectiveness of the Board.Guidelines:5.1 Every Board should implement a process to be carried out by the NCfor assessing the effectiveness of the Board as a whole and its board _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 86. committees and for assessing the contribution by the Chairman and eachindividual director to the effectiveness of the Board.The Board should state in the companys Annual Report how theassessment of the Board, its board committees and each director has beenconducted.If an external facilitator has been used, the Board should disclose in thecompanys Annual Report whether the external facilitator has any otherconnection with the company or any of its directors.This assessment process should be disclosed in the companys AnnualReport.5.2 The NC should decide how the Boards performance may beevaluated and propose objective performance criteria.Such performance criteria, which allow for comparison with industrypeers, should be approved by the Board and address how the Board hasenhanced long-term shareholder value.These performance criteria should not be changed from year to year, andwhere circumstances deem it necessary for any of the criteria to bechanged, the onus should be on the Board to justify this decision.5.3 Individual evaluation should aim to assess whether each directorcontinues to contribute effectively and demonstrate commitment to therole (including commitment of time for meetings of the Board and boardcommittees, and any other duties).The Chairman should act on the results of the performance evaluation,and, in consultation with the NC, propose, where appropriate, newmembers to be appointed to the Board or seek the resignation ofdirectors.ACCESS TO INFORMATION _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 87. Principle:6 In order to fulfil their responsibilities, directors should be provided withcomplete, adequate and timely information prior to board meetings andon an on-going basis so as to enable them to make informed decisions todischarge their duties and responsibilities.Guidelines:6.1 Management has an obligation to supply the Board with complete,adequate information in a timely manner.Relying purely on what is volunteered by Management is unlikely to beenough in all circumstances and further enquiries may be required if theparticular director is to fulfil his duties properly.Hence, the Board should have separate and independent access toManagement.Directors are entitled to request from Management and should beprovided with such additional information as needed to make informeddecisions.Management shall provide the same in a timely manner.6.2 Information provided should include board papers and relatedmaterials, background or explanatory information relating to matters tobe brought before the Board, and copies of disclosure documents,budgets, forecasts and monthly internal financial statements.In respect of budgets, any material variance between the projections andactual results should also be disclosed and explained.6.3 Directors should have separate and independent access to thecompany secretary. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 88. The role of the company secretary should be clearly defined and shouldinclude responsibility for ensuring that board procedures are followedand that applicable rules and regulations are complied with.Under the direction of the Chairman, the company secretarysresponsibilities include ensuring good information flows within theBoard and its board committees and between Management andnon-executive directors, advising the Board on all governance matters, aswell as facilitating orientation and assisting with professionaldevelopment as required.The company secretary should attend all board meetings.6.4 The appointment and the removal of the company secretary should bea matter for the Board as a whole.6.5 The Board should have a procedure for directors, either individually oras a group, in the furtherance of their duties, to take independentprofessional advice, if necessary, and at the companys expense.REMUNERATION MATTERSPROCEDURES FOR DEVELOPING REMUNERATIONPOLICIESPrinciple:7 There should be a formal and transparent procedure for developingpolicy on executive remuneration and for fixing the remunerationpackages of individual directors.No director should be involved in deciding his own remuneration.Guidelines:7.1 The Board should establish a Remuneration Committee ("RC") withwritten terms of reference which clearly set out its authority and duties. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 89. The RC should comprise at least three directors, the majority of whom,including the RC Chairman, should be independent.All of the members of the RC should be non-executive directors.This is to minimise the risk of any potential conflict of interest.The Board should disclose in the companys Annual Report the names ofthe members of the RC and the key terms of reference of the RC,explaining its role and the authority delegated to it by the Board.7.2 The RC should review and recommend to the Board a generalframework of remuneration for the Board and key managementpersonnel.The RC should also review and recommend to the Board the specificremuneration packages for each director as well as for the keymanagement personnel.The RCs recommendations should be submitted for endorsement by theentire Board.The RC should cover all aspects of remuneration, including but notlimited to directors fees, salaries, allowances, bonuses, options,share-based incentives and awards, and benefits in kind.7.3 If necessary, the RC should seek expert advice inside and/or outsidethe company on remuneration of all directors.The RC should ensure that existing relationships, if any, between thecompany and its appointed remuneration consultants will not affect theindependence and objectivity of the remuneration consultants.The company should also disclose the names and firms of theremuneration consultants in the annual remuneration report, and includea statement on whether the remuneration consultants have any suchrelationships with the company. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 90. 7.4 The RC should review the companys obligations arising in the eventof termination of the executive directors’ and key managementpersonnels contracts of service, to ensure that such contracts of servicecontain fair and reasonable termination clauses which are not overlygenerous.The RC should aim to be fair and avoid rewarding poor performance.LEVEL AND MIX OF REMUNERATIONPrinciple:8 The level and structure of remuneration should be aligned with thelong-term interest and risk policies of the company, and should beappropriate to attract, retain and motivate(a) The directors to provide good stewardship of the company, and(b) Key management personnel to successfully manage the company.However, companies should avoid paying more than is necessary for thispurpose.Guidelines:8.1 A significant and appropriate proportion of executive directors’ andkey management personnels remuneration should be structured so as tolink rewards to corporate and individual performance.Such performance-related remuneration should be aligned with theinterests of shareholders and promote the long-term success of thecompany.It should take account of the risk policies of the company, be symmetricwith risk outcomes and be sensitive to the time horizon of risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 91. There should be appropriate and meaningful measures for the purpose ofassessing executive directors’ and key management personnelsperformance.8.2 Long-term incentive schemes are generally encouraged for executivedirectors and key management personnel.The RC should review whether executive directors and key managementpersonnel should be eligible for benefits under long-term incentiveschemes.The costs and benefits of long-term incentive schemes should be carefullyevaluated.In normal circumstances, offers of shares or grants of options or otherforms of deferred remuneration should vest over a period of time.The use of vesting schedules, whereby only a portion of the benefits canbe exercised each year, is also strongly encouraged.Executive directors and key management personnel should beencouraged to hold their shares beyond the vesting period, subject to theneed to finance any cost of acquiring the shares and associated taxliability.8.3 The remuneration of non-executive directors should be appropriate tothe level of contribution, taking into account factors such as effort andtime spent, and responsibilities of the directors.Non-executive directors should not be over-compensated to the extentthat their independence may be compromised.The RC should also consider implementing schemes to encouragenon-executive directors to hold shares in the company so as to betteralign the interests of such non-executive directors with the interests ofshareholders. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 92. 8.4 Companies are encouraged to consider the use of contractualprovisions to allow the company to reclaim incentive components ofremuneration from executive directors and key management personnel inexceptional circumstances of misstatement of financial results, or ofmisconduct resulting in financial loss to the company.DISCLOSURE ON REMUNERATIONPrinciple:9 Every company should provide clear disclosure of its remunerationpolicies, level and mix of remuneration, and the procedure for settingremuneration, in the companys Annual Report.It should provide disclosure in relation to its remuneration policies toenable investors to understand the link between remuneration paid todirectors and key management personnel, and performance.Guidelines:9.1 The company should report to the shareholders each year on theremuneration of directors, the CEO and at least the top five keymanagement personnel (who are not also directors or the CEO) of thecompany.This annual remuneration report should form part of, or be annexed tothe companys annual report of its directors.It should be the main means through which the company reports toshareholders on remuneration matters.The annual remuneration report should include the aggregate amount ofany termination, retirement and post-employment benefits that may begranted to directors, the CEO and the top five key management personnel(who are not directors or the CEO). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 93. 9.2 The company should fully disclose the remuneration of eachindividual director and the CEO on a named basis.For administrative convenience, the company may round off thedisclosed figures to the nearest thousand dollars.There should be a breakdown (in percentage or dollar terms) of eachdirectors and the CEOs remuneration earned through base/fixed salary,variable or performance-related income/bonuses, benefits in kind, stockoptions granted, share-based incentives and awards, and other long-termincentives.9.3 The company should name and disclose the remuneration of at leastthe top five key management personnel (who are not directors or theCEO) in bands of S$250,000. Companies need only show the applicablebands.There should be a breakdown (in percentage or dollar terms) of each keymanagement personnels remuneration earned through base/fixedsalary, variable or performance-related income/bonuses, benefits in kind,stock options granted, share-based incentives and awards, and otherlong-term incentives.In addition, the company should disclose in aggregate the totalremuneration paid to the top five key management personnel (who arenot directors or the CEO).As best practice, companies are also encouraged to fully disclose theremuneration of the said top five key management personnel.9.4 For transparency, the annual remuneration report should disclose thedetails of the remuneration of employees who are immediate familymembers of a director or the CEO, and whose remuneration exceedsS$50,000 during the year.This will be done on a named basis with clear indication of theemployees relationship with the relevant director or the CEO. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 94. Disclosure of remuneration should be in incremental bands of S$50,000.The company need only show the applicable bands.9.5 The annual remuneration report should also contain details ofemployee share schemes to enable their shareholders to assess thebenefits and potential cost to the companies.The important terms of the share schemes should be disclosed, includingthe potential size of grants, methodology of valuing stock options,exercise price of options that were granted as well as outstanding,whether the exercise price was at the market or otherwise on the date ofgrant, market price on the date of exercise, the vesting schedule, and thejustifications for the terms adopted.9.6 For greater transparency, companies should disclose moreinformation on the link between remuneration paid to the executivedirectors and key management personnel, and performance.The annual remuneration report should set out a description ofperformance conditions to which entitlement to short-term and long-termincentive schemes are subject, an explanation on why such performanceconditions were chosen, and a statement of whether such performanceconditions are met.ACCOUNTABILITY AND AUDITACCOUNTABILITYPrinciple:10 The Board should present a balanced and understandable assessmentof the companys performance, position and prospects.Guidelines: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 95. 10.1 The Boards responsibility to provide a balanced and understandableassessment of the companys performance, position and prospectsextends to interim and other price sensitive public reports, and reports toregulators (if required).10.2 The Board should take adequate steps to ensure compliance withlegislative and regulatory requirements, including requirements underthe listing rules of the securities exchange, for instance, by establishingwritten policies where appropriate.10.3 Management should provide all members of the Board withmanagement accounts and such explanation and information on amonthly basis and as the Board may require from time to time to enablethe Board to make a balanced and informed assessment of the companysperformance, position and prospects.RISK MANAGEMENT AND INTERNAL CONTROLSPrinciple:11 The Board is responsible for the governance of risk.The Board should ensure that Management maintains a sound system ofrisk management and internal controls to safeguard shareholdersinterests and the companys assets, and should determine the nature andextent of the significant risks which the Board is willing to take inachieving its strategic objectives.Guidelines:11.1 The Board should determine the companys levels of risk toleranceand risk policies, and oversee Management in the design,implementation and monitoring of the risk management and internalcontrol systems. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 96. 11.2 The Board should, at least annually, review the adequacy andeffectiveness of the companys risk management and internal controlsystems, including financial, operational, compliance and informationtechnology controls.Such review can be carried out internally or with the assistance of anycompetent third parties.11.3 The Board should comment on the adequacy and effectiveness of theinternal controls, including financial, operational, compliance andinformation technology controls, and risk management systems, in thecompanys Annual Report.The Boards commentary should include information needed bystakeholders to make an informed assessment of the companys internalcontrol and risk management systems.The Board should also comment in the companys Annual Report onwhether it has received assurance from the CEO and the CFO:(a) That the financial records have been properly maintained and thefinancial statements give a true and fair view of the companys operationsand finances; and(b) Regarding the effectiveness of the companys risk management andinternal control systems.11.4 The Board may establish a separate board risk committee orotherwise assess appropriate means to assist it in carrying out itsresponsibility of overseeing the companys risk management frameworkand policies.AUDIT COMMITTEEPrinciple: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 97. 12 The Board should establish an Audit Committee ("AC") with writtenterms of reference which clearly set out its authority and duties.Guidelines:12.1 The AC should comprise at least three directors, the majority ofwhom, including the AC Chairman, should be independent.All of the members of the AC should be non-executive directors.The Board should disclose in the companys Annual Report the names ofthe members of the AC and the key terms of reference of the AC,explaining its role and the authority delegated to it by the Board.12.2 The Board should ensure that the members of the AC areappropriately qualified to discharge their responsibilities.At least two members, including the AC Chairman, should have recentand relevant accounting or related financial management expertise orexperience, as the Board interprets such qualification in its businessjudgement.12.3 The AC should have explicit authority to investigate any matterwithin its terms of reference, full access to and co-operation byManagement and full discretion to invite any director or executive officerto attend its meetings, and reasonable resources to enable it to dischargeits functions properly.12.4 The duties of the AC should include:(a) Reviewing the significant financial reporting issues and judgementsso as to ensure the integrity of the financial statements of the companyand any announcements relating to the companys financial performance;(b) Reviewing and reporting to the Board at least annually the adequacyand effectiveness of the companys internal controls, including financial, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 98. operational, compliance and information technology controls (suchreview can be carried out internally or with the assistance of anycompetent third parties);(c) Reviewing the effectiveness of the companys internal audit function;(d) Reviewing the scope and results of the external audit, and theindependence and objectivity of the external auditors; and(e) Making recommendations to the Board on the proposals to theshareholders on the appointment, re-appointment and removal of theexternal auditors, and approving the remuneration and terms ofengagement of the external auditors.12.5 The AC should meet(a) With the external auditors, and(b) With the internal auditors, in each case without the presence ofManagement, at least annually.12.6 The AC should review the independence of the external auditorsannually and should state(a) The aggregate amount of fees paid to the external auditors for thatfinancial year, and(b) A breakdown of the fees paid in total for audit and non-audit servicesrespectively, or an appropriate negative statement, in the companysAnnual Report.Where the external auditors also supply a substantial volume of non-auditservices to the company, the AC should keep the nature and extent ofsuch services under review, seeking to maintain objectivity.12.7 The AC should review the policy and arrangements by which staff ofthe company and any other persons may, in confidence, raise concerns _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 99. about possible improprieties in matters of financial reporting or othermatters.The ACs objective should be to ensure that arrangements are in place forsuch concerns to be raised and independently investigated, and forappropriate follow-up action to be taken.The existence of a whistle-blowing policy should be disclosed in thecompanys Annual Report, and procedures for raising such concernsshould be publicly disclosed as appropriate.12.8 The Board should disclose a summary of all the ACs activities in thecompanys Annual Report.The Board should also disclose in the companys Annual Reportmeasures taken by the AC members to keep abreast of changes toaccounting standards and issues which have a direct impact on financialstatements.12.9 A former partner or director of the companys existing auditing firmor auditing corporation should not act as a member of the companys AC:(a) Within a period of 12 months commencing on the date of his ceasingto be a partner of the auditing firm or director of the auditing corporation;and in any case(b) For as long as he has any financial interest in the auditing firm orauditing corporation.INTERNAL AUDITPrinciple:13 The company should establish an effective internal audit function thatis adequately resourced and independent of the activities it audits. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 100. Guidelines:13.1 The Internal Auditors primary line of reporting should be to the ACChairman although the Internal Auditor would also reportadministratively to the CEO.The AC approves the hiring, removal, evaluation and compensation of thehead of the internal audit function, or the accounting / auditing firm orcorporation to which the internal audit function is outsourced.The Internal Auditor should have unfettered access to all the companysdocuments, records, properties and personnel, including access to theAC.13.2 The AC should ensure that the internal audit function is adequatelyresourced and has appropriate standing within the company.For the avoidance of doubt, the internal audit function can be in-house,outsourced to a reputable accounting/auditing firm or corporation, orperformed by a major shareholder, holding company or controllingenterprise with an internal audit staff.13.3 The internal audit function should be staffed with persons with therelevant qualifications and experience.13.4 The Internal Auditor should carry out its function according to thestandards set by nationally or internationally recognised professionalbodies including the Standards for the Professional Practice of InternalAuditing set by The Institute of Internal Auditors.13.5 The AC should, at least annually, review the adequacy andeffectiveness of the internal audit function.SHAREHOLDER RIGHTS AND RESPONSIBILITIESSHAREHOLDER RIGHTS _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 101. Principle:14 Companies should treat all shareholders fairly and equitably, andshould recognise, protect and facilitate the exercise of shareholdersrights, and continually review and update such governance arrangements.Guidelines:14.1 Companies should facilitate the exercise of ownership rights by allshareholders.In particular, shareholders have the right to be sufficiently informed ofchanges in the company or its business which would be likely tomaterially affect the price or value of the companys shares.14.2 Companies should ensure that shareholders have the opportunity toparticipate effectively in and vote at general meetings of shareholders.Shareholders should be informed of the rules, including votingprocedures, that govern general meetings of shareholders.14.3 Companies should allow corporations which provide nominee orcustodial services to appoint more than two proxies so that shareholderswho hold shares through such corporations can attend and participate ingeneral meetings as proxies.COMMUNICATION WITH SHAREHOLDERSPrinciple:15 Companies should actively engage their shareholders and put in placean investor relations policy to promote regular, effective and faircommunication with shareholders.Guidelines: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 102. 15.1 Companies should devise an effective investor relations policy toregularly convey pertinent information to shareholders.In disclosing information, companies should be as descriptive, detailedand forthcoming as possible, and avoid boilerplate disclosures.15.2 Companies should disclose information on a timely basis throughSGXNET and other information channels, including a well-maintainedand updated corporate website.Where there is inadvertent disclosure made to a select group, companiesshould make the same disclosure publicly to all others as promptly aspossible15.3 The Board should establish and maintain regular dialogue withshareholders, to gather views or inputs, and address shareholdersconcerns.15.4 The Board should state in the companys Annual Report the steps ithas taken to solicit and understand the views of the shareholders e.g.through analyst briefings, investor roadshows or Investors Day briefings.15.5 Companies are encouraged to have a policy on payment of dividendsand should communicate it to shareholders. Where dividends are notpaid, companies should disclose their reasons.CONDUCT OF SHAREHOLDER MEETINGSPrinciple:16 Companies should encourage greater shareholder participation atgeneral meetings of shareholders, and allow shareholders the opportunityto communicate their views on various matters affecting the company.Guidelines: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 103. 16.1 Shareholders should have the opportunity to participate effectively inand to vote at general meetings of shareholders.Companies should make the appropriate provisions in their Articles ofAssociation (or other constitutive documents) to allow for absentia votingat general meetings of shareholders.16.2 There should be separate resolutions at general meetings on eachsubstantially separate issue.Companies should avoid "bundling" resolutions unless the resolutionsare interdependent and linked so as to form one significant proposal.16.3 All directors should attend general meetings of shareholders.In particular, the Chairman of the Board and the respective Chairman ofthe AC, NC and RC should be present and available to addressshareholders queries at these meetings.The external auditors should also be present to address shareholdersqueries about the conduct of audit and the preparation and content of theauditors report.16.4 Companies should prepare minutes of general meetings that includesubstantial and relevant comments or queries from shareholders relatingto the agenda of the meeting, and responses from the Board andManagement, and to make these minutes available to shareholders upontheir request.16.5 Companies should put all resolutions to vote by poll and make anannouncement of the detailed results showing the number of votes castfor and against each resolution and the respective percentages.Companies are encouraged to employ electronic polling.THE ROLE OF SHAREHOLDERS IN ENGAGING WITHCOMPANIES IN WHICH THEY INVEST _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 104. The Code on Corporate Governance focuses on providing principles andguidelines to listed companies and their Boards to spur them towards ahigh standard of corporate governance.To ensure that these standards are achieved and sustained in practice,active and constructive shareholder relations is crucial.Bearing in mind the diversity of shareholders in a listed company andtheir differing investment objectives, this statement sets out certain broadviews on the role of shareholders.The objective of creating sustainable and financially sound enterprisesthat offer long-term value to shareholders is best served through aconstructive relationship between shareholders and the Boards ofcompanies.Shareholder inputs on governance matters are useful to strengthen theoverall environment for good governance policies and practices, andconvey shareholders expectations to the Board.By constructively engaging with the Board, shareholders can help to setthe tone and expectation for governance of the company.A shareholders vote at general meetings is a direct way of expressingviews and expectations to the Board.Hence, shareholders should exercise their right to attend generalmeetings and vote responsibly.Where relevant, shareholders should communicate to the Board theirreasons for disagreeing with any proposal tabled at a general meeting.Where appropriate, specific shareholder groups and their associations areencouraged to consider adopting international best practices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 105. Initiatives by relevant industry associations or organisations to developguidelines on their roles as shareholders of listed companies will bewelcomed.For the avoidance of doubt, this statement does not form part of the Codeof Corporate Governance. It is aimed at enhancing the quality ofengagement between shareholders and companies, so as to help drivehigher standards of corporate governance and improve long-term returnsto shareholders.GLOSSARYThe following terms, unless the context requires otherwise, have thefollowing meanings:"AC": Audit Committee"Board": The board of directors of the company"CEO": Chief executive officer or equivalent"CFO": Chief financial officer or equivalent"Chairman": Chairman of the Board"Directly associated": A director will be considered "directly associated"to a 10% shareholder when the director is accustomed or under anobligation, whether formal or informal, to act in accordance with thedirections, instructions or wishes of the 10% shareholder in relation to thecorporate affairs of the corporation.A director will not be considered "directly associated" to a 10%shareholder by reason only of his appointment having been proposed bythat 10% shareholder _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 106. "Immediate family": As currently defined in the Listing Manual, to meanthe persons spouse, child, adopted child, step-child, brother, sister andparent"Key management personnel": The CEO and other persons havingauthority and responsibility for planning, directing and controlling theactivities of the company"NC": Nominating Committee"Principal commitments": Includes all commitments which involvesignificant time commitment such as full-time occupation, consultancywork, committee work, non-listed company board representations anddirectorships and involvement in non-profit organisations.Where a director sits on the Boards of non-active related corporations,those appointments should not normally be considered principalcommitments"Related corporation": In relation to the company, as currently defined inthe Companies Act, to mean a corporation that is the companys holdingcompany, subsidiary or fellow subsidiary"RC": Remuneration Committee"10% shareholder": A person who has an interest or interests in one ormore voting shares in the company; and the total votes attached to thatshare, or those shares, is not less than 10% of the total votes attached to allthe voting shares in the company."Voting shares": exclude treasury sharesReference to any gender shall include reference to any other gender,unless the context otherwise requires. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 107. Testimony on The Collapse of MF Global:Lessons Learned and Policy ImplicationsRobert Cook, Director, Division of Trading andMarkets, U.S. Securities and ExchangeCommission - Before the Committee on Banking,Housing, and Urban Affairs, United States SenateChairman Johnson, Ranking Member Shelby, members of theCommittee:My name is Robert Cook, and I am the Director of the Division ofTrading and Markets at the Securities and Exchange Commission("SEC").Thank you for the opportunity to testify on behalf of the SEC concerningthe collapse of MF Global.The bankruptcy of MF Global has resulted in serious hardship for manyof its customers, who have experienced significant delays and uncertaintywith respect to their ability to access their own assets.More broadly, the firms collapse and the apparent shortfall in customerassets highlight the need for financial firms and regulators to remainvigilant in ensuring that customer assets are appropriately protected andmade readily available to customers whenever they may be needed.To that end, the SEC and its staff are working with the trustee, our fellowfinancial regulators, and other authorities to facilitate the orderlyliquidation of MF Global and the return of MF Global customer assets.While the examination and review of the causes and implications of thecollapse of MF Global are ongoing, my testimony provides an overview ofthe regulation of MF Globals SEC-registered broker-dealer subsidiaryprior to the bankruptcy, the key events leading up to the bankruptcy, the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 108. status of approximately 318 securities accounts in the liquidationproceedings, and the securities customer protection regime.My testimony also describes some implications of MF Globalsbankruptcy for market oversight, as well as a summary of recent efforts bythe SEC to promote sharing of information among regulators, a proposalby the SEC to further strengthen the rules that affect the protection ofcustomer assets, and self-regulatory organization ("SRO") initiatives toenhance the financial responsibility regime for broker-dealers.Regulation of MF Global Prior to its BankruptcyMF Global Holdings Ltd. (together with its subsidiaries, "MF Global")was a publicly traded holding company that conducted financial activitiesthrough a number of subsidiaries located in various countries.MF Global Inc. ("MFGI"), an indirect subsidiary of the holdingcompany, was dually registered with the Commodity Futures TradingCommission ("CFTC") as a futures commission merchant ("FCM") andwith the SEC as a broker-dealer.As of October 31, 2011, MFGI had approximately 36,000 futures customersand approximately 318 custodial accounts for non-affiliated securitiescustomers.MFGI also was authorized by the Federal Reserve Bank of New York toact as a primary dealer in the U.S. Treasury markets.Another affiliate, MF Global UK Limited, was regulated by the U.K.Financial Services Authority ("FSA").There was no consolidated supervisor of MF Global at the holdingcompany level.The "front-line" supervisory function for the securities activities ofbroker-dealers is performed by the SROs, including the FinancialIndustry Regulatory Authority ("FINRA") and the various securitiesexchanges. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 109. When a broker-dealer is a member of multiple SROs, one SRO functionsas the "designated examining authority" ("DEA") responsible in the firstinstance for examining the securities component of the firms financialand operational programs, including its compliance with the SECscapital and customer protection requirements.In the case of MFGI, the DEA was the Chicago Board Options Exchange("CBOE"), although FINRA was also closely involved in the oversight ofMFGIs broker-dealer activities.The futures activities of financial firms, including related segregationrequirements, are overseen by the CFTC and the futures SROs, includingthe National Futures Association and the Chicago Mercantile Exchange.The SEC oversees the regulatory functions of securities SROs andregularly communicates and coordinates with them on examinations andother matters.In its SRO role, CBOE conducted examinations of MFGI for compliancewith financial responsibility rules.FINRA conducted examinations for compliance with other rules, such assales practice requirements.In addition, the SECs national examination program conducts its ownrisk-based examinations of SEC-registered broker-dealers.Unlike some other regulators of financial firms, the SEC does not have an"on site" presence at any broker-dealer and generally does not haveexamination staff dedicated solely to particular broker-dealers.Key Events Leading Up to the BankruptcyAlthough the investigation of the causes of MFGIs collapse is ongoing,we can highlight our current understanding of several key events leadingup to its failure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 110. Capital Treatment of Repo-to-Maturity TransactionsDuring 2010, MFGI started acquiring significant proprietary positions inEuropean sovereign debt, which were financed using an instrumentcalled a "repo-to-maturity" ("RTM").As of March 31, 2011, MFGI had accumulated several billion dollars ofEuropean sovereign debt positions using RTM transactions.In the summer of 2011, based on an analysis of MFGIs financialstatements, FINRA and CBOE staffs questioned MFGI about whetherthe firm was properly recognizing its RTM positions for purposes of itsregulatory net capital computations.The SECs net capital rules (which are similar to those of the CFTC inimportant respects) require broker-dealers, including MFGI, to maintaincertain minimum amounts of liquid capital based on their businessactivities.After consulting with SEC staff, SRO staff informed MFGI that under theSECs rules it must take capital charges for the European sovereignpositions as if they were on the firms balance sheet, notwithstanding thefact that the bonds had been "sold" pursuant to the RTM transactions.In August 2011, representatives of MFGI contacted SEC staff inWashington, D.C., to request a meeting to present the firms view that theRTM positions should be subject to lesser capital charges than thosedetermined by staff from the SROs and SEC.On August 15, 2011, SEC staff met with representatives of MF Global,including its Chief Executive Officer, Jon S. Corzine, to discuss this issue.After further consultations among the regulators, FINRA staff informedMFGI on or around August 24 that the regulators collective view that acapital charge was required for the RTM positions had not changed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 111. Following the resolution of that issue, the regulators also discussed withMFGI:(1) whether MFGI needed to provide a formal net capital deficiencynotice under SEC Rule 17a-11, which generally requires broker-dealers toprovide a "hindsight notice" of any deficiency in their compliance withthe SECs financial responsibility rules; and(2) whether MFGI needed to restate and refile its monthly "FOCUS"report (containing capital and certain other financial information) for July2011, which could result in the net capital deficiency becoming public.Pursuant to Rule 17a-11, once the deficiency was identified, the firm wasrequired to file the "hindsight notice" and, on August 25, it did so.After consulting with SEC staff, SRO staff also required the firm to file anamended FOCUS report for July 2011.On August 31, MFGI amended its FOCUS report for July 2011 to reflectthe required capital charges, reporting a "hindsight" capital deficiency ofapproximately $150 million as of July 31, 2011.At the holding company level, MF Global disclosed the net capital issueregarding the RTM positions at MFGI in an amendment to MF Globalspublic filings on September 1.7Bankruptcy of MF GlobalDuring the week of October 17, 2011, press reports noted that regulatorshad directed MF Global to increase capital at MFGI due to concernsabout MFGIs capital treatment of its RTM positions.On Tuesday, October 25, 2011, MF Global announced quarterly earnings,reporting a net loss of $192 million for the three months ending September30, 2011. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 112. Its stock price declined almost 50 percent that day and continued todecline over the week.During this same week, certain credit rating agencies downgraded thefirms credit rating or put it on negative watch.MF Global informed SEC staff during this week that certaincounterparties and customers were reducing their exposures to MFGI,and MFGI was undertaking significant efforts to reduce the size of itsbalance sheet.SEC staff commenced a continuous on-site presence at MFGIs NewYork office beginning on October 27 to monitor the firms condition, andto engage with senior management regarding the steps that were beingtaken by the firm.On Friday, October 28, MF Global management reported ondevelopments to Chairman Mary Schapiro and SEC staff, includingmyself.According to the firm, it was in discussions with various parties regardingpotential strategic transactions, such as the sale of the firm, the sale of theRTM positions, and the sale of the firms customer business.We continued to receive updates from our on-site staff and from calls withfirm management on Saturday and Sunday, and we continued to consultclosely with other regulators, including the CFTC, FINRA and the FSA.By Sunday afternoon, MF Global reported that the firm was close toconcluding a strategic transaction with a potential purchaser of thecustomer business of MFGI, which could provide customers withcontinued access to their accounts.SEC staff worked closely with the CFTC and FSA to review and commenton the key transaction terms to determine that they provided adequatecustomer protection. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 113. However, MF Global subsequently reported in the early morning hours ofMonday, October 31, that MFGI had identified a significant deficiency inits segregated accounts for futures customers, and that the acquisitionnegotiations had terminated.At that point, after considering MFGIs financial condition and availablealternatives, SEC staff determined, in consultation with the CFTC, thatthe safest and most prudent course of action to protect customer accountsand assets was to initiate a liquidation proceeding under the SecuritiesInvestor Protection Act ("SIPA").A referral was made to the Securities Investor Protection Corporation("SIPC") early in the morning on Monday, October 31.On that same day, the U.S. District Court for the Southern District of NewYork entered an order granting the application of SIPC to commence aliquidation of MFGI under SIPA and appointing James W. Giddens astrustee for the liquidation.The case was then removed to the U.S. Bankruptcy Court for the SouthernDistrict of New York ("Bankruptcy Court").Also on October 31, MF Global Holdings Ltd. separately filed a voluntarybankruptcy petition in the Bankruptcy Court, and MF Global U.K.Limited entered administration proceedings in the United Kingdom.MFGI Liquidation and the Impact on Securities CustomersThe preferred method of returning securities customer assets in a SIPAliquidation generally is to transfer those assets in bulk to another solventbroker-dealer.This approach typically provides customers with access to their securitiesand funds more quickly than the claims process.Accordingly, shortly after the initiation of the SIPA proceeding, thetrustee solicited from other broker-dealers interest in taking over MFGIssecurities customer accounts. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 114. Based on the available expressions of interest, on November 30, 2011, thetrustee filed an expedited motion seeking authorization to sell andtransfer substantially all securities custody accounts to anotherbroker-dealer.This sale and transfer applied to approximately 318 accounts held fornon-affiliated securities customers of MFGI.The transaction was approved by the Bankruptcy Court on December 9,2011.Securities customers are able to trade their securities and use their fundsupon completion of the transfer of their accounts.Moreover, each customer is given the option of maintaining thecustomers securities account at the receiving broker-dealer or movingthe account to a different broker-dealer selected by the customer.According to the trustee, of all former MFGI securities customers, nearlyall have received 60 percent or more of their account value, and 194 havereceived the entirety of their account balances, after giving effect to theprotection afforded by SIPC (up to $500,000).Customers who do not ultimately receive 100 percent of their net equitythrough this initial transfer may be able to receive additional funds, up tothe aggregate amount of their net equity, if the trustee determines thatthere is customer property available for that purpose.Although the claims submission deadline was January 31, 2012, for formerMFGI commodities customers and former MFGI securities customersseeking the maximum protection under SIPA, securities customers andall general claimants may still submit claims to the trustee through June2, 2012.Throughout this process, SEC staff has been working closely with thetrustee and SIPC, seeking to expedite the return of assets to customers ofMFGI. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 115. To that end, SEC staff has been in frequent communication with thetrustee with respect to the status of the transfers and claims made bysecurities customers.Securities Customer Protection RegimeMFGI acted as a "carrying" firm for a small number of securitiescustomers, meaning that it held their funds and securities.MFGI also had additional securities customers for which it executedpurchases and sales of securities but did not hold funds and securities —rather, such securities were held at other custodians that settledtransactions executed through MFGI on a "delivery versus payment"basis.As a broker-dealer registered with the SEC, MFGI was subject to theSECs customer protection rule.This rule requires that each broker-dealer that holds securities or cash forcustomers take two primary steps to safeguard customer property.These steps are designed to protect customer property by prohibitingbroker-dealers from using customer funds and securities to support theirproprietary positions or expenses.Together with the applicable SEC capital requirements, this regime alsois meant to make it more likely that, if the broker-dealer fails, segregatedsecurities and funds will be readily available to be returned to thecustomers.The first step required under the customer protection rule is that thebroker-dealer must maintain physical possession or control oversecurities that customers have paid for in full.This means that if a customer has fully paid for his or her securities, theycannot be used by the broker-dealer in its business — for example, they _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 116. cannot be pledged as collateral to finance the firms own trades or to raisefunds for the firm to invest.Further, if a customer has a margin loan, the customer protection rulestrictly limits the amount of securities that can be used by thebroker-dealer for financing purposes.The goal in both cases is to require broker-dealers to hold customersecurities in a manner that allows those securities to be readily availableto customers, either on demand or upon the liquidation of the firm.The second step required under the customer protection rule is that thebroker-dealer must maintain a reserve in an account at a bank for thebenefit of customers in an amount that exceeds the net funds attributableto customer positions.These funds cannot be invested in any instrument that is not guaranteed,as to principal and interest, by the full faith and credit of the U.S.government.The amount owed to customers must be computed pursuant to aprescribed formula, normally on a weekly basis.A broker-dealer cannot make a withdrawal from the reserve account untilthe next computation, and then only if the computation indicates thatthere is an excess amount in reserve — greater than what is required to bemaintained under the rule.In essence, this requirement complements the protection afforded tosecurities held at a broker-dealer by requiring the firm to maintain areserve of funds or U.S. government guaranteed securities equal to its netcash obligations attributable to customer positions.A broker-dealer that complies with the customer protection rule —isolating customer funds and securities through these steps andseparating them from the firms proprietary business — should be in a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 117. position to return all the securities and funds it owes to customers if itfalls into financial difficulty.If a broker-dealer cannot return all the securities and funds owed tocustomers, SIPC has the responsibility to institute a proceeding underSIPA to liquidate the broker-dealer.Under SIPA, all securities customers share pro rata in the availablesecurities customer property before any other types of creditors of thebroker-dealer.If the available securities customer property is insufficient to return 100percent of the amount owed to securities customers, SIPC may advanceup to $500,000 per customer (of which $250,000 can be used to make up acash shortfall).Implications for Market OversightWhile our near term focus has been on working with SIPC and the trusteeto facilitate the return of securities and funds to customers of MFGI, theSEC will continue to strive to identify further enhancements to itscustomer protection regime that may be appropriate.The events leading up to the bankruptcy of MF Global and its aftermathreinforce the importance of close and ongoing coordination andinformation sharing among regulators and other interested parties.In this case, these parties included not only the SEC and CFTC and otherfederal regulators, but also the SROs, the FSA, SIPC and, following thebankruptcy filing, the trustee.Protection of Customer AssetsWhile our experience with addressing MF Globals failure highlights theimportance of domestic and international regulatory coordination, it alsounderscores the paramount importance of the rules governing protection _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 118. of customer assets and the controls that are crucial for compliance withthose rules.In general, the rules governing protection of customer funds andsecurities that apply to registered broker-dealers, described above, haveworked well over time, but we are considering whether there are ways thatthey could be strengthened.In particular, in June 2011, the SEC proposed rule changes that are meantto clarify and strengthen the rules governing audits of broker-dealers,including an auditors examination of broker-dealer controls relating tothe custody of customer assets, as well as to enhance the SECs oversightof broker-dealers that hold customer securities and funds.Specifically, the proposal would:- Enhance the current requirement that a broker-dealer undergo an annual audit by a public accounting firm registered with the Public Company Accounting Oversight Board by strengthening the standards that govern the auditors examination of the broker-dealers compliance, and internal controls over compliance, with SEC net capital and custody requirements.- Require that broker-dealers that maintain custody of customer assets file with the SEC a new "Form Custody" every quarter.This form would contain more detailed information about howbroker-dealers maintain custody of customer assets in order to furtherfacilitate verification by examiners that customer assets are beingproperly protected.SEC staff has evaluated comments received in response to this proposaland is working to finalize a recommendation to the Commission.More broadly, the staff is evaluating other possible rule changes to thefinancial responsibility requirements, including some previously _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 119. considered by the Commission that could strengthen customerprotection.For example, one change under consideration would be to limit, forpurposes of the customer reserve fund required by Rule 15c3-3, theamount of cash a broker-dealer could maintain in any one bank, as apercentage of capital of the broker-dealer or the bank.The SEC also continues to work with the SROs to help strengthenbroker-dealer financial responsibility requirements.For example, in June 2011, the SEC approved a FINRA rule filing toestablish registration, qualification, examination, and continuingeducation requirements for certain operations — or "back office" —personnel, including those who handle customer assets.This rule should help to better ensure that those responsible foroperations functions are fully versed in all the relevant rules and theirobligations, including those relating to the segregation and protection ofcustomer assets.In addition, in February 2012, the SEC approved a FINRA proposal torequire each member firm to file certain additional financial oroperational schedules or reports to supplement existing requirements tofile FOCUS reports with FINRA pursuant to SEC Rule 17a-5.This rule allows FINRA to receive more granular data pertinent toincome and expense items, and therefore to better identify firms thatwarrant heightened scrutiny and to evaluate industry-wide trends.In February of this year, the SIPC Modernization Task Force, which wasestablished by SIPC for the purpose of undertaking a comprehensivereview of its operations and policies and to propose reforms to modernizeSIPA and SIPC, issued a number of recommendations, includingproposed statutory changes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 120. SEC staff is evaluating these recommendations, several of which aredirected to the scope and dollar limit of protection for individualcustomers in SIPC liquidations.Although SIPC has not itself yet responded to the recommendations, welook forward to discussing them with SIPC as part of our review.Finally, with regard to accounting standards, in March 2012, theChairman of the Financial Accounting Standards Board ("FASB") addeda project to the FASBs agenda to reconsider the accounting anddisclosure requirements for repurchase agreements and similartransactions.The FASB Chairman cited the need to revisit the accountingrequirements to address application issues as a result of changes in themarketplace and to ensure that investors obtain useful information aboutthese transactions.As part of the project, the FASB is expected to reconsider the accountingand disclosures requirements related to RTM transactions.There is ongoing communication between SEC staff and the FASBregarding their standard-setting efforts.Regulatory CooperationGiven the pace of developments in the financial markets generally and, inparticular, how quickly the financial condition of a financial firm that is indistress can deteriorate, the SEC is engaged in a number of efforts — bothdomestic and international — to share more and better data andqualitative assessments of firms and markets, and to do so in a timelyway.Some of these efforts involve coordination with the SROs, in recognitionof their importance as "front-line" supervisors. For example, examinationstaff in the SECs Office of Compliance Inspections and Examinations("OCIE") recently initiated quarterly meetings with FINRA and CBOE _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 121. and semi-annual meetings with the Chicago Stock Exchange ("CHX"),in each case in respect of the SROs capacity as a DEA.Further, OCIE recently has sought to enhance its inter-regulator Summitof Securities Regulators, increasing the frequency with which it convenesand expanding the group of regulators such that it now includes FINRA,CBOE, CHX, the Municipal Securities Rulemaking Board, the NorthAmerican Securities Administrators Association, the Federal ReserveBoard, various Federal Reserve Banks, and the CFTC.The first meeting of the expanded group will take place this month andwill provide an opportunity for this diverse gathering of regulators todiscuss issues and concerns regarding registrants, current regulatorydevelopments, and to identify common risks and collaborationopportunities.In addition to these recent initiatives, the Commission has been a keyparticipant in the Intermarket Surveillance Group ("ISG") since itsformation in the 1980s.The ISG provides a critical venue for sharing investigative informationand surveillance data among domestic and foreign market centers,market regulators, and exchanges, including both securities and futuresexchanges.For many years, the SEC has been engaged in numerous and ongoingefforts to increase cooperation and the flow of information relevant tomarket oversight among international regulators, through various means,including cooperative arrangements, such as memoranda ofunderstanding ("MOU"), informal and formal bilateral discussions, andparticipation in multilateral organizations.In the international sphere, the SEC works closely with both banking andsecurities regulators through various venues, including the FinancialStability Board, IOSCO, the Council of Securities Regulators of theAmericas, the Cross-border Crisis Management Working Group, and theSenior Supervisors Group. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 122. The SEC also has ongoing bilateral dialogues with key internationalregulatory counterparts, including the United Kingdom, India, China,Korea and Turkey.Furthermore, the SEC participates alongside the Department of theTreasury and the Federal Reserve Board in the Financial MarketsRegulatory Dialogue with the European Union.ConclusionThe SEC and its staff are working with our fellow financial regulators andother authorities to facilitate the identification and return of customerassets.We also are engaged in ongoing efforts to increase the exchange amongregulators of information that is relevant to oversight of markets andmarket intermediaries, and are considering measures to furtherstrengthen the existing customer protection regime. I would be pleased toanswer any questions you may have. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 123. Keynote Address: Driving Change to Achieve Independent andHigh Quality AuditsDATE: May 3, 2012SPEAKER(S): Jeanette M. Franzel, Board MemberEVENT: Baruch College Financial Reporting ConferenceLOCATION: New York, NYGood Afternoon,I am honored to be here today at this important conference. I thank all ofyou for your interest in advancing and improving financial reporting andauditing, as evidenced by your participation in this conference today.I am the newest Board Member, appointed in February of this year, andIve been on the job for almost 9 weeks now (not that I am counting).In January 2011, three new members were appointed to the Board, LewFerguson, Jay Hanson, and our Chairman, Jim Doty.With 4 of the 5 Board members being relatively new, we are often referredto as the "new Board." Of course, Steve Harris continues as our seniorstatesman, having been on the Board since 2008.Today, I will provide my impressions and observations from my first nineweeks on the job, as well as an update on the current activities of this verybusy, "new Board."Before I go further, however, I must tell you that the views I express today _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 124. are my personal views and do not necessarily reflect the views of theBoard, any other Board member, or the staff of the PCAOB.Reliability, Role, and Relevance of the AuditAuditors have been given an important role in the capital markets — toprovide assurance to investors, owners, lenders and others that theaudited companys financial statements and related disclosures fairlypresent the institutions financial results in conformity with applicableaccounting and disclosure standards and rules.Clearly, reliable financial statements play a key role in the financialmarkets, which are integral to the success and well-being of Americanhouseholds and businesses, the U.S. economy, and participants andstakeholders from around the world.The securities markets provide a reliable funding mechanism forAmerican — and, increasingly, foreign — businesses.More than half of American households invest their savings in securitiesto provide for retirement, education, and other goals.Our economy is resilient, even in the face of the recent financial crisis, inpart because millions of savers continue to be willing to invest in businessenterprises to fuel growth, growth that results in more workers, moresavings and more investment.This cycle promotes economic wealth, but it relies on the system ofaccurate financial disclosures by public companies to the investors whoentrust capital to them.As we approach the 10th anniversary of the Sarbanes-Oxley Act and 9years of PCAOB operations, we seem to be, once again, in a period ofre-examination of the role, relevance, and reliability of financial audits inprotecting investors and the public interest.Many of the topics currently being debated have been debated over the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 125. decades—auditor independence, the role of audit committees,professional skepticism and objectivity, audit quality, and the auditorsreport, among others.One possible line of response to reevaluating these issues is "we decideddecades ago on this," or "this has worked fine for the last 70 years."Even if these are some of the "same old topics" that have been debatedfor decades, we can also look to the many corporate failures and financialcrises that have occurred over the decades and recognize the importanceof ongoing re-examination and adjustments in the auditing model.First of all, auditing is very difficult and filled with competing tensions,and we can and should continue to learn from years of experience.Secondly, rapid changes in the financial markets, globalization,technology, and how business is conducted continue to drastically impactfinancial reporting and auditing.Often, we are inspired to re-examine financial reporting and auditing inreaction to a crisis. In a way, we may be reacting to the financial crisis andserious economic situation over the past several years.But the current efforts are occurring in a measured and forward-lookingmanner, in addition to looking back to examine the impact of theSarbanes-Oxley Act and PCAOBs accomplishments to date.Also, the profession and its oversight bodies have new information,including a large body of PCAOB inspection results and recent academicresearch that shed light on auditor processes, behavior, and judgments.Role of the PCAOBAs you know, the Sarbanes-Oxley Act of 2002 established the PCAOB tooversee the audits of the financial statements of public companies.In July 2010, the Dodd-Frank Act amended the Sarbanes-Oxley Act and, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 126. among other things, vested the PCAOB with the authority to overseeaudits of broker-dealers.The statutory mission of the PCAOB is to oversee the audits of publiccompanies in order to protect the interests of investors and further thepublic interest in the preparation of informative, accurate, andindependent audit reports.The PCAOB is also charged with overseeing the audits of broker-dealercompliance reports under federal securities laws to promote investorprotection.The PCAOB has four main responsibilities under the Act:- register public accounting firms that audit public companies or broker-dealers;- establish auditing and other professional standards;- conduct and report on regular inspections of registered public accounting firms that audit public companies or broker-dealers; and- conduct investigations and disciplinary proceedings in cases where auditors may have violated certain provisions of the Sarbanes-Oxley Act of 2002, the rules of the PCAOB and the Securities and Exchange Commission, and other laws, rules, and professional standards governing the audits of public companies, brokers, and dealers.Currently, approximately 2,400 firms are registered with the Board.Of those, approximately 516 are firms that reported auditingbroker-dealers but no issuers.In addition, the 2,400 total registered firms include approximately 815firms that reported issuing no audit reports for issuers or broker-dealers,but have nonetheless chosen to register with the PCAOB. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 127. PCAOB annually inspects firms that audit over 100 issuers, while firmsthat issue 100 or fewer audit reports each year are subject to inspectionevery three years.PCAOB does not inspect firms that do not perform audit work for issuers.In addition, PCAOB is currently conducting an interim inspectionprogram for auditors of broker-dealers, and will use information from thisinterim program to guide its decisions about a permanent program,including whether to differentiate among classes of brokers and dealers interms of inspection schedules, and possible exemptions from inspections.During 2011, PCAOB inspected 10 firms that audited more than 100issuers.As part of those inspections, PCAOB inspectors examined portions ofmore than 340 audits.Also during 2011, PCAOB inspected 203 firms in the 3-year category,examining portions of more than 485 audits by those firms.Finally, in the interim inspection program for broker-dealer auditors,PCAOB inspected 8 audit firms in 2011, covering portions of 19 audits ofbroker-dealers.Since it began its inspections operations, the PCAOB has conducted over1800 inspections and reviewed over 7800 audits.PCAOB inspection reports issued to the firms after their inspectionsidentify deficiencies in the firms audit work as well as weaknesses ordeficiencies in the firms quality control policies and procedures.Certain portions of the inspection reports — those dealing withparticularly significant audit deficiencies identified by inspectors — aremade publicly available.With respect to any problems found by the Board in the firms quality _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 128. control systems, firms are given twelve months to remediate those issuesor face publication of the portion of the inspection report describing thoseissues.Remediation is a very important part of the process.It is through these actions that firms propose to correct their qualitycontrol deficiencies in order to drive improvements in auditing.We have seen most firms take their responsibilities for remedial effortsand improvements seriously.In addition to our activities in connection with registering and inspectingfirms, the Board is responsible for setting auditing standards for theaudits of public companies and brokers and dealers.I will talk in a few minutes about some of our priorities in this area.Finally, the PCAOB also has an active Division of Enforcement andInvestigations.To date, the PCAOB has taken 49 disciplinary proceedings against 39registered accounting firms and 52 persons associated with registeredfirms.The sanctions have included censures, fines, suspensions or bars frombeing associated with a registered firm, and revocations of firmregistrations.To date, the Board has revoked the registration of 25 firms, barred 41individuals, and suspended 5 individuals and 1 firms registration.In my short time with the Board, I have put the registration, inspection,standards, and enforcement roles that I have just described into a"bucket" that I think of as the Boards "ordinary business operations."The workload associated with carrying out the Boards "ordinary _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 129. business" is heavy and varied, and is integral to fulfilling the Boardsmission and statutory responsibilities.The information and knowledge we gain from our operations alsoprovides input for the Boards priorities and consideration of longer-terminitiatives in order to promote independent and high quality audits thatprotect investors and further the public interest.PCAOB Priorities and InitiativesPCAOB is in a unique position given the knowledge and informationgained through the inspection program to identify trends and risks in theauditing profession.PCAOB staff and the Board also work one-on-one with firm personneland firm leadership in discussing issues impacting audits, includingeffective audit practices and responses and ways to enhance audit qualityin light of current pressures and risks.The Board also issues practice alerts, summary reports, research notes,interpretative releases and other communications in order to alsocommunicate these issues broadly.Finally, PCAOB uses input from its inspections, task forces, theAcademic community, and other stakeholders in developing its standardssetting agenda.I mentioned earlier the category of the PCAOB workload that I think of as"ordinary business operations."I think of our other work as being in the category of "leadership inprotecting investors and the public interest" by being a driving force forchange when needed, to ensure independent and high quality audits.In this category, we have several layers:- Drive change in the profession to correct gaps in auditing practice _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 130. under the current audit model in order to achieve needed improvements in the near term.- Determine what types of changes are needed in the audit model—including auditing standards, as well as the business model used by the firms in implementing those standards—in order to help ensure reliable audits and investor protection in the future.- Determine through ongoing monitoring whether, at any time, immediate actions are needed to mitigate unusual, emerging risks to financial audits from a variety of factors, including rapid changes and increasing complexity in business operations and financial markets, evolving technology, the global business environment, and other factors.Improvements Needed in Current Audit PracticesRegarding the current gaps in practice, PCAOB inspections continue tofind serious audit deficiencies on a regular basis.In fact, our inspection reports issued during 2011 related to the 2010inspection cycle, including reports on inspections of some of the largestfirms, show a significant and concerning increase in inspection findings.Such deficiencies include cases where auditors issue clean opinions eventhough:- the audit work is incomplete or not properly conducted;- financial statement information is contradicted by other available evidence; and/or- audit conclusions on material issues are based on managements views without independent verification.Clearly improvements are needed in current audit process under currentstandards. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 131. In that regard, the PCAOB staff and Board Members devote considerableattention and time to working with firms to evaluate systemic root causeswithin a firms structure, operations, processes or other areas that detractfrom audit quality or cause deficiencies.When the Board issues inspection reports, the portion of the reportcontaining findings about deficiencies in a firms system of qualitycontrol, referred to as "part 2" of the report, are subject to statutoryrestriction on public disclosure.The firm has 12 months from the issuance of the inspection report toaddress the issues to the Boards satisfaction.The PCAOB staff and Board also spend considerable time evaluatingfirms remediation plans and actions.If a firm does not satisfactorily address any of the quality controlcriticisms within 12 months, the portion of the report discussing theparticular criticism(s) is made publicly available.PCAOB Standards-Setting ActivitiesThe Board uses information that it learns in its inspections and fromother sources to evaluate the need for changes in auditing standards.In developing new standards, the PCAOB also seeks advice from a widevariety of interested stakeholders on ways to improve audits.The Boards standards activities are informed by meetings and dialoguewith investors, auditors, representatives of public companies, members ofthe academic community, and through its Standing Advisory Group.The Board also holds roundtable discussions and other public meetingsto deepen its dialogue with commenters and other interested parties.The Board works closely with the SEC on the development of standards _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 132. and monitors the work of accounting standard setters, such as theFinancial Accounting Standards Board, for developments that may affectauditing.The Board currently has a full agenda for seeking views on ideas andspecific proposals impacting auditing and related professional practicestandards through concept releases, proposed standards, and potentialfuture projects.Concept ReleasesThe Board is currently evaluating comments and feedback on twoconcept releases, one dealing with the auditors reporting model andanother with auditor independence and mandatory firm rotation.These concept releases did not propose new auditing standards.Rather, they sought the publics views on particular matters so that theBoard can better evaluate the need for future standard-setting.- Auditors Reporting Model — On June 21, 2011, the Board issued a concept release to seek public comment on potential changes to the auditors reporting model. Such potential changes could include a supplement to the auditors report in which the auditor would be required to provide additional information about the audit and the auditors view of the companys financial statements (an "Auditors Discussion and Analysis"); required and expanded use of emphasis paragraphs in the auditors report; auditor reporting on other information outside the financial statements; and clarification of certain language in the auditors report. The concept release was preceded by several discussions with the PCAOBs advisory groups, and extensive outreach by PCAOB staff in 2010 and early 2011. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 133. In addition, the Board solicited further comment at a roundtable on Sept. 15, 2011. The deadline for comments on the concept release was Sept. 30, 2011. Staff is currently preparing a proposed standard.- Auditor Independence and Audit Firm Rotation — As a result of PCAOB inspections, the experience of other audit regulators and concerns expressed by investors, the Board issued a concept release Aug. 16, 2011, seeking public comment on a variety of possible approaches to improving auditor independence, objectivity and professional skepticism. As part of that concept release, the Board sought comment on whether a rotation requirement would risk significant cost and disruption and how mandatory rotation would serve the Boards goals of protecting investors and enhancing audit quality. The Board also sought comment on whether other measures could meaningfully enhance auditor independence. The deadline for comments was Dec. 14, 2011. The Board held a public meeting to obtain further comment on the concept release on March 21 and 22, for which the comment period was reopened. Future such public meetings are planned.Proposed standardsThe Board is currently evaluating comments on several proposedstandards and seeking comment on one proposal.- Audits of SEC-Registered Brokers and Dealers — The Dodd-Frank Act gave the PCAOB the authority to oversee auditors of SEC-registered brokers and dealers, including authority to set standards and rules for audits of brokers and dealers. On July 12, 2011, the Board proposed standards dealing with (1) _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 134. examination engagements for compliance reports, (2) review engagements of exemption reports, and (3) auditing supplemental information. The deadline for comments on the proposed PCAOB standards was Sept. 12, 2011. Further action on the Boards proposals is dependent on the SECs adoption of the proposed amendments to its Exchange Act 17a-5 rule.- Transparency — On Oct. 11, 2011, the Board proposed amendments to its standards that would improve the transparency of public company audits by requiring that audit reports disclose the name of the engagement partner as well as the names of other independent public accounting firms and other persons that took part in the audit. The amendments would also require registered public accounting firms to disclose the name of the engagement partner for each audit listed on the firms annual reports filed with the PCAOB. The deadline for comments on the proposed amendments was Jan. 9, 2012.- Communications with Audit Committees — On Dec. 20, 2011, the Board reproposed a new auditing standard, Communications with Audit Committees, and related amendments. The standard is intended to benefit investors by establishing requirements that enhance the relevance and quality of the communications between the auditor and the audit committee. The deadline for comments was Feb. 29, 2012.- Auditing Related Party Transactions — On February 28, 2012, the Board proposed a new standard, Related Parties, as well as amendments to certain PCAOB auditing standards to assist auditors in detecting and addressing the audit risks associated with related _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 135. parties and other unusual transactions. The comment period expires May 15, 2012.Potential future projectsThe Board is also considering possible revisions to standards in thefollowing areas to strengthen and clarify requirements:  auditors use of specialists,  part of the audit performed by other auditors,  assignment and documentation of firm supervisory responsibilities,  fair value measurements,  going concern,  confirmation,  quality control,  codification of PCAOB standards, and  subsequent events.As you can see, the Board is working on an ambitious agenda includingnumerous areas of audit practice aimed at strengthening auditingstandards themselves, while improving audit practices and approaches.Risk Monitoring, Assessment, and ResearchThrough the Office of Research and Analysis, the PCAOB also monitorsinformation obtained from a variety of sources, including PCAOBinspections, public company financial reporting, price and volatilityinformation from debt and equity markets, and corporate governanceinformation in order to identify emerging risks to financial reporting andauditing.This information is then used by PCAOBs inspections, standards setting,and enforcement functions. In addition, information is provided to thepublic, as appropriate. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 136. On March 15, 2011, PCAOB issued its first public "Research Note" toprovide new data on the growth of reverse merger transactions involvingcompanies based in China, Hong Kong, and Taiwan.A reverse merger typically occurs when an operating company mergeswith a U.S. shell company that had previously registered its securities on aU.S. exchange.The Research Note, along with Staff Audit Practice alerts issued in July2010 and October 2011, represented an effort by PCAOB to provide moreinformation to investors and other users of financial statements about theaudit environment for companies from the China region.Additionally, the Office of Research and Analysis performs regularresearch and analysis to support the various efforts of the Board while alsomonitoring risks and identifying emerging issues.Current Legislative InitiativesCurrently, legislation is pending (HR 3503 and S 1907) that would amendthe Sarbanes-Oxley Act of 2002 to make PCAOB disciplinary proceedingsopen to the public.Under the Sarbanes-Oxley Act as it exists today, the PCAOBsdisciplinary proceedings are nonpublic, unless the Board finds there isgood cause for a hearing to be public and each party consents to publichearings.PCAOB disciplinary proceedings remain nonpublic even after a hearinghas been completed and adverse findings made by a disinterested hearingofficer, if the auditors and firms opt to appeal and do not consent to makethe proceedings public.The auditors and audit firms charged with violating applicable laws, rulesor standards have little incentive to consent to public disclosure ofdisciplinary proceedings against them, and in fact, none have ever doneso. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 137. Continued litigation postpones — often for several years — publicdisclosure that the PCAOB has charged the auditor or firm, the nature ofthose charges, and the content of adverse findings.In addition, unlike the authority the Securities Exchange Act of 1934provides the SEC in its administrative proceedings, the PCAOB has noauthority, while litigation is pending, to issue temporary cease-and-desistorders in appropriate cases, to prevent potential further harm to investorsor the public interest.This situation results in a variety of unfortunate consequences for investorprotection and the public interest.The public is denied access to important information regarding PCAOBcases and respondents alleged misconduct — no matter how serious.As a result, investors are unaware that companies in which they may haveinvested are being audited by accountants who have been charged, evensanctioned, by the Board, and meanwhile, the audit firm and associatedpersons may continue to issue audit reports.If the SEC were to bring the same case as the PCAOB, alleging the sameviolations, against the same auditor, the SECs charges would bedisclosed at the time the Commission instituted its proceeding.Any administrative trial would be open to the public.If there were an appeal to the Commission and an oral argument, thepublic could attend. The ability — or inability — of the SECs staff toprove its charges would be a matter of public record.The non-public nature of PCAOBs enforcement proceedings is not goodfor investors, for the auditing profession, or for the public at large.* * * _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 138. The reliability, role, and relevance of financial audits, auditorindependence, and audit quality are enduring themes that we mustregularly monitor and evaluate in order to protect investors and the publicinterest in a dynamic, global business environment.This involves looking beyond the status quo and the current businesscycle.We also need to carefully consider and analyze the potential costs andbenefits of various actions as well as the risks of unintendedconsequences.I am pleased to have the opportunity as a Board member to explore thebroad range of issues impacting the auditing profession as we seek tomake progress to strengthen the reliability and accuracy of audit reports. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 139. SpeechGabriel Bernardino, Chairman of EIOPAEIOPA, Solvency II and the LossAdjusting ProfessionGeneral Assembly of the European Federation ofLoss Adjusting ExpertsPorto, 11 May 2012Important partsI will touch on three main issues:I. What is EIOPA, the European Insuranceand Occupational Pensions Authority forwhom I have the privilege to serve aschairman;II. How Solvency II can contribute to theimprovement of risk management;III. The loss adjusting profession, itsrelevance for the insurance market and the overall society.What is EIOPA?EIOPA is the European supervisory authority for the insurance andoccupational pensions sectors.We are a young organisation: in January, we completed our first year as aEuropean agency, one of the three European Supervisory Authorities inthe financial system.We are an independent Union body with legal personality, accountable tothe European Parliament and the Council.We clearly see our mission, tasks and responsibilities. We see EIOPA’smission in protecting public interest by contributing to the short, medium _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 140. and long term stability and effectiveness of the financial system, for theEU citizens and economy.This mission is pursued by promoting a sound regulatory framework andconsistent supervisory practices in order to protect the rights ofpolicyholders, pension scheme members and beneficiaries and contributeto the public confidence in the European Union’s insurance andoccupational pensions sectors.This is a very important mission if we realize the relevance of insuranceand occupational pensions in the daily life of citizens and on thedevelopment of the economy.The objectives of the new European supervisory authorities, andparticularly of EIOPA, are extremely relevant:  Contribute to a stable and effective financial system;  Promote sound regulation and supervision;  Enhance customer protection;  Ensure the transparent, efficient and orderly functioning of the markets;  Contribute to international supervisory co2ordination;  Avoid regulatory arbitrage;  Ensure equal conditions of competition; and  Implement appropriate regulation and supervision of risks.In order to fulfil these objectives, EIOPA has important powers.We develop technical standards that become binding for all insuranceundertakings in the EU and issue guidelines and recommendations thatnational supervisors apply on a “comply or explain” basis.We settle disagreements between national supervisory authorities in crossborder situations and have a coordinating role in crisis situations. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 141. EIOPA monitors the correct application of the EU law in the differentMember States, by using, if necessary, its powers of investigation in localmarkets.EIOPA and national supervisors are independent from one another, butclosely cooperate with one another.EIOPA does not substitute local authorities.It has its own powers and responsibilities, but day to day supervisionremains a task of the national authorities.The key decision organ of EIOPA is the Board of Supervisors, where theheads of the national supervisory authorities are represented.However, it is very important to mention that the EIOPA Regulationprovides that members of the Board of Supervisors must act withindependence and within the sole interest of the European Union.Most of our decisions are taken by simple majority, some by qualifiedmajority.EIOPA wants to represent an added value to European consumers and tothe European supervisory landscape.In order to fulfil its mandate, EIOPA is building up its own resources andexploiting the knowledge and experience of its Members.This is a very important element. We want to create a truly Europeansupervisory culture. A culture based on best and robust practices.In order to create this culture, I want to bring together all the nationalsupervisory authorities. All of them have an important contribution tomake. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 142. EIOPA’s regulatory tasksEIOPA has been working on Solvency II, advising the EU Commissionon the Level 2 implementing measures.We have also been developing draft technical standards and guidelines onaround 40 different areas of Solvency II.We are doing this in a transparent way by informally consulting with keystakeholders.We plan to publicly consult as soon as the legal framework will allow us todo that.In order to facilitate the preparatory work of insurance undertakings forSolvency II, we launched a number of important public consultations inareas such as the Own Risk and Solvency Assessment (ORSA) andSupervisory Reporting and Public Disclosure, including the Solvency IIXBRL Taxonomy.We continued to work on the Solvency II specifications for example byissuing a joint report on calibration of non life risk factors in the standardformula.EIOPA also provided input into the Commission’s revision of theInsurance Mediation Directive (IMD) by carrying out an extensive surveyof national laws providing for sanctions (both criminal andadministrative) for violations of the provisions of the IMD.The Commission’s legislative proposal (IMD2) is expected soon and I amaware that the Commission intends to capture loss adjusters under thescope of IMD2.Also, on the regulatory side, we delivered our advice to the Commissionon the revision of the IORP Directive. Stability and consumer protectionwere at the core of our advice. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 143. We advocate the use of a consistent and realistic measurement of allassets and liabilities and proposed the adoption of a Key InformationDocument (KID), containing the fundamental elements aboutperformance, costs, charges and risks of defined contribution schemes.I believe that this will help to increase the confidence of consumers in thistype of plans.OversightAt EIOPA, we are committed and motivated to contribute to the creationof a truly European supervisory culture: a culture that promotes stability,enhances transparency and fosters consumer protection.A culture based on intelligent and effective regulation which does notstifle innovation.That is why in the area of oversight we took as a priority our participationin the colleges of supervisors, contributing to a more consistent practice.In the course of 2011, colleges of supervisors with at least one physicalmeeting or teleconference were organized for 69 European insurancegroups.Last year, we set an annual action plan for colleges of supervisors andwere monitoring its actual implementation.In February 2012, EIOPA issued the report on the functioning of collegesin 2011 and the Action Plan 2012 for colleges of supervisors.In the Action Plan, we defined clear timelines within the colleges for thesetting up of an appropriate work plan to deal with the group internalmodel validation process.Consumer protection and financial innovation _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 144. Consumer protection and financial innovation are priority areas forEIOPA.We have prepared Guidelines and a Best Practices Report on ComplaintsHandling by Insurers.With these Guidelines, we intend to fill an existing regulatory gap at EUlevel and promote convergence of regulatory practice.They were the subject of a public consultation at the end of last year andare due to be finalised in the second quarter of 2012.At the end of last year, EIOPA published a Report on Financial Literacyand Education Initiatives by national competent authorities; it was astock take of existing structures/processes in Member States.This was in line with a requirement under our empowering legislation toreview and coordinate such initiatives.We collected data on consumer trends amongst our Members authorities.This helped us to prepare an Initial Overview, analysing and reporting onthose trends.This Overview was published this year in February.The Overview identified three key trends:(i) Consumer protection issues around Payment Protection Insurance(PPI)(ii) Development of unit linked life insurance and(iii) Increased use of comparison websites by consumers.This is just the start of our ongoing monitoring of consumer trends. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 145. And finally, we focused on disclosure and selling practices of VariableAnnuities.This exercise was brought about by the fact that some variable annuitiesproducts may achieve outcomes that are not easy for consumers tounderstand.We consulted on a draft Report at the end of last year and its final versionwas published this year in April.Finally, last year, we organized our first EIOPA Consumer Strategy Daywhere we had the opportunity to discuss important consumer issues withdifferent stakeholders.Financial stabilityEIOPA was also active in the financial stability domain by assessing theresilience of the EU insurance sector to major shocks through the EUwide stress test exercise and by testing different scenarios on the low yieldstress test which shows that the insurance industry would be negativelyaffected if a scenario were to materialize where yields remain low for aprolonged period of time.EIOPA also issues, on a biannual basis, Financial Stability Reports.One of the conclusions we made in our December publication is that“due to significant natural catastrophes during the examined period,reinsurers suffered above average losses.Furthermore, life insurers may be subject to the risk of having insufficientliquidity, which can be emphasised by banking related transactions, e.g.through “liquidity swaps” and similar products as well as due toincreasing surrenders”.Furthermore, EIOPA is contributing to macroprudential discussions andrisk analysis in the context of the European Systemic Risk Board,supported by the establishment of the EIOPA Risk Dashboard. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 146. International relationsEIOPA is fully aware of the importance of international relations in aglobalized world.In this area, we provided final advice to the European Commission on theassessment of the Solvency II equivalence of the Swiss, Bermudan andJapanese supervisory systems and we have started to contribute to thedevelopment of robust international standards by actively participating inthe work of the International Association of Insurance Supervisors (IAIS).During 2011, EIOPA maintained its regulatory and supervisory dialogueswith the US National Association of Insurance Commissioners (NAIC),the China Insurance Regulatory Commission, the Japanese FinancialServices Authority and the Latin American Association of InsuranceSupervisors.EIOPA also enhanced its regular exchanges with the US FederalInsurance Office (FIO) in the context of FIO’s responsibilities forinsurance law harmonisation at US federal level and in the area ofinternational relations.EIOPA’s valuesI would like to say a couple of words about EIOPA’s values.In our daily activities and relations with our members and stakeholders,we are governed by the principles of Independence, Responsibility,Integrity, Transparency, Efficiency and Team Spirit.We aim to be a modern, competent and professional organization that isaware of the expectations of European citizens and wants to ensure thatthey all are taken on board in our strategies and actions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 147. Our goal is to act independently in an effective and efficient way towardsthe creation of a common European supervisory culture – and this shouldnot be just empty words.We consider it our shared responsibility to build a sound framework forthe future of insurance activities; a framework that takes into account thespecificities of their business models.I would like to assure you that we are ambitious in fulfilling ourobligations towards EU citizens and businesses and I am confident thattogether we will succeed.Solvency IIAs you know, Solvency II is the new regulatory regime for the EUinsurance industry and will be implemented on 1 January 2014.Solvency II will bring a better alignment between risk and capital,promoting good risk management practices and fostering transparency.Regulatory regimes are always a result of a balancing act betweendifferent objectives.Solvency II will provide an appropriate basis for increased policyholderprotection and will contribute to reinforce financial stability, allowinginsurance companies to continue to play their natural countercyclical rolein times of stressed markets.Gladly, the Solvency II regime is increasingly being perceived as morethan a “check the box” regulatory exercise that determines capitalrequirements.It requires the European insurance industry to critically analyze its risks,and in the process, assess the true costs attached to them.Today, I would like to talk to you particularly about risk management,which I think is of particular relevance for your profession. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 148. Now, more than ever, insurers need to rely on strong risk managementcapabilities in order to deal with the different challenges posed by theeconomic slowdown, the financial market volatility, the stress onsovereign debt, the demographic changes and the evolving pattern ofnatural catastrophes.During the last decade, not only risk management itself but also itspractical application underwent a major transformation.Improvements in modelling methodology, significant development ofnew internal control instruments, increasing investors’ and analysts’pressure as well as a new generation of risk managers with a more holisticview arriving in the company’s also triggered change.Companies which invested, early and continuously, in establishing aneffective and well integrated risk management are now taking the benefitsfrom that strategic decision.It should not come as a surprise that insurance and reinsuranceundertakings are at the forefront of applying sound and robust practicesof risk management.After all, insurance is in itself a risk management tool and thus theindustry possess a wide range of specific know how and experience in thisarea.Nevertheless, from an historical perspective, risk management has notbeen viewed as a relevant element of the insurance regulatory regime.This has changed with Solvency II.I believe that appropriate risk management is a cornerstone of anymodern risk based regulatory regime and consequently has its own role inthe supervisory process.Solvency II is mostly known for its risk based capital requirementcalculation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 149. However, it is essential to recognize that one of the most importantelements in this regime is the heavy reliance on robust risk managementpractices.Under the Solvency II regime, insurance and reinsurance undertakingsmust have in place an effective risk management system comprisingstrategies, processes and reporting procedures necessary to identify,measure, monitor, manage and report, on a continuous basis the risks, atan individual and at an aggregated level, to which they are or could beexposed, and their interdependencies.Importantly, risk management cannot be seen as a point in timeprocedure.It is a continuous process that should be used in the implementation ofthe undertaking’s overall strategy and should allow an appropriateunderstanding of the nature and significance of the risks to which it isexposed, including its sensitivity to those risks and its ability to mitigatethem.Taking into consideration some lessons learned from the financial crisis,Solvency II identifies a number of elements which are particularlyrelevant for a robust implementation of a risk management system:• First of all, it is paramount to recognize the ultimate responsibility of themanagement body in ensuring that the implemented risk managementsystem is suitable, effective and proportionate to the nature, scale andcomplexity of the risks inherent in the business.• Secondly, the risk management system needs to be documented andcommunicated to the relevant management and staff, to ensure it isembedded within the business.• Thirdly, an effective risk management system should cover all materialrisks the undertaking might be exposed to. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 150. • Finally, and significantly, the risk management system must beintegrated into the organizational structure of the undertaking and itsdecision making processes.From a supervisory perspective, the insurance undertaking’s riskmanagement system must be comprehensive, covering at least areas likeunderwriting and reserving, asset–liability management, investment,liquidity and concentrations, operational risk and reinsurance and otherrisk mitigation techniques.In each of these areas, supervisors have been transparent in theirexpectations towards undertakings.Let me touch particularly on the area of underwriting and reserving.Underwriting risk is at the centre of the insurance business.The risk of loss or of adverse change in the value of insurance liabilities,due to inadequate pricing and reserving assumptions is clearly related tothe quality of the information available and its management.Consequently, supervisors expect that suitable processes and procedureswill be in place to ensure the reliability, sufficiency and adequacy of boththe statistical and accounting data to be considered both in theunderwriting and reserving processes.As part of the system of governance, insurance undertakings should berequired to employ personnel with the skills, knowledge and expertisenecessary to discharge the responsibilities allocated to them properly.Furthermore, insurance undertakings should ensure that effectivesystems are in place to prevent conflicts of interest and that potentialsources of conflicts of interest are identified and procedures areestablished in order to ensure that those involved with theimplementation of the undertaking’s strategies and policies understandwhere conflicts of interest could arise and how such conflicts are to beaddressed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 151. Furthermore, the undertaking should ensure that all policies andprocedures established for underwriting are applied by all distributionchannels of the undertaking insofar as they are relevant for them and thatthey have in place adequate claims management procedures whichshould cover the overall cycle of claims: receipt, assessment, processingand settlement, complaints and dispute settlement and reinsurancerecoverables.I believe that the practical implementation of these requirements is offundamental relevance for the loss adjusting profession.The Loss Adjusting professionThe profession of loss adjuster is crucial for the insurance business andfor the society.The services provided by loss adjusters to insurers and other customersshould be based on professionalism, independence and impartial andaccurate assessment of claims.These are indeed the key words of your federation.Your role is particularly sensitive in the relationship between insurers andtheir clients and claimants.You have a particularly relevant role when dealing with majorcatastrophes.I am aware that, during the years of its existence, FUEDI made a lot ofefforts in maintaining high standards of professional conduct andcompetence, high educational standards as well as unified standards ofcustomer services.I believe that these efforts represent a priceless contribution to the fullyintegrated and reliable insurance market of the European Union and tothe overall reinforcement of consumer protection. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 152. I am sure that, in the near future, the loss adjusting profession will befurther recognized at the EU level.In my opinion, it is fundamental to assure that all loss adjusters workingin the EU follow strict rules of professional conduct includingmaintaining qualities of integrity and impartiality and are bound bysound loss adjusting practices.It is also my belief that proper self regulation is an important tool in thisarea, but nevertheless, some basic principles should be incorporated inthe EU regulatory framework.I am looking forward to work in close cooperation with your professionand with the insurance industry to ensure increased confidence forpolicyholders and beneficiaries in the insurance sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 153. Formation of the Enhanced Disclosure Task ForceThe importance to market confidence of useful disclosure by financialinstitutions of their risk exposures and risk management practices hasbeen underscored in recent years, and the FSB mentioned, in its pressrelease on 20 March 2012, that it will facilitate the formation of aprivate-sector task force to develop principles for improved disclosures.The FSB is pleased to announce that the Enhanced Disclosure TaskForce (EDTF) has been established.The co-chairs of the EDTF are: Hugo Bänziger, Chief Risk Officer andMember of the Management Board, Deutsche Bank; Russell Picot, GroupGeneral Manager and Group Chief Accounting Officer, HSBC Holdingsplc; and Christian Stracke, Managing Director, Member of InvestmentCommittee, and Global Head of Credit Research Group, PIMCO.In addition to the co-chairs, the EDTF initially has 25 senior officials andexperts representing financial institutions, investors and analysts, creditrating agencies, and external auditors. Summary biographies of theco-chairs and a listing of the task force’s initial participants are shown inthe annex to this press release.The primary objectives of the EDTF are(i) to develop principles for enhanced disclosures, based on currentmarket conditions and risks, including ways to enhance the comparabilityof disclosures, and(ii) to identify leading practice risk disclosures presented in annualreports for end-year 2011 based on broad risk areas such as those _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 154. identified in the summary of the first FSB roundtable on risk disclosuresheld in December 2011.The EDTF will have dialogue with standard-setting bodies, such as theInternational Organization of Securities Commissions, the BaselCommittee on Banking Supervision, the International Association ofInsurance Supervisors, the International Accounting Standards Board,the US Financial Accounting Standards Board, and the InternationalAuditing and Assurance Standards Board, at key stages as it develops itsrecommendations.The recommendations of the EDTF are expected to be reported to theFSB and published during October 2012.The FSB will consider holding another international roundtable byend-2012 to facilitate further discussion by investors, financialinstitutions, auditors, standard setters, regulators and supervisors onmarket conditions and risks at that time and the progress towardimproving the transparency of risks and risk management throughrelevant disclosures.Mark Carney, Chairman, FSB, said “We welcome the formation of theEnhanced Disclosure Task Force”.He added “The FSB supports these efforts which, together with theactivities of standard setters, are expected to result in improved riskdisclosure practices by financial institutions that will provide timely anduseful information to investors”.Summary of key themes that arose during an FSB roundtable onrisk disclosureThe FSB held a roundtable on risk disclosure in Basel on 9 December2011. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 155. Eighty-two senior officials and other experts from around the world tookpart in the roundtable, representing investors and analysts, assetmanagers, credit rating agencies, banks, insurance companies, auditfirms, audit regulators, accounting and auditing standard setters, as wellas prudential and market authorities.It fostered a rich and lively dialogue about the current state of risks andrelated disclosures and how to improve their transparency.The key themes that arose during the course of the discussion aresummarised below:Risk disclosure foundationsParticipants generally preferred risk disclosure requirements inaccounting standards and securities regulatory requirements that areprinciples-based rather than rules-based, but investors also called formeasures to improve comparability, such as more consistent riskdisclosure formats or templates.Principles-based approaches, such as those in the IASB’s IFRS 7 (onfinancial instrument disclosure) and the US Securities and ExchangeCommission’s guidance on management’s discussion and analysis(MD&A), may be sufficient to underpin disclosure improvements of thetype discussed at the roundtable without the issuance of new disclosurerequirements, but greater attention needs to be paid to address user needsfor information about emerging risks.A key theme raised was that while participation from the private sector isessential in driving forward leading practice risk disclosures, the publicsector also plays a vital role in promoting financial stability and inencouraging improved disclosure practices.Views of regulators and accounting standard setters.The IASB and FASB discussed their initiatives in recent years to enhancerisk disclosures. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 156. These include IASB improvements in standards for disclosures aboutfinancial instrument risks and valuations, and about offbalance sheetexposures, and FASB enhancements in standards for disclosures aboutcredit risk, valuations and off-balance sheet risks.The two Boards have issued converged standards for disclosures aboutthe gross and net exposures associated with derivatives and certain otherfinancial instruments.Regulators generally acknowledged some recent improvements in riskdisclosure practices but they shared the view that further improvementwould be useful to enhance transparency.Securities regulators noted the benefits of regulators and firms reachingout to key stakeholders about disclosure issues and the importance ofmonitoring information discussed during senior management calls withanalysts and the related presentations, which could provide insights intoways to improve financial report disclosures.They noted, however, that this required significant resources.The Financial Policy Committee of the Bank of England has encouragedimprovements in the quality of disclosures as indicated the Bank’sFinancial Stability Reports in June and December 2011.Participants noted that banks and investors in emerging marketeconomies may not have the capacity to produce and assess moregranular disclosures of the types that some were recommending duringthe roundtable.The role of auditors in risk disclosuresExternal auditors are currently required to consider the risk of materialmisstatement of the financial statements in planning and performing theaudit. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 157. Where the applicable accounting framework requires disclosure in thefinancial statements of information relating to risk, the auditor is requiredto audit that disclosure.The auditor’s responsibility for disclosures in documents accompanyingthe financial statements – such as those in MD&A or the financial reviewsection of financial reports – is generally limited to considering whether itis materially inconsistent with the audited financial statements or amaterial misstatement of fact.Auditors’ roles are also limited with respect to disclosures in interimfinancial reports.Generally, other risk disclosures, such as those in presentations toinvestors and analysts or on a firm’s websites, are not subject to externalauditor’s review.Audit regulators and standard setters summarised their recent guidancewhich included(i) alerts to auditors for assessing and responding to the risk of materialfinancial statement misstatement in this difficult economic environmentand(ii) consultative documents to explore possible improvements in auditorreporting and/or changes in the role of the external auditor fordisclosures outside the financial statements (e.g., risk disclosures inMD&A).They are considering ways of expanding the scope of risk-relatedreporting responsibilities through consultative documents issued in 2011and further work planned for 2012.Challenges remain in areas such as auditability of forward-lookingstatements, application of materiality concepts, and going concernassessments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 158. Improvements needed in financial institution risk disclosuresInvestors and analysts stressed that disclosure that enhances thetransparency of risks and risk management practices helps to buildconfidence in the firm’s management, which can be particularlyimportant to attract debt and equity investors.However, they argued that still many financial firms provide only minimalrisk disclosures or obscure important information in voluminousdisclosures that are not relevant or prioritised.Many participants encouraged that disclosure on past risks no longer ofkey importance should be allowed to be phased out, to ensure morerelevant disclosure and avoid unnecessary reporting burden.Given the current financial market environment, participants expressedthe view that enhanced qualitative and quantitative disclosure isparticularly important in the following areas:Information on governance and risk management strategies.Investors requested better qualitative disclosures about governance, riskmanagement oversight and related controls, and qualitative andquantitative disclosures about risk management practices, risk exposuresand remuneration.Banking and insurance representatives noted the relevance ofinformation about a financial institution’s risk appetite and that riskdisclosures would be most relevant if they were consistent withinformation used internally for risk management purposes.Disclosure should be put in the context of the financial institution’sbusiness model to facilitate market understanding of risk managementpractices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 159. Summary disclosure and benefits of achieving comparabilityParticipants agreed that risk disclosure should be timely, clear,prioritised, consistent and comparable, as highlighted by a recent surveyof financial report users.Many analysts recommended more use of executive summaries of the keyrisk categories, which should include key metrics on entity-wide riskexposure and risk management effectiveness.Disclosures should better differentiate market risk components (e.g.,interest rate, foreign currency and commodity risk as separate disclosurecategories) and firms should avoid voluminous or boilerplate disclosurespresented as a compliance exercise.Some supported the idea of standardised common disclosure templates tofacilitate comparability across firms and jurisdictions and to aidaggregation and assessment of system-wide risks.Others pointed out that risk disclosure should be supported by qualitativeinformation that provides management’s context for measurements andimportant firm-specific considerations.Credit riskWhile acknowledging that some banks have enhanced their disclosures inrecent interim reports, participants encouraged improved disclosureabout exposures to sovereign debt and to other financial institutions.In addition to the areas for potential enhanced credit risk disclosureraised in the FSB Report, including the disclosure of renegotiated loansfor troubled borrowers, participants discussed other areas whereenhanced risk disclosure could be useful, such as:(i) expected credit losses for impaired financial assets,(ii) counterparty exposures, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 160. (iii) derivatives,(iv) off-balance sheet and joint venture structures, and(v) risk concentrations.Liquidity riskParticipants noted the importance of transparency about liquidity andfunding risks, including potentially additional disclosures aboutsensitivity analyses, sources and volume of liquidity buffers, and maturitytables including contingent lending commitments.Given the increasing role of collateral, participants shared the view thatthe degree of asset encumbrance should be disclosed at a reasonableinterim frequency as well as annually.Some mentioned the importance of addressing the liquidity of collateraland the extent of its use and residual availability.Capital adequacy and risk weighted assets (RWAs)Participants said that disclosures on capital planning (including theability of firms to transfer capital across borders) were important.An issue of concern was the resilience of earnings since, for example,extended periods of low interest rates could erode banks’ profit marginsand impose downward pressures on bank capital ratios.Further disclosure about RWAs and their calculation methods would behelpful.Investors noted as a positive development that some banks had started todisclose their regulatory leverage ratios voluntarily. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 161. Pillar 3 disclosureParticipants indicated that the usefulness of Pillar 3 disclosures washampered by difficulties in reconciling the unaudited Pillar 3 informationto the audited financial statements of firms.Participants generally supported more integrated presentation whichwould, for example, better link and allow navigation between the Pillar 3and financial report (e.g., IFRS 7) risk disclosures, align the timing oftheir publication, and achieve more comparability across jurisdictionsand banks.For example, there are several methods available under Pillar 3 fordisclosures about certain risks and collateral.In addition, some noted as important that liquidity information wasincluded in the Pillar 3 framework, as set forth in the Basel Committee’scurrent plans.Scenario and sensitivity analysesSome participants expressed their desire that the results of stress testsshould be disclosed in financial reports, possibly with an indication as towhether the results are reviewed by external auditors.Care should be taken to properly interpret stress test results andsummarise information in a manner useful to investors (e.g., using theimpacts on earnings and capital of a certain change in interest rates,providing relevant information about non-linearity).ConclusionsThe roundtable showed the value of robust exchanges on shortcomings indisclosures among a wide range of private sector and public sectorstakeholders. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 162. The full range of participants – users and providers of disclosures,auditors, regulators and standard setters – agreed that it would beimportant for investors, financial institutions and auditors to developprinciples and formats for better risk disclosures going forward, withinput from standard setters and regulators, as recommended in the FSBReport.Participants noted that these principles and leading practice disclosuresshould be broad in scope to avoid disclosure arbitrage among variousmarket participants.However, some felt that the private sector would not initially be able tocarry forward this work on its own.Some called for more proactive involvement of the official sector underthe current stressed situations where voluntary risk disclosure initiated bysome in the private sector alone might not be sufficient to restoreconfidence quickly.Many expressed the view that the FSB should continue to help encourageand facilitate this work, perhaps by conducting another roundtable in2012 and prompting a task force of investors, analysts, rating agencies,financial institutions, and auditors, with input from standard setters andregulators, to take forward this work.The FSB Plenary has considered the views expressed during theroundtable and by its members and has decided next steps to enhancerisk disclosure practices, as described in its press release in March 2012. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 163. FSA publishes Recovery and Resolution Plan (RRP) updateThe Financial Services Authority (FSA) has published a feedbackstatement setting out the approach being taken by the FSA to ensurefirms develop appropriate recovery plans and resolution packs.The feedback statement provides firms with clarity regarding what theyare expected to do while final rules are being adjusted to take into accountdevelopments in the international arena.A draft of the core rules has been published with today’s feedbackstatement, and final rules will be published in the autumn.The decision to delay the final rules is due to the various significantinternational developments which are relevant to RRP, notably theexpected proposal by the EU Commission for a directive on recovery andresolution.Accordingly, the FSA is publishing today’s feedback statement, alongwith draft ‘core’ rules and an updated information pack.The development and submission of recovery plans and resolution packswill continue as planned and the delay in final rules will not result in a lossof momentum.Large firms involved in the pilot exercise will submit recovery plans andresolution packs by the end of June, as agreed with their supervisors. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 164. Other large firms are expected to provide sufficient information to theirsupervisors to meet the timetable set by the Financial Stability Board(FSB).For all other firms, supervisors will agree the timing and content of theirmaterials bi-laterally.The FSA is also publishing some frequently asked questions with moreinformation on the implementation timetable.The 2008 banking crisis highlighted that firms failed to have effectiveplans in place to deal with financial stresses and potential failure.If firms had put plans in place prior to the advent of the crisis, they maywell have been able to cope better with the stresses that developed andthose failures might have been avoided.The feedback statement is relevant to all UK incorporated deposit-takersand significant UK investment firms with assets exceeding £15 billion.In addition, the FSA intends to consult at a later date, on applying RRPrules to the UK branches of non-EEA firms without UK subsidiaries.It sets out what will be expected of firms with regards to planning for astressed situation which will require a firm to take action to recover orundertake resolution in an orderly manner without the need for publicfunded support.The announcement builds on work published by the FSB and the SpecialResolution Regime (SRR) put in place under the Banking Act 2009.Firms will be required to put in place recovery plans and provideinformation for the authorities to develop resolution plans.Recovery plans aim to reduce the likelihood of failure by requiring firmsto identify options to achieve recovery, to be implemented when a crisisoccurs. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 165. The plans must be developed and maintained by the firm, in coordinationwith the FSA, but they should all have the following features: - sufficient number of material and credible options to cope with a range of scenarios including both firm-specific and market wide stresses; - options which address capital shortfalls, liquidity pressures and profitability issues and should aim to return the firm to a stable and sustainable position; - options that the firm would consider in more severe circumstances such as: disposals of the whole business, parts of the businesses or group entities; raising equity capital which has not been planned for in the firm’s business plan; complete elimination of dividends and variable remuneration; and debt exchanges and other liability management actions;Resolution packs will assist the authorities to wind-down a firm if it failsfor whatever reason.The resolution data and analysis to be provided by firms is intended toidentify significant barriers to resolution, to facilitate the effective use ofthe powers under the SRR and so reduce the risk that taxpayers fundswill be required to support the resolution of the firm.The information provided to the authorities will help to prepare aresolution plan with the following aims:- ensure that resolution can be carried out without public solvency support exposing taxpayers to the risk of loss;- seek to minimise the impact on financial stability;- seek to minimise the effect on UK depositors and consumers;- allow decisions and actions to be taken and executed in a short space of time (or the resolution weekend); _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 166. - identify those economic functions which will need to be continued because the availability of those functions is critical to the UK economy or financial system, or would need to be wound up in an orderly fashion so as to avoid financial instability (critical economic functions);- identify and consider ways of removing barriers which may prevent critical economic functions being resolved successfully;- isolate and identify critical economic functions from non-critical activities which could be allowed to fail; and- enhance cooperation and crisis management planning for global systemically important financial institutions (G-SIFIs) with international regulators.Andrew Bailey, FSA director of banks and building societies, said:“The financial crisis laid bare a complete failure in banks globally to thinkseriously about how they could and would deal with the risk of majorinstability and even failure.The result has been that taxpayers around the world have had to foot thebill in order to support our banking sectors.“Major reforms have been taken forward both nationally andinternationally to increase the strength and resilience of our bankingsectors but we need to maintain the momentum. Recovery andResolution Plans require firms to think ahead and plan for the worst.We will be building on what has been put in place since last year andfirms must continue to develop their plans.” _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 167. Speech by SEC Staff:Address at the Private Equity International Private FundCompliance ForumBy Carlo V. di Florio, Director, Office of Compliance Inspections andExaminations, U.S. Securities and Exchange CommissionNew York, NY, May 2, 2012Q1. Thanks for being with us Carlo. As everyone here is aware, thedeadline has now passed for advisers to large private equity firms toregister with the SEC. Can you discuss what the agency is doing toprepare for the nearly 4000 private fund advisers that are registered withthe Commission?Let me begin by thanking you for inviting me to speak to you today onimportant topics of concern to private equity fund advisers, many ofwhom are newly registered with the Commission as required under theDodd-Frank Act.We in the National Examination Program (“NEP”) have sharedobjectives when it comes to protecting investors, market integrity andcapital formation.Many of you have been charged by your firms with bolstering theircompliance functions to prepare for registration with the Commission.I salute you for the important work that you are undertaking to promotegood risk management, compliance and ethics in the private equity fundsector.My door is always open and I welcome the dialogue and collaboration aswe work together to prevent fraud, improve compliance, monitor risk andinform policy.As you know, the views that I express here today are my own and do notnecessarily reflect the views of the Commission or of my colleagues on thestaff of the Commission. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 168. The Data Profile of New Registrants.This morning I can share with you some new data, as of March 30, 2012,about changes to the population of investment advisers registered withthe Commission as a result of the recent deadline for new private fundregistrants under Dodd-Frank:  There are now close to 4000 IAs that manage one or more private funds registered with the Commission, of which 34 per cent have registered since the effective date of the Dodd-Frank Act.  32 per cent of all advisers that register with us report that they adviser at least one private fund.  Of the roughly 4000 registered private fund advisers, 7 per cent are domiciled in a foreign country (the UK is the most significant).  Registered private fund advisers report that they advise nearly 31,000 private funds with total assets of $8 trillion (16% of total assets managed by all registered advisers).  Based on available information, of the 50 largest hedge fund advisers in the world, 48 are now registered with the Commission. Fourteen of these are new registrants.  Of the 50 largest private equity funds in the world, 37 are now registered with the Commission. 18 of these are new registrants.Examination Strategy.Regarding NEP staff preparations for new registrants, we are identifyingthe unique risks presented by private equity funds, as well as by hedgefunds, based on a number of factors.These include our past examination experience with these types ofregistrants and staff expertise that we have been developing throughhiring and training in anticipation of our new responsibilities.We are also developing information management systems to help usorganize and evaluate the new information we will be collecting on _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 169. private equity firms on new Form PF as well as on Form ADV, to help usidentify where and how best to allocate our examination resources acrossexisting and new registrants.We are also working to ensure the integrity of confidential informationinternally, while also developing processes to ensure that examiners aregiven access to information that will provide them with a betterunderstanding of an entity and allow for better scoping of exams.Based on these factors, we have a three-fold strategy.First, we will have an initial phase of industry outreach and education,sharing our expectations and perceptions of the highest-risk areas.This will be followed by coordinated examinations of a significantpercentage of new registrants, focusing on highest risk areas of theirbusiness, and helping us to risk-rate the new registrants.Finally, we intend to culminate in publication of a series of “after-action”reports on the broad issues, risks and themes identified.All of this will be planned and executed in consideration of otherresponsibilities of the exam program, fulfilling the NEP mission toimprove compliance, prevent fraud, inform policy and monitorindustry-wide and firm-specific risks.Regulatory Expectations.An important part of NEP’s examination strategy for private equityadvisers is to be clear and transparent about our expectations.Registration with the SEC imposes important obligations on newlyregistered advisers.Upon registration, advisers to hedge funds must comply with all of theapplicable provisions of the Advisers Act and the rules that have beenadopted by the SEC.These provisions require, among other things, adopting andimplementing written policies and procedures, designating a chiefcompliance officer, maintaining certain books and records, filing annual _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 170. updates of Form ADV, implementing a code of ethics and ensuring thatadvertising and performance reporting complies with regulatory rules.In addition, once registered, advisers become subject to examinations bythe SEC.Some of the compliance obligations that I want to highlight for youinclude: 1. The “Compliance Rule” requires registered advisers, including hedge fund advisers, to (a) adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and rules that the Commission has adopted under the Advisers Act; (b) conduct a review, no less than annually, of the adequacy of the policies and procedures; and, (c) designate a chief compliance officer who is responsible for administering the policies and procedures.1 2. The “Books and Records Rule” requires registered advisers, including private equity advisers, to make and keep true, accurate and current certain books and records relating to the firm’s investment advisory business. Generally, most books and records must be kept for five years from the end of the year created, in an easily accessible location. 3. Form ADV Updates—Rule 204-1 of the Advisers Act requires registered advisers to complete and file an annual update of Parts 1A and 2A of the Form ADV registration form through Investment Advisers Registration Depository (IARD). Advisers must file an annual updating amendment to Form ADV within 90 days after the end of the firm’s fiscal year. In addition to annual filings, amendments must promptly be filed whenever certain information contained in the Form ADV becomes inaccurate. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 171. 4. The “Code of Ethics Rule” requires a registered adviser to adopt a code of ethics which sets forth the standards of business conduct expected of the adviser’s supervised persons and must address the personal trading of their securities. 5. The “Advertising Rule” prohibits advertisements by investment advisers that are false or misleading advertising or contain any untrue statements of material fact. Advertising, like all statements made to clients or prospective clients, is subject to the general prohibition on fraud under section 206 of the Advisers Act as well as other anti-fraud provisions under the federal securities laws. In addition to specific regulatory requirements, SEC staff has also indicated its view that, if you advertise performance data, the firm should disclose all material facts necessary to avoid any unwarranted inferences.Another important dimension to your responsibilities is that investmentadvisers are “fiduciaries” to their advisory clients – the funds.This means that advisers have a fundamental obligation to act in the bestinterests of their clients and to provide investment advice in their clients’best interests.Investment advisers owe their clients a duty of loyalty and good faith.Advisers to private equity funds should consider some of the followingissues:Fees/Expenses:As a fiduciary, it is important that private equity advisers allocate theirfees and expenses fairly.A firm should clearly disclose to clients the fees that it is earning inconnection with managing investments as well as expense allocationsbetween a firm and its client fund. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 172. Advisers should ensure the timeliness, accuracy and completeness ofsuch reporting.A firm’s disclosure policies and procedures should address the allocationof their fees and expenses.In cases where two funds managed by the same investment adviserco-invest in the same investment vehicle, expenses should be allocatedfairly across both funds.Conflicts of InterestPrivate equity fund advisers should identify any conflicts presented by thetype and structure of investments their funds typically make, and ensurethat such conflicts are properly mitigated and disclosed.Advisers of pooled investment vehicles also have a duty to disclosematerial facts to investors and prospective investors and failure to do somay constitute fraud.As I discussed in my presentation at this conference last year, it is usefulto think about conflicts in the context of the lifecycle of a private equityfund: The Fund-Raising Stage, the Investment Stage, the ManagementStage, and the Exit Stage.Without replicating what I said there, there are a number of conflicts thatarise at particular stages of that lifecycle.For example, in the Fund-Raising Stage there are a number of potentialconflicts around the use of third-party consultants such as placementagents, and potential conflicts between the private equity fund manager,the fund or its investors, around preferential terms in side-letters forexample.There could also be conflicts over how the fund is marketed, particularlywhere marketing materials make representations about returns onprevious investments.In the Investment Stage, among other potential conflicts, there arepotential opportunities for insider trading. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 173. For example, even if the portfolio company has been taken private, a fundmanager serving on its board could learn material non public informationabout public companies that the portfolio company does business with.There may also be opportunities for insider trading when a private equityfirm makes an equity investment in a public company. Other examples ofpotential conflicts at the investment stage include allocation ofinvestment opportunities, and allocation of fees.In the Management Stage some of the same conflicts described in theinvestment stage can also arise.There is also the potential for misleading reporting to current orprospective investors on PE fund performance by selectively highlightingonly the most successful portfolio companies while ignoring orunderweighting portfolio companies that underperform.Finally, in the Exit Stage, which is typically set so that the fund has a10-year lifespan, with scope to extend for up to three 1-year periods(subject to investor approval) there are several other potential conflicts.For example, the manager could claim to need more time to divest thefund of any remaining assets, but have an ulterior motive to accrueadditional management fees.Issues surrounding liquidity events also raise potential conflicts, andvaluation of portfolio assets is again an area of potential concern.Risk ManagementThe management of conflicts of interest is just one part of good riskmanagement.Private equity fund advisers should evaluate their risk managementstructures and processes by asking themselves the following types ofquestions.1) Do the business units manage risks effectively at the fund levels inaccordance with the tolerances and appetites set by the principals and bysenior management of the organization? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 174. 2) Are the key control, compliance and risk management functionseffectively integrated into the structure of the organization while stillhaving the necessary independence, standing and authority to effectivelyidentify, manage and mitigate risk?3) Does the firm have an independent assurance process, whetherthrough an internal audit department or a third party performing acomparable function by independently verifying the effectiveness of thefirm’s compliance, control and risk management functions?4) Do senior managers effectively exercise oversight of enterprise riskmanagement?5) Does the organization have the proper staffing and structure toadequately set its risk parameters, foster a culture of effective riskmanagement, and oversee risk-based compensations systems and the riskprofiles of the firm?Q2 You have spoken extensively about the SEC’s new strategy withregard to other types of financial institutions of engaging seniormanagement and corporate boards. Can you explain what that means inregard to private equity firms?We at NEP have been seeking to strengthen channels of communicationswith senior management across the entire range of entities that weexamine, including broker-dealers, fund complexes, clearing agencies,etc.In the context of private equity firms, of course there often may not be thesame level or complexity of organization that we might find at, forexample, a major broker-dealer.Instead of meeting with senior officers and a board of directors, we mightinstead meet with the principals, senior investment professionals orgeneral partners of the organization.In all instances, our expectations of who we would want to engage aretailored to the structure and nature of the particular entity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 175. But the purposes and goals of this dialog are largely the same regardlessof the titles of the individuals.This helps us to assess the corporate culture and tone being set at the topof organizations.It also furthers our goal of improving compliance, by helping us todetermine if the CCO has the full support and engagement of seniormanagement and the principals (or board of directors, if applicable).In addition, this enables us to understand the firm’s approach toenterprise-wide risk management – e.g., from the perspective of the boardof directors (if one exists) or the principals of the firm, and then fromsenior management.This engagement also gives us a strong overall context for anyexamination of the firm. Finally, these types of communications help usindentify risks across the industry or determine areas of focus not just atthe firm but similar registrants, to help us better allocate and leverage ourresources on the most significant risks.I believe that this approach is good for us, good for CCOs, and good forthe entities that we examine.I hope that you will agree with me that good ethics and risk managementis vital to business success, in private equity just as much as in any otherare of financial services.There is another reason why meeting with firms’ leadership is especiallyimportant in connection with private equity firms.I have said in front of other audiences that an effective risk governanceframework includes three critical lines of defense, which are in turnsupported by senior management and the board of directors or theprincipal owners of the firm. 1. The business is the first line of defense responsible for taking, managing and supervising risk effectively and in accordance with laws, regulations and the risk appetite set by the board and senior management of the whole organization. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 176. 2. Key support functions, such as compliance and ethics or risk management, are the second line of defense. They need to have adequate resources, independence, standing and authority to implement effective programs and objectively monitor and escalate risk issues. 3. Internal Audit is the third line of defense and is responsible for providing independent verification and assurance that controls are in place and operating effectively.While I understand that some private equity firms have not traditionallyhad internal audit functions, I am encouraged to see such functions startto develop, and I hope to see further development of the internal auditfunction.In the meantime, at firms that lack a robust internal audit function theNEP will place even greater weight on assurance that senior managementand the firm’s principals are supporting each of the other two levels byreinforcing the tone at the top, driving a culture of compliance and ethicsand ensuring effective implementation of risk management in keybusiness processes, including strategic planning, capital allocation,performance management and compensation incentives.Q3. You mentioned a National Exam Program that will take a morerisk-based approach in how it exams registered advisers, can youelaborate on how that will look in practice?Let me divide this question into two parts: identifying risks to informwhich candidates to select for examination, and identifying the scope ofindividual examinations.Regarding candidate selection, over the past two years, OCIE hasundertaken a comprehensive set of improvement initiatives designed toimprove the exam process, break down silos, and promote teamwork andcollaboration across the SEC and with other regulatory partners.In particular, OCIE has implemented a National Exam Program, basedaround a risk-focused exam strategy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 177. In 2011 we created a centralized Risk Assessment and Surveillance(“RAS”) Unit to enhance the ability of the National Exam Program toperform more sophisticated data analytics to identify the firms andpractices that present the greatest risks to investors, markets and capitalformation.This risk-based approach is partly a matter of wanting to use ourresources as effectively as possible, and partly a matter of necessity, giventhat the exam program has only been able to cover a very small portion ofthe individuals and entities that register with the Commission, evenbefore new registrants such as are represented in this audience camewithin our purview as a result of the new requirements of the Dodd-FrankAct.It is not possible for me to discuss very specifically all of the risks we arecurrently monitoring, but I can give you an overview of how this processworks.Generally, we rely on four categories of inputs for risk identification.The first is the National Exam Program itself, this includes the leadershipin each program area (the National Associates) and the observations fromour 900 examiners across the nation our tips, complaints and referralsystem, and our RAS Unit.The second is other parts of the Commission, particularly the Division ofRisk, Strategy and Financial Innovation, the Enforcement Division’sAsset Management Unit, the Office of Market Intelligence, and theDivisions of Trading and Markets and Investment Management.Third are other regulators, such as sister federal financial regulators,SROs, state regulators, and foreign regulators. Fourth are externalsources such as trade groups and news media reports.This process of collecting and inventorying risks is a continual, real-timeprocess, and feeds into an annual strategic plan for the National ExamProgram, as well as mid-year assessments of that plan.Based on the risks identified, we then make a top-down assessment ofwhich firms appear to exhibit these risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 178. We also make a bottom-up assessment, based on the data available forour registrants, as to which firms exhibit a higher risk profile given theirbusiness activities and regulatory history.For example, leveraging data and information provided in filings andreports made with the Commission and the SROs, our staff can developrisk profiles of Registrants, their personnel and their business activities.This risk-screening process is particularly challenging for us with regardto private equity funds due to the general lack of data in this area.However, there are a number of risk characteristics that we are likely toconsider, and we expect that as we gain more experience with this sectorof the capital markets we will become more effective in identifying andassessing risks related to private equity.Examples of some basic risk characteristics that we would track includeany information from our TCR system, any material changes in businessactivities such as lines of business or investment strategies, changes inkey personnel, outside business activities of the firm or its personnel, anyregulatory history of the firm or its personnel, anomalies in key metricssuch as fees, performance, disclosures when compared to peers or toprevious periods, and possible financial stress or weaknesses.Regarding the application of risk-based analysis to examinationexecution, we seek to conduct robust pre-exam work and due diligence,leveraging data from the examination selection process so that we canhave focused document requests and interviews that hone in on higherrisk areas.The National Exam Program is also working with all areas of theCommission, particularly the Divisions of Investment Management,Enforcement, and Risk, Strategy and Financial Innovation – to use dataand data analytics to target specific risk areas.In general, the fundamental questions that we are seeking to answer inmost examinations are these:Is the firm’s process for identifying and assessing problems and conflictsof interest that may occur in its activities effective? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 179. Is that process likely to identify new problems and conflicts that mayoccur as the future unfolds?How effective and well-managed are the firm’s policies and procedures,as well as its process for creating and adapting those policies andprocedures, in addressing potential problems and conflicts?Some of the risk areas regarding private equity that might be consideredduring an examination include these: 1. What is the Fund strategy? Does the Fund control portfolio companies or hold only minority positions? Is the strategy to invest with other firms or alone? Does strategy make general sense? Are investments in easily understandable companies? 2. How clear are investor disclosures around ancillary fees (particularly those charged to portfolio companies), management fee offsets and allocation of expenses? How robust are the processes to ensure compliance with those disclosures? 3. Does the firm have a complicated set of diverse products? If so, how are inter-product conflicts managed? These conflicts can arise, for instance, from two products investing in different parts of a deal’s capital structure or products competing for deal allocation. 4. What risks are posed by the life cycle of the funds? For example, for funds approaching the end of their life fund raising may be necessary, in which case risks related to claims about the fund’s track record and valuation should be in focus. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 180. Conversely, a “Zombie” adviser who is unlikely to raise additional capital may be motivated to extract value from its current holdings, in which case risks related to fees, expenses and liquidity would come into focus. For a fund at the beginning of its life cycle, deal allocations between investment vehicles, or other types of favoritism might be a greater focus of concern. 5. How sophisticated and reliable are the processes used by the Fund? Is the valuation process robust, fair and transparent? Are there strong processes for compliance with the fund’s agreements and formation documents? Are compliance and other key risk management and back office functions sufficiently staffed? What is the quality of investor communications? What is the quality of processes to ensure conflict resolution in disputes with or among investors? 6. What is the overall attitude of management towards the examination process, its compliance obligations, and towards risk management generally, compared to its peers?Finally, in our experience with examinations of private funds in the past,we have found that private fund advisers were slightly more likely to havesignificant findings, be cited for a deficiency, or have findings referred toenforcement, than the non-private fund adviser population.Perhaps this was attributable, at least in part, to the fact that many privatefund advisers then, like many of your firms now, were new registrants,and might not have built the compliance systems and controls that otheradvisers with longer experience as regulated entities had put in place.Q4. I suspect conflicts of interest is also part of that risk assessment.Coming back to your earlier comments on conflicts of interest, can you _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 181. elaborate further on what conflicts the agency sees and what firms shoulddo to address them?Based on our experience with private equity firms to date, I would like tomention two factors that seem to be important sources of conflicts ofinterest for these firms.First, many conflicts of interest can arise when fund professionalsco-invest with their clients.Second, fund professionals taking roles at portfolio companies also createa number of conflicts that we will want to look at.Let me hasten to add that there is nothing inherently wrong with either ofthese activities. In particular, fund professionals being active in portfoliocompanies is a part of the PE business model.My point is simply that these activities increase the risk of other conflictsthat need to be managed.From the examinations of private equity firms that we have conducted todate, there are a number of conflicts that we have identified that I canshare with you.These include: a. The profitability of the management company is obviously an important concern for private equity general partners and this creates an incentive to maximize fees and minimize expenses. We have seen instances where expenses that should have been paid by the management company were pushed to the funds and have also seen instances where questionable fees were charged to portfolio companies. In addition, the same manager may be incentivized to be opaque with fee disclosures for fear that fund investors may not see extra fees as being in their best interest and to pursue larger deals which can absorb more fees. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 182. While I have no opinion about the merits of a management company choosing to offer equity shares to the public, I would encourage such firms to consider, as part of their risk management process, whether the short term earnings focus of the public equity markets could exacerbate these conflicts.b. The adviser negotiates more favorable discounts with vendors for itself than it does for the fund;c. The adviser favors side-by-side funds and preferred separate accounts by shifting certain expenses to its less favored funds;d. The adviser puts one or more of the funds that it manages into both equity and debt of a company, which traditionally have conflicting interests, especially during initial pricing and restructuring situations;e. One or more of a private equity firm’s portfolio companies may hire a related party to the adviser to perform consulting or investment banking services. This type of conflict may be remediated through strong disclosures, but we have seen instances where disclosures were not very robust;f. Conflicts between different business lines, where there may be the potential for confidential information to be improperly shared. The traditional means of remediating these types of conflicts is to maintain effective information barriers, but here too we have seen weaknesses in private funds’ practices. For example, we have observed instances of weak or nonexistent controls where the public and private sides of the adviser’s business hold meetings or telephone conversations regarding an issuer about which the private side has confidential information, or poor physical security during business hours over the adviser’s office space such that employees of unrelated financial firms that have offices in the same building could gain access to the adviser’s offices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 183. Q5.I’m sure everyone here would love to be tested on their ability toaddress those conflicts of interest, but for those who don’t, how does afirm stay off your radar? Or if a firm is selected for an exam, how do they,for a lack of better words, end the exam as quickly as possible?The best way to avoid attracting our attention would be to be veryproactive and thoughtful about identifying conflicts, both the ones I havementioned as well as others that you are aware of, and remediating thoseconflicts with strong policies, procedures and other risk controls, as wellas making sure that your firm has a strong ethical culture from top tobottom.If your firm is selected for an examination, things are certain to go betterif you are prepared, know how to readily access data that our examinersare likely to want to see, and have your policies and procedures ready toshow us.Having strong records to document your due diligence on transactionsand on valuations will also help you greatly.It will also be enormously helpful to you and to us if you can show us thatyou have documented ongoing monitoring and testing of theeffectiveness of your policies and procedures.Finally, it is important to be forthcoming about problems.Nothing could be worse than for us to find a problem, through anexamination or through a tip, referral or complaint, that personnel in yourorganization knew about but tried to conceal. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 184. Statistical release: OTC derivativesstatistics at end-December 2011Monetary and Economic DepartmentMay 2012Bank for International SettlementsA summary of the latest statistics onover-the-counter (OTC) derivatives markets.Data at end-December 2011 are not fullycomparable with previous periods because ofan increase in the reporting population.Australia and Spain reported for the first time,expanding the reporting population to dealers headquartered in 13countries.(The other reporting countries are Belgium, Canada, France, Germany,Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdomand the United States.)Total notional amounts outstanding of OTC derivatives amounted to$648 trillion at end-2011 (Graph 1, left-hand panel, and Table 1).Notwithstanding the increase in the reporting population, total notionalamounts declined between end-June and end-December 2011.At the same time, gross market values, which measure the cost ofreplacing existing contracts, increased to $27.3 trillion, driven mainly byan increase in the market value of interest rate contracts.Consequently, gross market values rose from 2.8% of notional amounts atend-June 2011 to 4.2% at end-December 2011. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 185. The rise in gross market values was the largest since the second half of2008.Gross credit exposures, which take account of legally enforceable bilateralnetting agreements, also increased, but not by as much as market values.Gross credit exposures rose to $3.9 trillion, their highest level sinceend-2008 (Graph 1, right-hand panel).At the same time, they declined from 15.2% of gross market values atend-June 2011 to 14.3% at end-2011 as dealers made greater use of nettingto reduce their credit and settlement risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 186. _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • 187. _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)
  • 188. Number 1Press Releases Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation Office of the Comptroller of the CurrencyFor Immediate Release May 14, 2012Agencies Finalize Large Bank Stress Testing GuidanceThe Federal Reserve Board, the Office of the Comptroller of theCurrency, and the Federal Deposit Insurance Corporation on Mondayissued final supervisory guidance regarding stress-testing practices atbanking organizations with total consolidated assets of more than $10billion.The guidance highlights the importance of stress testing at bankingorganizations as an ongoing risk management practice that supports abanking organizations forward-looking assessment of its risks and betterequips it to address a range of adverse outcomes.The recent financial crisis underscored the need for bankingorganizations to incorporate stress testing into their risk managementpractices, demonstrating that banking organizations unprepared forparticularly adverse events and circumstances can suffer acute threats totheir financial condition and viability.This guidance builds upon previously issued supervisory guidance thatdiscusses the uses and merits of stress testing in specific areas of riskmanagement. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 189. The guidance outlines general principles for a satisfactory stress testingframework and describes various stress testing approaches and howstress testing should be used at various levels within an organization.The guidance also discusses the importance of stress testing in capitaland liquidity planning and the importance of strong internal governanceand controls as part of an effective stress-testing framework.The guidance does not implement the stress testing requirements in theDodd-Frank Wall Street Reform and Consumer Protection Act(Dodd-Frank Act) or in the Federal Reserve Boards capital plan rule thatapply to certain companies, as those requirements have been or are beingimplemented through separate proposals by the respective agencies.However, the agencies expect that banking organizations with totalconsolidated assets of more than $10 billion would follow the principlesset forth in the guidance--as well as other relevant supervisoryguidance--when conducting stress testing in accordance with theDodd-Frank Act, the capital plan rule, and other statutory or regulatoryrequirements.DEPARTMENT OF THE TREASURYOffice of the Comptroller of the CurrencyFEDERAL RESERVE SYSTEMFEDERAL DEPOSIT INSURANCE CORPORATIONSupervisory Guidance on Stress Testing for BankingOrganizations with More Than $10 Billion In TotalConsolidated AssetsAGENCIES: Board of Governors of the Federal Reserve System(“Board” or “Federal Reserve”); Federal Deposit Insurance Corporation(“FDIC”); Office of the Comptroller of the Currency, Treasury (“OCC”).ACTION: Final supervisory guidance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 190. SUMMARY: The Board, FDIC and OCC, (collectively, the “agencies”)are issuing this guidance, which outlines high-level principles for stresstesting practices, applicable to all Federal Reserve-supervised,FDIC-supervised, and OCC-supervised banking organizations with morethan $10 billion in total consolidated assets.The guidance highlights the importance of stress testing as an ongoingrisk management practice that supports a banking organization’sforward-looking assessment of its risks and better equips the organizationto address a range of adverse outcomes.DATES: This guidance will become effective on July 23, 2012.I. BackgroundOn June 15, 2011, the agencies requested public comment on jointproposed guidance on the use of stress testing as an ongoing riskmanagement practice by banking organizations with more than $10billion in total consolidated assets (the proposed guidance).The public comment period on the proposed guidance closed on July 29,2011.The agencies are adopting the guidance in final form with certainmodifications that are discussed below (the final guidance).As described below, this guidance does not apply to bankingorganizations with consolidated assets of $10 billion or less.All banking organizations should have the capacity to understand theirrisks and the potential impact of stressful events and circumstances ontheir financial condition.The agencies have previously highlighted the use of stress testing as ameans to better understand the range of a banking organization’spotential risk exposures. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 191. The 2007- 2009 financial crisis further underscored the need for bankingorganizations to incorporate stress testing into their risk management, asbanking organizations unprepared for stressful events and circumstancescan suffer acute threats to their financial condition and viability.The final guidance is intended to be consistent with sound industrypractices and with international supervisory standards.Building upon previously issued supervisory guidance that discusses theuses and merits of stress testing in specific areas of risk management, thefinal guidance provides principles that a banking organization shouldfollow when conducting its stress testing activities.The guidance outlines broad principles for a satisfactory stress testingframework and describes the manner in which stress testing should beemployed as an integral component of risk management that is applicableat various levels of aggregation within a banking organization and thatcontributes to capital and liquidity planning.While the guidance is not intended to provide detailed instructions forconducting stress testing for any particular risk or business area, theguidance describes several types of stress testing activities and how theymay be most appropriately used by banking organizations subject to thisguidance.The final guidance does not implement the stress testing requirementsimposed by the Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank Act) on financial companies regulated by theOCC, FDIC, or Board with total consolidated assets of more than $10billion or by the Board’s capital plan rule on U.S. bank holding companieswith total consolidated assets equal to or greater than $50 billion.The Dodd-Frank Act’s stress testing requirements are beingimplemented through separate notices of proposed rulemaking by therespective agencies.The Board issued the final capital plan rule on November 22, 2011. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 192. In light of these recent rulemaking efforts on stress testing, the guidanceprovides banking organizations with principles for conducting theirstress testing activities to, among other things, ensure that those activitiesare adequately integrated into overall risk management.The agencies expect such companies would follow the principles set forthin the guidance – as well as other relevant supervisory guidance – whenconducting stress testing in accordance with statutory or regulatoryrequirements.II. Discussion of Comments on the Proposed GuidanceThe agencies received 17 comment letters on the proposed guidance.Commenters included financial trade associations, bank holdingcompanies, financial advisory firms, and individuals. Commentersgenerally expressed support for the proposed guidance.However, several commenters recommended changes to, or clarificationof, certain provisions of the proposed guidance, as discussed below.In response to these comments, the agencies have clarified the principlesset forth in the guidance and modified the proposed guidance in certainrespects as described in this section.A. Scope of applicationThe proposed guidance would have applied to all banking organizationssupervised by the agencies with more than $10 billion in totalconsolidated assets.Specifically,- with respect to the OCC, these banking organizations would have included national banking associations and federal branches and agencies; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 193. - with respect to the Board, these banking organizations would have included state member banks, bank holding companies, and all other institutions for which the Board is the primary federal supervisor;- with respect to the FDIC, these banking organizations would have included state nonmember banks and all other institutions for which the FDIC is the primary federal supervisor.The proposed guidance indicated that a banking organization shoulddevelop and implement its stress testing framework in a mannercommensurate with its size, complexity, business activities, and overallrisk profile.Some commenters supported the total consolidated asset threshold (i.e.,more than $10 billion), but others noted the importance and value ofstress testing for smaller banking organizations.Consistent with the proposed guidance, no supervised bankingorganization with $10 billion or less in total consolidated assets is subjectto this final guidance.The agencies believe that $10 billion is the appropriate threshold for theguidance based on the general complexity of firms above this size.However, the agencies note that previously issued supervisory guidanceapplicable to all supervised institutions discusses the use of stress testingas a tool in certain aspects of risk management—such as for commercialreal estate concentrations, liquidity risk management, and interest-raterisk management.The agencies received two comments suggesting that the $10 billion totalconsolidated asset threshold be measured over a four quarter period inorder to minimize the likelihood that temporary asset fluctuations wouldtrigger application of the guidance.The agencies do not establish an asset calculation methodology in thefinal guidance; however, banking organizations with assets near the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 194. threshold should use reasonable judgment and consider, in conjunctionwith their primary federal supervisor as appropriate, whether they shouldconsider preparing to follow the guidance.Three commenters expressed concern that foreign banking organizations(FBOs) are required to follow stress testing guidelines established bytheir home country supervisors and suggested that the agencies giveconsideration to those requirements.When developing the guidance, the agencies sought to ensure that itwould not introduce inconsistencies with internationally agreedsupervisory standards.The agencies recognize that an FBO’s U.S. operations are part of theFBO’s global enterprise subject to requirements of its home country.The agencies provided sufficient flexibility in the proposed guidance sothat the guidance could apply to various types of organizations.In this final guidance, the agencies clarify that certain aspects of theguidance may not apply to U.S. branches and agencies of FBOs (such asthe portions related to capital stress testing) or may apply differently(such as portions related to governance and controls).Supervisors will take these issues into consideration when evaluating theability of U.S. offices of FBOs to meet the principles in the guidance.Two commenters expressed concern regarding the application of theproposed guidance to savings and loan holding companies (SLHCs).They suggested that the Board issue separate guidance for SLHCs, asthese institutions would face a different set of stress testing assumptionsand scenarios than banking organizations.The Board believes that the guidance is instructive to SLHCs to the samedegree it is for bank holding companies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 195. The Federal Reserve became the primary federal supervisor forSLHCs on July 21, 2011, after the agencies published the proposedguidance for public comment but before the end of the comment period.While the Board recognizes that certain differences do exist betweenbank holding companies and SLHCs, the Board believes the guidancecontains flexibility adequate to accommodate the variations in size,complexity, business activities, and overall risk profile of all bankingorganizations that meet the asset threshold.Thus, the guidance anticipates that each banking organization,including each SLHC, would implement stress testing in a mannerconsistent with its own business and risk profile.Similarly, one commenter advocated that the OCC propose separateguidance on stress testing specifically tailored to savings associations.The OCC became the primary federal supervisor for federal savingsassociations on July 21, 2011.While the OCC recognizes that certain differences do exist betweennational banks and federal savings associations, the OCC notes that thefinal guidance contains flexibility adequate to accommodate thevariations in size, complexity, business activities, and overall riskprofile of all banking organizations that meet the asset threshold.Thus, it is also expected that each federal savings association wouldimplement the guidance consistent with its own business and risk profile.Several commenters requested clarification on the linkage between thestress testing guidance and the stress testing requirements in theDodd-Frank Act.In devising the guidance, the agencies endeavored to ensure that theproposed and final guidance is consistent with the stress testingrequirements under the Dodd-Frank Act and believe that the principlesset forth in the final guidance are useful when conducting the stress tests _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 196. required under the Act.Notably, the final guidance was framed broadly to inform a bankingorganization’s use of stress testing in overall risk management, not juststress tests required under the Dodd-Frank Act.Dodd-Frank stress tests would generally be considered part of anorganization’s overall stress testing framework as described in thestress testing guidance.B. Stress Testing PrinciplesAs noted above, the proposed guidance identified and included adiscussion of four key principles for a banking organization’s stresstesting framework and related stress test results, namely that:(1) A banking organization’s stress testing framework should includeactivities and exercises that are tailored to and sufficiently capture thebanking organization’s exposures, activities, and risks;(2) An effective stress testing framework employs multiple conceptuallysound stress testing activities and approaches;(3) An effective stress testing framework is forward-looking and flexible;and(4) Stress test results should be clear, actionable, well supported, andinform decision-making.In the final guidance, the agencies have incorporated a fifth principlespecifying that an organization’s stress testing framework should includestrong governance and effective internal controls.The elements of the fifth principle had been set forth in section VI of theproposed guidance, and the fifth principle does not expand on this aspectof the proposed guidance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 197. Rather, the agencies reorganized this discussion into a fifth principlein order to underscore the importance of governance and controls as a keyelement in a banking organization’s stress testing framework.As noted above, commenters were supportive of the principles-basedapproach and the notion that a banking organization’s stress testingframework should be implemented in a manner commensurate withfactors such as the complexity and size of the organization.With more specific regard to the proposed principles, commenterssuggested that the final guidance address the standardization of stresstesting through the inclusion of common coefficients, models, orbenchmarks.These commenters expressed concerns that banking organizations wouldimplement the principles inconsistently and that standardization wouldhelp regulators conduct comparative analyses across firms.Another commenter suggested that the agencies prescribe more detailedand integrated stress testing between different entities or business unitswithin an organization.The agencies did not modify the guidance in response to thesecomments.A key aspect of the guidance is to provide organizations flexibility on howthey design their individual stress testing frameworks.Thus, each banking organization should design a specific stress testingframework to capture risks relevant to the organization.The agencies believe that prescribing standardized stress tests in thisguidance would have its own inherent limitations and may notappropriately cover a banking organization’s material risks and activities.In addition, commenters suggested that the agencies mandate publicrelease of stress testing results through the guidance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 198. The agencies have considered these comments, but do not believe thefinal guidance is the appropriate place for such a requirement given itsbroader focus on banking organizations’ overall stress testingframeworks.The agencies note, however, that banking organizations may be requiredto disclose information about their stress tests pursuant to other statutory,regulatory, or supervisory requirements.A few commenters stated that a banking organization should explain andjustify the stress testing methodologies it utilizes to its primary federalsupervisor.The agencies note that supervisors will examine firms’ stress testingmethodologies through the supervisory process.One commenter noted that the guidance should explicitly indicate thatliabilities should be part of a banking organization’s stress testingactivities; the agencies intended that stress testing activities would takean organization’s liabilities into account and have clarified this in the finalguidance.Three commenters suggested that operational risk be specificallyreferenced in the guidance.In response, the agencies have clarified in the final guidance thatoperational risk should be among the risks considered by anorganization’s stress testing framework.Another commenter expressed concern that the frequency of stresstesting and communication of results might eventually desensitize seniormanagement to them.The agencies believe that regular review of stress test results is useful –both during periods of economic downturn and benign periods – andhave clarified that such review can help a banking organization track over _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 199. time the impact of ongoing business activities, changes in exposures,varying economic conditions, and market movements on its financialcondition.Aside from the inclusion of a fifth principle as described above, theagencies have otherwise adopted the proposed principles in the finalguidance with only minor additional refinements.C. Stress testing approaches and applicationsThe proposed guidance described certain stress testing approaches andapplications – scenario analysis, sensitivity analysis, enterprise-widetesting, and reverse stress testing – that a banking organization couldconsider using within its stress testing framework, as appropriate.The proposed guidance provided that each banking organization shouldapply these approaches and applications commensurate with its size,complexity, and business profile, and may not need to incorporate all ofthe details described in the guidance.Some commenters questioned the appropriate number and types of stresstest approaches an organization should utilize.The agencies do not believe that specifying a number or particular typesof approaches – including the number of scenarios – is appropriate in theguidance given the wide range of stress testing activities that differentbanking organizations may undertake.A banking organization should choose the approaches that appropriatelyconsider the unique characteristics of that particular organization and therelevant risks it faces.The agencies expect that stress testing methodologies will evolve overtime as banking organizations develop approaches that best capture theirindividual risk profiles. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 200. In addition, the proposed guidance described reverse stress testing as atool that would allow a banking organization to assume a known adverseoutcome, such as suffering a credit loss that causes it to breach aminimum regulatory capital ratio or suffering severe liquidity constraintsmaking it unable to meet its obligations, and then deduce the types ofevents that could lead to such an outcome.This type of stress testing may help a banking organization to considerscenarios beyond its normal business expectations and see the impact ofsevere systemic effects on the banking organization.It also would allow a banking organization to challenge commonassumptions about its performance and expected mitigation strategies.Three commenters expressed doubts regarding the effectiveness ofreverse stress testing, as the approach could produce results ofquestionable value and captures unlikely, “extreme” scenarios.The agencies reiterate the value of reverse stress testing, as it helps abanking organization evaluate the combined effect of several types ofextreme events and circumstances that might threaten the survival of thebanking organization, even if in isolation each of the effects might bemanageable.Another commenter expressed concern that the results of severe scenariosused for reverse stress testing would directly lead to a supervisoryrequirement to raise capital if the results of the approach wereunfavorable to the organization.In addition, some commenters sought clarification that results would notbe used by regulators to criticize banking organizations.As stated in the proposed guidance, a given stress test result will notnecessarily lead to immediate action by a firm, and in some cases stresstest results – including those from reverse stress tests – are most useful forthe additional information they provide. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 201. In terms of supervisory responses to an organization’s stress testingactivities, the agencies expect to consider a banking organization’s stresstest results and the appropriateness of its overall stress testing framework,along with all other relevant information, in assessing a bankingorganization’s risk management practices, as well as its capital andliquidity adequacy.The guidance sets forth supervisory expectations for prudent riskmanagement practices and a firms decision not to follow the principlesin this guidance will be examined as part of the supervisory process andmay be cited as evidence of unsafe and unsound practices.D. Stress testing for assessing adequacy of capital and liquidityGiven the importance of capital and liquidity to a banking organization’sviability, stress testing should be applied to these two areas on a regularbasis.Stress testing for capital and liquidity adequacy should be conducted incoordination with a banking organization’s overall business strategy andannual planning cycles.Results should be refreshed in the event of major strategic decisions, orother changes that can materially impact capital or liquidity.An effective stress testing framework should explore the potential forcapital and liquidity problems to arise at the same time or exacerbate oneanother.A banking organization’s liquidity stress analysis should exploresituations in which the banking organization may be operating with acapital position that exceeds regulatory minimums, but is nonethelessviewed within the financial markets or by its counterparties as being ofquestionable viability.For its capital and liquidity stress tests, a banking organization _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 202. should articulate clearly its objectives for a post-stress outcome, forinstance to remain a viable financial market participant that is able tomeet its existing and prospective obligations and commitments.In response to comments received on the planning horizon for stresstests, the agencies clarified that while capital stress tests should generallybe conducted with a horizon of at least two years, organizations shouldrecognize that the effects of certain stress conditions could extend beyondthat horizon.The agencies have also clarified, in response to comments, thatconsolidated stress tests should account for the fact that certain legalentities within the consolidated organization are required to meetregulatory capital requirements.A commenter requested clarification on whether capital and liquiditystress testing should be evaluated in unified or separate stress tests.The proposed guidance did not specify the precise manner in whichcapital and liquidity stress tests should be performed.The final guidance notes that assessing the potential interaction of capitaland liquidity can be challenging and may not be possible within a singlestress test, so a banking organization should explore several avenues toassess that interaction.In any case, the agencies believe that stress testing for both liquidity andcapital adequacy should be an integral part of a banking organization’sstress testing framework.E. Governance and controlsAs noted under the new fifth principle of the final guidance, a bankingorganization’s stress testing framework will be effective only if it issubject to strong governance and controls to ensure that the frameworkfunctions as intended. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 203. Strong governance and controls also help ensure that the frameworkcontains core elements, from clearly defined stress testing objectives torecommended actions.Importantly, strong governance provides critical review of elements of thestress testing framework, especially regarding key assumptions,uncertainties, and limitations.A banking organization should ensure that the stress testing framework isnot isolated within a banking organization’s risk management function,but is firmly integrated into business lines, capital and asset-liabilitycommittees, and other decision-making bodies.As part of their overall responsibilities, a banking organization’s boardand senior management should establish a comprehensive, integratedand effective stress testing framework that fits into the broader riskmanagement of the banking organization.Stress testing results should be used to inform the board about alignmentof the banking organization’s risk profile with the board’s chosen riskappetite, as well as inform operating and strategic decisions.Stress testing results should be considered directly by the board andsenior management for decisions relating to capital and liquidityadequacy.Senior management, in consultation with the board, should ensure thatthe stress testing framework includes a sufficient range of stress testingactivities applied at the appropriate levels of the banking organization(i.e., not just one enterprise-wide stress test).Several commenters raised concerns regarding the proposedresponsibilities of a banking organization’s board of directors withrespect to stress tests and the framework. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 204. One commenter believed that the board of directors should not review allstress test results, but rather only those that were expected to have amaterial impact on the overall organization.Another commenter expressed the belief that the board of directorsshould be involved in providing direction and oversight regarding thebanking organization’s stress testing framework, but that the board ofdirectors should not be expected to be involved directly in moreoperational aspects of the framework.The agencies have modified the final guidance to clarify that seniormanagement, not the board of directors, should have the primaryresponsibility for stress testing implementation and technical design.However, the agencies emphasize that a banking organization’s board ofdirectors should be provided with information from senior managementon stress testing developments (including the process to design tests anddevelop scenarios) and on stress testing results (including from individualtests, where material).As a general matter, the board of directors is also responsible formonitoring effectiveness of the overall framework, and using the resultsto inform their decision making process.In addition, the final guidance specifies that senior management should,in consultation with the board of directors, review stress testing activitiesand results with an appropriately critical eye to ensure that there isobjective review and that the stress testing framework includes asufficient range of stress testing activities applied at the appropriate levelsof the banking organization.Finally, in response to comments, the agencies have clarified that abanking organization’s minimum annual review and assessment of theeffectiveness of their stress testing framework should ensure that stresstesting coverage is comprehensive, tests are relevant and current,methodologies are sound, and results are properly considered. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 205. IV. Administrative Law MattersA. Paperwork Reduction Act AnalysisIn accordance with the Paperwork Reduction Act (“PRA”) of 1995 theagencies reviewed the final guidance. The agencies may not conduct orsponsor, and an organization is not required to respond to, an informationcollection unless the information collection displays a currently validOMB control number.While the guidance is not being adopted as a rule, the agenciesdetermined that certain aspects of the guidance may constitute acollection of information and, therefore, believed it was helpful to publisha burden estimate with the guidance.In particular, the aspects of the guidance that may constitute aninformation collection are the provisions that state a bankingorganization should(i) Have a stress testing framework that includes clearly definedobjectives, well-designed scenarios tailored to the banking organization’sbusiness and risks, well-documented assumptions, conceptually soundmethodologies to assess potential impact on the banking organization’sfinancial condition, informative management reports, and recommendedactions based on stress test results; and(ii) Have policies and procedures for a stress testing framework.The agencies estimated that the above-described information collectionsincluded in the guidance would take respondents, on average, 260 hourseach year.The frequency of information collection is estimated to be annual.Respondents are banking organizations with more than $10 billion in totalconsolidated assets, as defined in the guidance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 206. The agencies received three comment letters regarding the paperworkburden of the guidance, stating that implementation will require amultiple of the 260 estimated hours.The agencies emphasize that the guidance does not implement the stresstesting requirements imposed by the Dodd-Frank Act or the Board’scapital plan rule, and does not otherwise impose mandatory stress testingrequirements.The burden of information collections associated with mandatory stresstests will be accounted for in the respective rules that implement thoserequirements.In addition, the agencies believe that in some respects, the informationcollection elements of this guidance augment certain expectations thatalready are in place relative to certain existing supervisory guidance.The burden estimates for this guidance take into consideration only thosecollections of information, such as documentation of policies andprocedures and relevant reports, that are specific to this guidance.Based on these factors, the agencies believe the burden estimatesincluded in the proposed guidance continue to be appropriate.V. Final supervisory guidanceThe text of the final supervisory guidance is as follows:Office of the Comptroller of the CurrencyFederal Reserve SystemFederal Deposit Insurance CorporationGuidance on Stress Testing for Banking Organizations withTotal Consolidated Assets of More Than $10 BillionI. Introduction _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 207. All banking organizations should have the capacity to understand fullytheir risks and the potential impact of stressful events and circumstanceson their financial condition.The U.S. federal banking agencies have previously highlighted the use ofstress testing as a means to better understand the range of a bankingorganization’s potential risk exposures.The 2007-2009 financial crisis underscored the need for bankingorganizations to incorporate stress testing into their risk managementpractices, demonstrating that banking organizations unprepared forstressful events and circumstances can suffer acute threats to theirfinancial condition and viability.The Federal Reserve, the Office of the Comptroller of the Currency, andthe Federal Deposit Insurance Corporation (collectively, the “agencies”)are issuing this guidance to emphasize the importance of stress testing asan ongoing risk management practice that supports bankingorganizations’ forward-looking assessment of risks and better equipsthem to address a range of adverse outcomes.This joint guidance is applicable to all institutions supervised by theagencies with more than $10 billion in total consolidated assets.Specifically, with respect to the OCC, these banking organizationsinclude national banking associations, federal savings associations, andfederal branches and agencies; with respect to the Board, these bankingorganizations include state member banks, bank holding companies,savings and loan holding companies, and all other institutions for whichthe Federal Reserve is the primary federal supervisor; with respect to theFDIC, these banking organizations include state nonmember banks,state savings associations and insured branches of foreign banks.The guidance does not apply to any supervised institution below thedesignated asset threshold. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 208. Certain other existing supervisory guidance that applies to all supervisedinstitutions discusses the use of stress testing as a tool in certain aspectsof risk management, such as for commercial real estate concentrations,liquidity risk management, and interest-rate risk management.However, no institution at or below $10 billion in total consolidated assetsis subject to this final guidance.Building upon previously issued supervisory guidance that discusses theuses and merits of stress testing in specific areas of risk management, thisguidance provides broad principles a banking organization should followin conducting its stress testing activities, such as ensuring that thoseactivities fit into the organization’s overall risk management program.The guidance outlines broad principles for a satisfactory stress testingframework and describes the manner in which stress testing should beemployed as an integral component of risk management that is applicableat various levels of aggregation within a banking organization, as well asfor contributing to capital and liquidity planning.While the guidance is not intended to provide detailed instructions forconducting stress testing for any particular risk or business area, thedocument describes several types of stress testing activities and how theymay be most appropriately used by banking organizations.II. Overview of Stress Testing FrameworkFor purposes of this guidance, stress testing refers to exercises used toconduct a forward looking assessment of the potential impact of variousadverse events and circumstances on a banking organization.Stress testing occurs at various levels of aggregation, including on anenterprise-wide basis.As outlined in section IV, there are several approaches and applicationsfor stress testing and a banking organization should consider the use ofeach in its stress testing framework. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 209. An effective stress testing framework provides a comprehensive,integrated, and forward looking set of activities for a bankingorganization to employ along with other practices in order to assist in theidentification and measurement of its material risks and vulnerabilities,including those that may manifest themselves during stressful economicor financial environments, or arise from firm-specific adverse events.Such a framework should supplement other quantitative riskmanagement practices, such as those that rely primarily on statisticalestimates of risk or loss estimates based on historical data, as well asqualitative practices.In this manner, stress testing can assist in highlighting unidentified orunder-assessed risk concentrations and interrelationships and theirpotential impact on the banking organization during times of stress.A banking organization should develop and implement its stress testingframework in a manner commensurate with its size, complexity, businessactivities, and overall risk profile.Its stress testing framework should include clearly defined objectives,well-designed scenarios tailored to the banking organization’s businessand risks, well-documented assumptions, sound methodologies to assesspotential impact on the banking organization’s financial condition,informative management reports, ongoing and effective review of stresstesting processes, and recommended actions based on stress test results.Stress testing should incorporate the use of high-quality data andappropriate assumptions about the performance of the institution understress to ensure that the outputs are credible and can be used to supportdecision-making.Importantly, a banking organization should have a sound governance andcontrol infrastructure with objective, critical review to ensure the stresstesting framework is functioning as intended. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 210. A stress testing framework should allow a banking organization toconduct consistent, repeatable exercises that focus on its materialexposures, activities, risks, and strategies, and also conduct ad hocscenarios as needed.The framework should consider the impact of both firm specific andsystemic stress events and circumstances that are based on historicalexperience as well as on hypothetical occurrences that could have anadverse impact on a banking organization’s operations and financialcondition.Banking organizations subject to this guidance should develop policieson reviewing and assessing the effectiveness of their stresstesting frameworks, and use those policies at least annually to assess theeffectiveness of their frameworks.Such assessments should help to ensure that stress testing coverage iscomprehensive, tests are relevant and current, methodologies are sound,and results are properly considered.III. General Stress Testing PrinciplesA banking organization should develop and implement an effective stresstesting framework as part of its broader risk management and governanceprocesses.The framework should include several activities and exercises, and notjust rely on any single test or type of test, since every stress test haslimitations and relies on certain assumptions.The uses of a banking organization’s stress testing framework shouldinclude, but are not limited to,- augmenting risk identification and measurement; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 211. - estimating business line revenues and losses and informing business line strategies;- identifying vulnerabilities, assessing the potential impact from those vulnerabilities, and identifying appropriate actions;- assessing capital adequacy and enhancing capital planning; assessing liquidity adequacy and informing contingency funding plans;- contributing to strategic planning;- enabling senior management to better integrate strategy, risk management, and capital and liquidity planning decisions; and assisting with recovery and resolution planning.This section describes general principles that a banking organizationshould apply in implementing such a framework.Principle 1:A banking organization’s stress testing framework should includeactivities and exercises that are tailored to and sufficiently capture thebanking organization’s exposures, activities, and risks.An effective stress testing framework covers a banking organization’s fullset of material exposures, activities, and risks, whether on or off thebalance sheet, based on effective enterprise-wide risk identification andassessment.Risks addressed in a firm’s stress testing framework may include (but arenot limited to) credit, market, operational, interest-rate, liquidity,country, and strategic risk.The framework should also address non-contractual sources of risks,such as those related to a banking organization’s reputation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 212. Appropriate coverage is important as stress testing results could give afalse sense of comfort if certain portfolios, exposures, liabilities, orbusiness line activities are not included.Stress testing exercises should be part of a banking organization’s regularrisk identification and measurement activities.For example, in assessing credit risk a banking organization shouldevaluate the potential impact of adverse outcomes, such as an economicdownturn or declining asset values, on the condition of its borrowers andcounterparties, and on the value of any supporting collateral.As another example, in assessing interest-rate risk, banking organizationsshould analyze the effects of significant interest rate shocks or otheryield-curve movements.An effective stress testing framework should be applied at various levelsin the banking organization, such as business line, portfolio, and risktype, as well as on an enterprise-wide basis.In many cases, stress testing may be more effective at business line andportfolio levels, as a higher level of aggregation may cloud orunderestimate the potential impact of adverse outcomes on a bankingorganization’s financial condition.In some cases, stress testing can also be applied to individual exposuresor instruments.Each stress test should be tailored to the relevant level of aggregation,capturing critical risk drivers, internal and external influences, and otherkey considerations at the relevant level.Stress testing should capture the interplay among different exposures,activities, and risks and their combined effects.While stress testing several types of risks or business lines simultaneouslymay prove operationally challenging, a banking organization should aim _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 213. to identify common risk drivers across risk types and business lines thatcan adversely affect its financial condition.Accordingly, stress tests should provide a banking organization with theability to identify potential concentrations – including those that may notbe readily observable during benign periods and whose sensitivity to acommon set of factors is apparent only during times of stress – and toassess the impact of identified concentrations of exposures, activities, andrisks within and across portfolios and business lines and on theorganization as a whole.Stress testing should be tailored to the banking organization’sidiosyncrasies and specific business mix and include all major businesslines and significant individual counterparties.For example, a banking organization that is geographically concentratedmay determine that a certain segment of its business may be moreadversely affected by shocks to economic activity at the state or local levelthan by a severe national recession.On the other hand, if the banking organization has significant globaloperations, it should consider scenarios that have an internationalcomponent and stress conditions that could affect the different aspects ofits operations in different ways, as well as conditions that could adverselyaffect all of its operations at the same time.A banking organization should use its stress testing framework todetermine whether exposures, activities, and risks under normal andstressed conditions are aligned with the banking organization’s riskappetite.A banking organization can use stress testing to help inform decisionsabout its strategic direction and/or risk appetite by better understandingthe risks from its exposures or of engaging in certain business practices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 214. For example, if a banking organization pursues a business strategy for anew or modified product, and the banking organization does not havelong-standing experience with that product or lacks extensive data,the banking organization can use stress testing to identify the product’spotential downsides and unanticipated risks.Scenarios used in a banking organization’s stress tests should be relevantto the direction and strategy set by its board of directors, as well assufficiently severe to be credible to internal and external stakeholders.Principle 2:An effective stress testing framework employs multiple conceptuallysound stress testing activities and approaches.All measures of risk, including stress tests, have an element of uncertaintydue to assumptions, limitations, and other factors associated with usingpast performance measures and forward-looking estimates.Banking organizations should, therefore, use multiple stress testingactivities and approaches (consistent with section IV), and ensure thateach is conceptually sound.Stress tests usually vary in design and complexity, including the numberof factors employed and the degree of stress applied.A banking organization should ensure that the complexity of any giventest does not undermine its integrity, usefulness, or clarity.In some cases, relatively simple tests can be very useful and informative.Additionally, effective stress testing relies on high-quality input data andinformation to produce credible outcomes.A banking organization should ensure that it has readily available dataand other information for the types of stress tests it uses, including keyvariables that drive performance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 215. In addition, a banking organization should have appropriatemanagement information systems (MIS) and data processes that enable itto collect, sort, aggregate, and update data and other informationefficiently and reliably within business lines and across the bankingorganization for use in stress testing.If certain data and information are not current or not available, or ifproxies are used, a banking organization should analyze the stress testoutputs with an understanding of those data limitations.A banking organization should also document the assumptions used inits stress tests and note the degree of uncertainty that may beincorporated into the tools used for stress testing.In some cases, it may be appropriate to present and analyze test resultsnot just in terms of point estimates, but also including the potentialmargin of error or statistical uncertainty around the estimates.Furthermore, almost all stress tests, including well-developedquantitative tests supported by high-quality data, employ a certainamount of expert or business judgment, and the role and impact of suchjudgment should be clearly documented.In some cases, when credible data are lacking and more quantitative testsare operationally challenging or in the early stages of development, abanking organization may choose to employ more qualitatively basedtests, provided that the tests are properly documented and theirassumptions are transparent.Regardless of the type of stress tests used, a banking organization shouldunderstand and clearly document all assumptions, uncertainties, andlimitations, and provide that information to users of the stress testingresults.Principle 3:An effective stress testing framework is forward-looking and flexible. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 216. A stress testing framework should be sufficiently dynamic and flexible toincorporate changes in a banking organization’s on- andoff-balance-sheet activities, portfolio composition, asset quality,operating environment, business strategy, and other risks that may ariseover time from firm-specific events, macroeconomic and financial marketdevelopments, or some combination of these events.A banking organization should also ensure that its MIS are capable ofincorporating relatively rapid changes in exposures, activities, and risks.While stress testing should utilize available historical information, abanking organization should look beyond assumptions based only onhistorical data and challenge conventional assumptions.A banking organization should ensure that it is not constrained by pastexperience and that it considers multiple scenarios, even scenarios thathave not occurred in the recent past or during the banking organization’shistory.For example, a banking organization should not assume that if it hassuffered no or minimal losses in a certain business line or product thatsuch a pattern will continue.Structural changes in customer, product, and financial markets canpresent unprecedented situations for a banking organization.A banking organization with any type of significant concentration can beparticularly vulnerable to rapid changes in economic and financialconditions and should try to identify and better understand the impact ofthose vulnerabilities in advance.For example, the risks related to residential mortgages wereunderestimated for a number of years leading up to the 2007-2009financial crisis by a large number of banking organizations, and thoserisks eventually affected the banking organizations in a variety of ways.Effective stress testing can help a banking organization identify any such _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 217. concentrations and help understand the potential impact of several keyaspects of the business being exposed to common drivers.Stress testing should be conducted over various relevant time horizons toadequately capture both conditions that may materialize in the near termand adverse situations that take longer to develop.For example, when a banking organization stress tests a portfolio formarket and credit risks simultaneously, it should consider that certaincredit risk losses may take longer to materialize than market risk losses,and also that the severity and speed of mark-to-market losses may createsignificant vulnerabilities for the firm, even if a more fundamentalanalysis of how realized losses may play out over time seems to show lessthreatening results.A banking organization should carefully consider the incremental andcumulative effects of stress conditions, particularly with respect topotential interactions among exposures, activities, and risks and possiblesecond-order or “knock-on” effects.In addition to conducting formal, routine stress tests, a bankingorganization should have the flexibility to conduct new or ad hoc stresstests in a timely manner to address rapidly emerging risks.These less routine tests usually can be conducted in a short amount oftime and may be simpler and less extensive than a banking organization’smore formal, regular tests.However, for its ad hoc tests a banking organization should still have thecapacity to bring together approximated information on risks, exposures,and activities and assess their impact.More broadly, a banking organization should continue updating andmaintaining its stress testing framework in light of new risks, betterunderstanding of the banking organization’s exposures and activities,new stress testing techniques, and any changes in its operating structureand environment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 218. A banking organization’s stress testing development should be iterative,with ongoing adjustments and refinements to better calibrate the tests toprovide current and relevant information.Banking organizations should document the ongoing development oftheir stress testing practices.Principle 4:Stress test results should be clear, actionable, well supported, and informdecision-making.Stress testing should incorporate measures that adequately and effectivelyconvey results of the impact of adverse outcomes.Such measures may include, for example, changes to asset values,accounting and economic profit and loss, revenue streams, liquiditylevels, cash flows, regulatory capital, risk-weighted assets, the loan lossallowance, internal capital estimates, levels of problem assets, breaches incovenants or key trigger levels, or other relevant measures.Stress test measures should be tailored to the type of test and theparticular level at which the test is applied (for example, at the businessline or risk level). Some stress tests may require using a range of measuresto evaluate the full impact of certain events, such as a severe systemicevent.In addition, all stress test results should be accompanied by descriptiveand qualitative information (such as key assumptions and limitations) toallow users to interpret the exercises in context.The analysis and the process should be well documented so that stresstesting processes can be replicated if need be.A banking organization should regularly communicate stress test resultsto appropriate levels within the banking organization to foster dialoguearound stress testing, keep the board of directors, management, and staff _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 219. apprised, and to inform stress testing approaches, results, and decisionsin other areas of the banking organization.A banking organization should maintain an internal summary of testresults to document at a high level the range of its stress testing activitiesand outcomes, as well as proposed follow-up actions.Regular review of stress test results can be an important part of a bankingorganization’s ability over time to track the impact of ongoing businessactivities, changes in exposures, varying economic conditions, andmarket movements on its financial condition.In addition, management should review stress testing activities on aregular basis to determine, among other things, the validity of theassumptions, the severity of tests, the robustness of the estimates, theperformance of any underlying models, and the stability andreasonableness of the results.Stress test results should inform analysis and decision-making related tobusiness strategies, limits, risk profile, and other aspects of riskmanagement, consistent with the banking organization’s established riskappetite.A banking organization should review the results of its various stress testswith the strengths and limitations of each test in mind (consistent withPrinciple 2), determines which results should be given greater or lesserweight, analyze the combined impact of its tests, and then evaluatepotential courses of action based on that analysis.A banking organization may decide to maintain its current course basedon test results; indeed, the results of highly severe stress tests need notalways indicate that immediate action has to be taken.Wherever possible, benchmarking or other comparative analysis shouldbe used to evaluate the stress testing results relative to other tools andmeasures – both internal and external to the banking organization – toprovide proper context and a check on results. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 220. Principle 5:An organization’s stress testing framework should include stronggovernance and effective internal controls.Similar to other aspects of its risk management, a banking organization’sstress testing framework will be effective only if it is subject to stronggovernance and effective internal controls to ensure the framework isfunctioning as intended. Strong governance and effective internalcontrols help ensure that the framework contains core elements, fromclearly defined stress testing objectives to recommended actions.Importantly, strong governance provides critical review of elements of thestress testing framework, especially regarding key assumptions,uncertainties, and limitations.A banking organization should ensure that the stress testing framework isnot isolated within a banking organization’s risk management function,but is firmly integrated into business lines, capital and asset-liabilitycommittees, and other decision making bodies.Along those lines, the board of directors and senior management shouldplay key roles in ensuring strong governance and controls.The extent and sophistication of a banking organization’s governanceover its stress testing framework should align with the extent andsophistication of that framework.Additional details regarding governance and controls of an organization’sstress testing framework are outlined in section VI.IV. Stress Testing Approaches and ApplicationsThis section discusses some general types of stress testing approachesand applications. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 221. For any type of stress test, banking organizations should indicate thespecific purpose and the focus of the test.Defining the scope of a given stress test is also important, whether itapplies at the portfolio, business line, risk type, or enterprise-wide level,or even just for an individual exposure or counterparty.Based on the purpose and scope of the test, different stress testingtechniques are most useful.Thus, a banking organization should employ several approaches andapplications; these might include scenario analysis, sensitivity analysis,enterprise-wide stress testing, and reverse stress testing.Consistent with Principle 1, banking organizations should apply thesecommensurate with their size, complexity, and business profile, and maynot need to incorporate all of the details described below.Consistent with Principle 3, banking organizations should also recognizethat stress testing approaches will evolve over time and they shouldupdate their practices as needed.Scenario AnalysisScenario analysis refers to a type of stress testing in which a bankingorganization applies historical or hypothetical scenarios to assess theimpact of various events and circumstances, including extreme ones.Scenarios usually involve some kind of coherent, logical narrative or“story” as to why certain events and circumstances can occur and inwhich combination and order, such as a severe recession, failure of amajor counterparty, loss of major clients, natural or man-made disaster,localized economic downturn, disruptions in funding or capital markets,or a sudden change in interest rates brought about by unfavorableinflation developments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 222. Scenario analysis can be applied at various levels of the bankingorganization, such as within individual business lines to help identifyfactors that could harm those business lines most.Stress scenarios should reflect a banking organization’s uniquevulnerabilities to factors that affect its exposures, activities, and risks.For example, if a banking organization is concentrated in a particular lineof business, such as commercial real estate or residential mortgagelending, it would be appropriate to explore the impact of a downturn inthose particular market segments.Similarly, a banking organization with lending concentrations to oil andgas companies should include scenarios related to the energy sector.Other relevant factors to be considered in scenario analysis relate tooperational, reputational and legal risks to a banking organization, suchas significant events of fraud or litigation, or a situation when a bankingorganization feels compelled to provide support to an affiliate or provideother types of non-contractual support to avoid reputational damage.Scenarios should be internally consistent and portray realistic outcomesbased on underlying relationships among variables, and should includeonly those mitigating developments that are consistent with the scenario.Additionally, a banking organization should consider the best manner totry to capture combinations of stressful events and circumstances,including second-order and “knock-on” effects.Ultimately, a banking organization should select and design multiplescenarios that are relevant to its profile and make intuitive sense, useenough scenarios to explore the range of potential outcomes, and ensurethat the scenarios continue to be timely and relevant.A banking organization may apply scenario analysis within the context ofits existing risk measurement tools (e.g., the impact of a severe decline in _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 223. market prices on a banking organization’s value-at-risk (VaR) measure)or use it as an alternative, supplemental measure.For instance, a banking organization may use scenario analysis tomeasure the impact of a severe financial market disturbance and comparethose results to what is produced by its VaR or other measures.This type of scenario analysis should account for known shortcomings ofother risk measurement practices.For example, market risk VaR models generally assume liquid marketswith known prices.Scenario analysis could shed light on the effects of a breakdown inliquidity and of valuation difficulties.One of the key challenges with scenario analysis is to translate a scenariointo balance sheet impact, changes in risk measures, potential losses, orother measures of adverse financial impact, which would vary dependingon the test design and the type of scenario used.For some aspects of scenario analysis, banking organizations may useeconometric or similar types of analysis to estimate a relationshipbetween some underlying factors or drivers and risk estimates or lossprojections based on a given data set, and then extrapolate to see theimpact of more severe inputs.Care should be taken not to make assumptions that relationships frombenign or mildly adverse times will hold during more severe times or thatestimating such relationships is relatively straightforward.For example, linear relationships between risk drivers and losses maybecome nonlinear during times of stress.In addition, organizations should recognize that there can be multiplepermutations of outcomes from just a few key risk drivers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 224. Sensitivity AnalysisSensitivity analysis refers to a banking organization’s assessment of itsexposures, activities, and risks when certain variables, parameters, andinputs are “stressed” or “shocked.”A key goal of sensitivity analysis is to test the impact of assumptions onoutcomes.Generally, sensitivity analysis differs from scenario analysis in that itinvolves changing variables, parameters, or inputs without an explicitunderlying reason or narrative, in order to explore what occurs under arange of inputs and at extreme or highly adverse levels.In this type of analysis a banking organization may realize, for example,that a given relationship is much more difficult to estimate at extremelevels.A banking organization may apply sensitivity analysis at various levels ofaggregation to estimate the impact from a change in one or more keyvariables.The results may help a banking organization better understand the rangeof outcomes from some of its models, such as developing a distribution ofoutput based on a variety of extreme inputs.For example, a banking organization may choose to calculate a range ofchanges to a structured security’s overall value using a range of differentassumptions about the performance and linkage of underlying cash flows.Sensitivity analysis should be conducted periodically due to potentialchanges in a banking organization’s exposures, activities, operatingenvironment, or the relationship of variables to one another.Sensitivity analysis can also help to assess a combined impact on abanking organization of several variables, parameters, factors, or drivers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 225. For example, a banking organization could better understand the impacton its credit losses from a combined increase in default rates and adecrease in collateral values.A banking organization could also explore the impact of highly adversecapitalization rates, declines in net operating income, and reductions incollateral when evaluating its risks from commercial real estateexposures.Sensitivity analysis can be especially useful because it is not necessarilyaccompanied by a particular narrative or scenario; that is, sensitivityanalysis can provide banking organizations more flexibility to explore theimpact of potential stresses that they may not be able to capture indesigned scenarios.Furthermore, banking organizations may decide to conduct sensitivityanalysis of their scenarios, i.e., choosing different levels or paths ofvariables to understand the sensitivities of choices made during scenariodesign.For instance, banking organizations may decide to apply a few differentinterest-rate paths for a given scenario.Enterprise-Wide Stress TestingEnterprise-wide stress testing is an application of stress testing thatinvolves assessing the impact of certain specified scenarios on thebanking organization as a whole, particularly with regard to capital andliquidity.As is the case with scenario analysis more generally, enterprise widestress testing involves robust scenario design and effective translation ofscenarios into measures of impact.Enterprise-wide stress tests can help a banking organization in its effortsto assess the impact of its full set of risks under adverse events andcircumstances, but should be supplemented with other stress tests and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 226. other risk measurement tools given inherent limitations in capturing allrisks and all adverse outcomes in one test.Scenario design for enterprise-wide stress testing involves developingscenarios that affect the banking organization as a whole that stem frommacroeconomic, market-wide, and/or firm-specific events.These scenarios should incorporate the potential simultaneousoccurrence of both firm-specific and macroeconomic and market-wideevents, considering system-wide interactions and feedback effects.For example, price shocks may lead to significant portfolio losses, risingfunding gaps, a ratings downgrade, and diminished access to funding.In general, it is a good practice to consult with a large set of individualswithin the banking organization – in various business lines, research andrisk areas – to gain a wide perspective on how enterprise wide scenariosshould be designed and to ensure that the scenarios capture the relevantaspects of the banking organization’s business and risks.Banking organizations should also conduct scenarios of varying severityto gauge the relative impact.At least some scenarios should be of sufficient severity to challenge theviability of the banking organization, and should include instantaneousmarket shocks and stressful periods of extended duration (e.g., not just aone or two-quarter shock after which conditions return to normal).Selection of scenario variables is important for enterprise-wide tests,because these variables generally serve as the link between the overallnarrative of the scenario and tangible impact on the banking organizationas a whole.For instance, in aiming to capture the combined impact of a severerecession and a financial market downturn, a banking organization may _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 227. choose a set of variables such as changes in gross domestic product(GDP), unemployment rate, interest rates, stock market levels, or homeprice levels.However, particularly when assessing the impact on the whole bankingorganization, using a large number of variables can make a test morecumbersome and complicated – so a banking organization may alsobenefit from simpler scenarios or from those with fewer variables.Banking organizations should balance the comprehensiveness ofcontributing variables and tractability of the exercise.As with scenario analysis generally, translating scenarios into tangibleeffects on the banking organization as a whole presents certainchallenges.A banking organization should identify appropriate and meaningfulmechanisms for translating scenarios into relevant internal riskparameters that provide a firm-wide view of risks and understanding ofhow these risks are translated into loss estimates.Not all business areas are equally affected by a given scenario, andproblems in one business area can have effects on other units.However, for an enterprise-wide test, assumptions across business linesand risk areas should remain constant for the chosen scenario, since theobjective is to see how the banking organization as a whole will beaffected by a common scenario.Reverse Stress TestingReverse stress testing is a tool that allows a banking organization toassume a known adverse outcome, such as suffering a credit loss thatbreaches regulatory capital ratios or suffering severe liquidity constraintsthat render it unable to meet its obligations, and then deduce the types ofevents that could lead to such an outcome. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 228. This type of stress testing may help a banking organization to considerscenarios beyond its normal business expectations and see the impact ofsevere systemic effects on the banking organization.It also allows a banking organization to challenge common assumptionsabout its performance and expected mitigation strategies.Reverse stress testing helps to explore so-called “break the bank”situations, allowing a banking organization to set aside the issue ofestimating the likelihood of severe events and to focus more on whatkinds of events could threaten the viability of the banking organization.This type of stress testing also helps a banking organization evaluate thecombined effect of several types of extreme events and circumstances thatmight threaten the survival of the banking organization, even if inisolation each of the effects might be manageable.For instance, reverse stress testing may help a banking organizationrecognize that a certain level of unemployment would have a severeimpact on credit losses, that a market disturbance could create additionallosses and result in rising funding costs, and that a firm-specific case offraud would cause even further losses and reputational impact that couldthreaten a banking organization’s viability.In some cases, reverse stress tests could reveal to a banking organizationthat “breaking the bank” is not as remote an outcome as originallythought.Given the numerous potential threats to a banking organization’sviability, the organization should ensure that it focuses first on thosescenarios that have the largest firm-wide impact, such as insolvency orilliquidity, but also on those that seem most imminent given the currentenvironment.Focusing on the most prominent vulnerabilities helps a bankingorganization prioritize its choice of scenarios for reverse stress testing. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 229. However, a banking organization should also consider a wider range ofpossible scenarios that could jeopardize the viability of the bankingorganization, exploring what could represent potential blind spots.Reverse stress testing can highlight previously unacknowledged sourcesof risk that could be mitigated through enhanced risk management.V. Stress Testing for Assessing the Adequacy of Capital andLiquidityThere are many uses of stress testing within banking organizations.Prominent among these are stress tests designed to assess the adequacyof capital and liquidity.Given the importance of capital and liquidity to a banking organization’sviability, stress testing should be applied in these two areas in particular,including an evaluation of the interaction between capital and liquidityand the potential for both to become impaired at the same time.Depletions and shortages of capital or liquidity can cause a bankingorganization to no longer perform effectively as a financial intermediary,be viewed by its counterparties as no longer viable, become insolvent, ordiminish its capacity to meet legal and financial obligations.A banking organization’s capital and liquidity stress testing shouldconsider how losses, earnings, cash flows, capital, and liquidity would beaffected in an environment in which multiple risks manifest themselves atthe same time, for example, an increase in credit losses during an adverseinterest-rate environment.Additionally, banking organizations should recognize that at the endof the time horizon considered by a given stress test, they may still havesubstantial residual risks or problem exposures that may continue topressure capital and liquidity resources. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 230. Stress testing for capital and liquidity adequacy should be conducted incoordination with a banking organization’s overall strategy and annualplanning cycles.Results should be refreshed in the event of major strategic decisions, orother decisions that can materially impact capital or liquidity.Banking organizations should conduct stress testing for capital andliquidity adequacy periodically.Capital Stress TestingCapital stress testing results can serve as a useful tool to support abanking organization’s capital planning and corporate governance.They may help a banking organization better understand itsvulnerabilities and evaluate the impact of adverse outcomes on its capitalposition and ensure that the banking organization holds adequate capitalgiven its business model, including the complexity of its activities and itsrisk profile.Capital stress testing complements a banking organization’s regulatorycapital analysis by providing a forward-looking assessment of capitaladequacy, usually with a forecast horizon of at least two years (with therecognition that the effects of certain stress conditions could extendbeyond two years for some stress tests), and highlighting the potentialadverse effects on capital levels and ratios from risks not fully capturedin regulatory capital requirements.It should also be used to help a banking organization assess the qualityand composition of capital and its ability to absorb losses.Stress testing can aid capital contingency planning by helpingmanagement identify exposures or risks in advance that would need to bereduced and actions that could be taken to bolster capital levels orotherwise maintain capital adequacy, as well as actions that in times ofstress might not be possible – such as raising capital. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 231. Capital stress testing should include exercises that analyze the potentialfor changes in earnings, losses, reserves, and other potential effects oncapital under a variety of stressful circumstances.Such testing should also capture any potential change in risk-weightedassets, the ability of capital to absorb losses, and any resulting impact onthe banking organization’s capital ratios.It should include all relevant risk types and other factors that have apotential to affect capital adequacy, whether directly or indirectly,including firm-specific ones.A banking organization should also explore the potential for possiblebalance sheet expansion to put pressure on capital ratios and considerrisk mitigation and capital preservation options, other than simplyshrinking the balance sheet.Capital stress testing should assess the potential impact of a bankingorganization’s material subsidiaries suffering capital problems on theirown – such as being unable to meet local country capital requirements –even if the consolidated banking organization is not encounteringproblems.Where material relative to the banking organizations capital,counterparty exposures should also be included in capital stress testing.Enterprise-wide stress testing, as described in section IV, should be anintegral part of a banking organization’s capital stress testing.Such enterprise-wide testing should include proforma estimates of notonly potential losses and resources available to absorb losses, but alsopotential planned capital actions (such as dividends or share repurchases)that would affect the banking organization’s capital position, includingregulatory and other capital ratios.There should also be consideration of the impact on the bankingorganization’s allowance for loan and lease losses and other relevantfinancial metrics. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 232. Even with very effective enterprise-wide tests, banking organizationsshould use capital stress testing in conjunction with other internalapproaches (in addition to regulatory measures) for assessing capitaladequacy, such as those that rely primarily on statistical estimates of riskor loss estimates based on historical data.Liquidity stress testingA banking organization should also conduct stress testing for liquidityadequacy.Through such stress testing a banking organization can work to identifyvulnerabilities related to liquidity adequacy in light of both firm-specificand market-wide stress events and circumstances.Effective stress testing helps a banking organization identify and quantifythe depth, source, and degree of potential liquidity and funding strain andto analyze possible impacts on its cash flows, liquidity position,profitability, and other aspects of its financial condition over various timehorizons.For example, stress testing can be used to explore potential fundingshortfalls, shortages in liquid assets, the inability to issue debt, exposureto possible deposit outflows, volatility in short-term brokered deposits,sensitivity of funding to a ratings downgrade, and the impact of reducedcollateral values on borrowing capacity at the Federal Home Loan Banks,the Federal Reserve discount window, or other secured wholesale fundingsources.Liquidity stress testing should explore the potential impact of adversedevelopments that may affect market and asset liquidity, including thefreezing up of credit and funding markets, and the corresponding impacton the banking organization.Such tests can also help identify the conditions under which balancesheets might expand, thus creating additional funding needs (e.g.,through accelerated drawdowns on unfunded commitments). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 233. These tests also help determine whether the banking organization has asufficient liquidity buffer to meet various types of future liquiditydemands under stressful conditions.In this regard, liquidity stress testing should be an integral part of thedevelopment and maintenance of a banking organization’s contingencyfunding planning.Liquidity stress testing should include enterprise wide tests as discussedin section IV, but should also be applied, as appropriate, at lower levelsof the banking organization, and in particular should account forregulatory or supervisory restrictions on inter-affiliate funding and assettransfers.As with capital stress testing, banking organizations may need to conductliquidity stress tests at both the consolidated and subsidiary level.In undertaking enterprise-wide liquidity tests banking organizationsshould make realistic assumptions as to the implications of liquiditystresses in one part of the banking organization on other parts.An effective stress testing framework should explore the potential forcapital and liquidity problems to arise at the same time or exacerbate oneanother.For example, a banking organization in a stressed liquidity position isoften required to take actions that have a negative direct or indirectcapital impact (e.g., selling assets at a loss or incurring funding costs atabove market rates to meet funding needs).A banking organization’s liquidity stress analysis should exploresituations in which the banking organization may be operating with acapital position that exceeds regulatory minimums, but is nonethelessviewed within the financial markets or by its counterparties as being ofquestionable viability.Assessing the potential interaction of capital and liquidity can be _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 234. challenging and may not be possible within a single stress test, soorganizations should explore several avenues to assess that interaction.As with other applications of stress testing, for its capital and liquiditystress tests, it is beneficial for a banking organization to articulate clearlyits objectives for a post-stress outcome, for instance to remain a viablefinancial market participant that is able to meet its existing andprospective obligations and commitments.In such cases, banking organizations would have to consider whichmeasures of financial condition would need to be met on a post-stressbasis to secure the confidence of counterparties and market participants.VI. Governance and ControlsAs noted under Principle 5, a banking organization’s stress testingframework will be effective only if it is subject to strong governance andcontrols to ensure the framework is functioning as intended.The extent and sophistication of a banking organization’s governanceover its stress testing framework should align with the extent andsophistication of that framework.Governance over a banking organization’s stress testing framework restswith the banking organization’s board of directors and seniormanagement.As part of their overall responsibilities, a banking organization’s boardand senior management should establish a comprehensive, integratedand effective stress testing framework that fits into the broader riskmanagement of the banking organization.While the board is ultimately responsible for ensuring that the bankingorganization has an effective stress testing framework, seniormanagement generally has responsibility for implementing thatframework. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 235. Senior management duties should include establishing adequate policiesand procedures and ensuring compliance with those policies andprocedures, assigning competent staff, overseeing stress testdevelopment and implementation, evaluating stress test results,reviewing any findings related to the functioning of stress test processes,and taking prompt remedial action where necessary.Senior management, directly and through relevant committees, alsoshould be responsible for regularly reporting to the board on stress testingdevelopments (including the process to design tests and developscenarios) and on stress testing results (including from individual tests,where material), as well as on compliance with stress testing policy.Board members should actively evaluate and discuss this information,ensuring that the stress testing framework is in line with the bankingorganization’s risk appetite, overall strategy and business plans, andcontingency plans, directing changes where appropriate.A banking organization should have written policies, approved andannually reviewed by the board, that direct and govern theimplementation of the stress testing framework in a comprehensivemanner.Policies, along with procedures to implement them, should: overall purpose of stress testing activities; consistent and sufficiently rigorous stress testing practicesacross the entire banking organization; roles and responsibilities, including controlsover external resources used for any part of stress testing (such as vendorsand data providers); frequency and priority with which stress testing activitiesshould be conducted; how stress test results are used, by whom, and outline _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 236. instances in which remedial actions should be taken; and reviewed and updated as necessary to ensure that stress testingpractices remain appropriate and keep up to date with changes in marketconditions, banking organization products and strategies, bankingorganization exposures and activities, the banking organization’sestablished risk appetite, and industry stress testing practices.A stress testing framework should incorporate validation or other type ofindependent review to ensure the integrity of stress testing processes andresults, consistent with existing supervisory expectations.If a banking organization engages a third party vendor to support some orall of its stress testing activities, there should be appropriate controls inplace to ensure that those externally developed systems and processes aresound, applied correctly, and appropriate for the banking organization’srisks, activities, and exposures.Additionally, senior management should be mindful of any potentialinconsistencies, contradictions, or gaps among its stress tests and assesswhat actions should be taken as a result.Internal audit should also provide independent evaluation of the ongoingperformance, integrity, and reliability of the stress testing framework.A banking organization should ensure that its stress tests are documentedappropriately, including a description of the types of stress tests andmethodologies used, key assumptions, results, and suggested actions.Senior management, in consultation with the board, should review stresstesting activities and results with an appropriately critical eye and ensurethat there is objective review of all stress testing processes.The results of stress testing analyses should facilitate decision-making bythe board and senior management.Stress testing results should be used to inform the board about alignmentof the banking organization’s risk profile with the board’s chosen risk _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 237. appetite, as well as inform operating and strategic decisions.Stress testing results should be considered directly by the board andsenior management for decisions relating to capital and liquidityadequacy, including capital contingency plans and contingency fundingplans.Senior management, in consultation with the board, should ensure thatthe stress testing framework includes a sufficient range of stress testingactivities applied at the appropriate levels of the banking organization(i.e., not just one enterprise-wide stress test).Sound governance also includes using stress testing to consider theeffectiveness of a banking organization’s risk mitigation techniques forvarious risk types over their respective time horizons, such as to explorewhat could occur if expected mitigation techniques break down duringstressful periods.VII. ConclusionA banking organization should use the principles laid out in this guidanceto develop, implement, and maintain an effective stress testingframework.Such a framework should be adequately tailored to the bankingorganization’s size, complexity, risks, exposures, and activities.A key purpose of stress testing is to explore various types of possibleoutcomes, including rare and extreme events and circumstances, assesstheir impact on the banking organization, and then evaluate theboundaries up to which the banking organization plans to be able towithstand such outcomes.Stress testing may be particularly valuable during benign periods whenother measures may not indicate emerging risks.While stress testing can provide valuable information regarding potential _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 238. future outcomes, similar to any other risk management tool it haslimitations and cannot provide absolute certainty regarding theimplications of assumed events and impacts.Furthermore, management should ensure that stress testing activities arenot constrained to reflect past experiences, but instead consider a broadrange of possibilities.No single stress test can accurately estimate the impact of all stressfulevents and circumstances; therefore, a banking organization shouldunderstand and account for stress testing limitations and uncertainties,and use stress tests in combination with other risk management tools tomake informed risk management and business decisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 239. Guidelines on Stressed Value-At-Risk (Stressed VaR) and on theIncremental Default and Migration Risk Charge (IRC)16 May 2012The EBA published today two sets of Guidelines on Stressed Value-At-Risk (StressedVaR) and on the Incremental Default and Migration Risk Charge (IRC) modellingapproaches employed by credit institutions using the Internal Model Approach(IMA).These Guidelines are seen as an important means of addressing weaknesses in theregulatory capital framework and in the risk management of financial institutions.Their objective is to contribute to a level playing field and to enhance convergence ofsupervisory practices across the EU.National competent authorities are expected to implement the provisions set out inthe Guidelines within six months after their publication.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.Guidelines on Stressed Value-At-Risk (Stressed VaR)These Guidelines include provisions on Stressed VaR modelling by credit institutionsusing the Internal Model Approach for the calculation of the required capital formarket risk in the trading book.The main provisions of the Guidelines relate to: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 240. - The identification and the review of the stressed period;- The Stressed VaR methodology;- The Use test.Guidelines on the Incremental Default and Migration RiskCharge (IRC)These Guidelines include provisions on the IRC modelling approaches employed bycredit institutions using the Internal Model Approach (‘IMA’) for the calculation ofthe required capital for specific interest risk in the trading book.The incremental risk charge is intended to complement additional standards beingapplied to the value-at-risk (VaR) modelling framework in the trading book.The main provisions of the Guidelines relate to:- The scope of application; Individual modelling of all aspects of the IRC approach- The interdependence between default and migration events;- The profit and losses (P&L) valuation including how ratings changes impact onmarket prices and on the computation of P&L;- The liquidity horizons;- The validation and use test for IRC models.Notes1) According to the amendments of the Capital Requirements Directive by Directive2010/76/EU, entered into force on 31 December 2011, the EBA is tasked withmonitoring the range of practices in the area of Stressed Value-at-Risk (Stressed VaR)and Incremental Default and Migration Risk Charge (IRC) in the trading book.The EBA shall draw up guidelines in order to ensure convergence of supervisorypractices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 241. 2) In accordance with Article 16(3) of the EBA Regulation, Guidelines set out theEBA’s view of appropriate supervisory practices within the European System ofFinancial Supervision or of how Union law should be applied in a particular area.Competent authorities and financial market participants must make every effort tocomply with the guidelines.Before the deadline indicated in the Guidelines, i.e 6 months from the date ofpublication, Competent authorities must notify the EBA as to whether they comply orintend to comply with these guidelines, or otherwise with reasons for non-compliance.The notifications shall be published on the EBA website. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 242. EBA Guidelines on Stressed Value At Risk (Stressed VaR)16.05.2012I. Executive SummaryThe amendments to the Capital Requirements Directive1 by Directive 2010/76/EU(CRD III) relate, among others, to Stressed Value-at-Risk (Stressed VaR) in thetrading book.According to these amendments, the predecessor of the EBA, the Committee ofEuropean Banking Supervisors (CEBS) is tasked with monitoring the range ofpractices in this area and drawing up guidelines in order to ensure convergence ofsupervisory practices.The amendments to the Capital Requirements Directive by Directive 2010/76/EU(CRD III) entered into force on 31 December 2011.Providing guidance on Stressed VaR modelling by credit institutions using theInternal Model Approach (‘IMA’) for the calculation of the required capital for marketrisk in the trading book, is seen as an important means of addressing weaknesses inthe regulatory capital framework and in the risk management of financial institutionsthat contributed to the turmoil in global financial markets.It is also expected to reduce reliance on cyclical VaR-based capital estimates as wellas to contribute to the development of a more robust financial system.The first chapter, on ‘Identification and validation of the stressed period’, elaborateson the value-at-risk model inputs calibrated to historical data from a continuous12-month period of significant financial stress relevant to an institution’s portfolio anddeals withi) The length of the stressed period,ii) The number of stressed periods to use for calibration,iii) The approach to identify the appropriate historical period andiv) The required documentation to support the approach used to identify the stressedperiod.The second chapter, on ‘Review of the stressed period’ provides guidance on thefrequency and monitoring of a stressed period. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 243. The third chapter on ‘Stressed VaR methodology’ deals withi) Consistency issues between the VaR and Stressed VaR methodologies andii) The use and validation of proxies in Stressed VaR modelling.The fourth and final chapter, entitled ‘Use tests’ specifies use test requirements.The Guidelines on Stressed VaR are expected to contribute to a level playing fieldamong institutions and to enhance convergence of supervisory practices among thecompetent authorities across the EU.It is expected that the national competent authorities around the EU will implementthe Guidelines by incorporating them within their supervisory procedures within sixmonths after publication of the final guidelines.After that date, the competent authorities must ensure that institutions comply withthe Guidelines effectively.II. Background and RationaleThe CRD III trading book amendments, including the requirement of Stressed Valueat Risk (VaR) modelling for the calculation of the regulatory capital for market risk inthe trading book, are the result of widespread international (G20, Basel, FSF)recognition in 2008 that further regulatory reform was needed to address weaknessesin the current regulatory capital framework and in the risk management of financialinstitutions that contributed to the turmoil in global financial markets.In January 2009, the Basel Committee on Banking Supervision (BCBS) proposedsupplementing the current VaR-based trading book framework with, among othermeasures, an incremental risk capital charge (IRC), which includes default risk aswell as migration risk for unsecuritised credit products and a stressed value-at-riskrequirement.As observed losses in banks trading books during the financial crisis have beensignificantly higher than the minimum capital requirements under the Pillar 1 marketrisk rules, the BCBS proposed to enhance the framework through requiring banks tocalculate, in addition to the current VaR, a stressed VaR taking into account aone-year observation period relating to significant losses.The additional stressed VaR requirement is expected to help reduce thepro-cyclicality of the minimum capital requirements for market risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 244. In the process of refining capital requirements for market risk, the BCBS conducted aquantitative impact study.In the summer of 2009, the Trading Book Group (TBG) investigated the impact of theprovisions of the ‘Revisions to the Basel II market risk framework’ and of the‘Guidelines for computing capital for incremental risk in the trading book’consultation papers published in January 2009, focusing (generally) on biginternationally-active banks with extensive trading activities.The amendments to the Capital Requirements Directive by Directive 2010/76/EU(CRD III) relating to Stressed VaR in the trading book are a direct transposition of theproposals from the BCBS in the EU context.The European Banking Authority is requested to monitor the range of practices inthis area and to provide guidelines on Stressed VaR models.The objectives of these Guidelines on Stressed VaR are:I. To achieve a common understanding among the competent authorities across theEU on Stressed VaR modelling in order to enhance convergence of supervisorypractices;II. To create more transparency for institutions when implementing Stressed VaR intothe calculation of the required capital for market risk in the trading book and into theirrisk management practices; andIII. To create a level playing field among institutions in this area.The guidelines presented in this paper do not aim to be a comprehensive set of rules,but rather to complement the new CRD provisions relating to Stressed VaR whereadditional guidance by the EBA was deemed necessary or appropriate.Given that the Guidelines discussed in this paper do not go beyond the provisions ofthe CRD but rather clarify how the rules are to be applied in practice a detailedassessment of the costs and benefits associated with them is not required.These costs and benefits are unlikely to be incremental to those identified in the EUCommission’s Impact Assessment accompanying its CRDIII proposal.III. EBA Guidelines on Stressed VaRStatus of these Guidelines _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 245. 1. This document contains guidelines issued pursuant to Article 16 of Regulation (EU)No 1093/2010 of the European Parliament and of the Council of 24 November 2010establishing a European Supervisory Authority (European Banking Authority),amending Decision No 716/2009/EC and repealing Commission Decision2009/78/EC (‘the EBA Regulation’).In accordance with Article 16(3) of the EBA Regulation, competent authorities andfinancial market participants must make every effort to comply with the guidelines.2. Guidelines set out the EBA’s view of appropriate supervisory practices within theEuropean System of Financial Supervision or of how Union law should be applied in aparticular area.The EBA therefore expects all competent authorities and financial marketparticipants to whom guidelines are addressed to comply.Competent authorities to whom guidelines apply should comply by incorporatingthem into their supervisory practices as appropriate (e.g. by amending their legalframework or their supervisory rules and/or guidance or supervisory processes),including where particular guidelines are directed primarily at institutions.Notification Requirements3. According to Article 16(3) of the EBA Regulation, competent authorities mustnotify the EBA as to whether they comply or intend to comply with these guidelines,or otherwise with reasons for non-compliance, by 16.07.2012.In the absence of any notification by this deadline, competent authorities will beconsidered by the EBA to be non-compliant.Notifications should be sent by submitting the form provided at Section V with the reference ‘EBA/GL/2012/2’. Notificationsshould be submitted by persons with appropriate authority to report compliance onbehalf of their competent authorities.4. The notification of competent authorities mentioned in the previous paragraphshall be published on the EBA website, as per article 16 of EBA Regulation.Title I – Subject matter, Scope and Definitions1. Subject matter _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 246. These guidelines aim at achieving a common understanding among the competentauthorities across the EU on Stressed Value at Risk (VaR) models in order to enhanceconvergence of supervisory practices in line with Annex V of Directive 2006/49/EC,as amended by Directive 2010/76/EU.2. Scope and level of application1. Competent authorities should require institutions to comply with the provisions laiddown in these Guidelines on Stressed VaR.2. These guidelines should apply to institutions using an Internal Model Approach(IMA) for the purpose of calculating the capital requirement for market risk in thetrading book.3. The guidelines apply to institutions at the level (solo and/or consolidated) on whichthe model is authorised to be used by the relevant competent authority, unless statedotherwise in these Guidelines.3. DefinitionsIn these guidelines the following definitions should apply:a. The term institutions should mean credit institutions and investment firms as setout in Directives 2006/48/EC and 2006/49/EC.b. The term antithetic data under point 6 of these Guidelines should mean pricemovements which are considered relevant irrespective of their direction.c. The term de-meaning under point 10 of these Guidelines should mean aquantitative process to remove a trend from historical data.Depending on the positions and the size of the trend, not removing the drift from thehistorical data to simulate the price variations could generate mainly profitablescenarios and very few and limited losses.d. The term proxy under point 11 of these Guidelines should mean an observablevariable or price taken from a liquid market that is used to substitute a variable thatcannot be observed (or whose hypothetical price does not reflect real transactionsfrom a deep two-way market) and thus cannot be accurately measured. Institutionsuse proxies both for valuation and risk measurement purposes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 247. From a theoretical perspective three types of proxies can be identified: those appliedin the valuation of instruments (which would affect the adequacy of VaR and StressedVaR as capital measures); those used for VaR calculations (which would also bepresent in Stressed VaR metrics); and those affecting solely the Stressed VaRcalculation.Title II – Requirements regarding institutions’ Stressed VaRmodelling - A. Identification and validation of the stressedperiod4. Length of the stressed period1. The requirement set out in the CRD that the historical data used to calibrate theStressed VaR measure have to cover a continuous 12-month period, applies also whereinstitutions identify a period which is shorter than 12 months but which is consideredto be a significant stress event relevant to an institution’s portfolio.2. The approach to be applied to identify the stressed period in order to meet therequirement of Paragraph 10a of Annex 5 of Directive 2006/49/EC as amended byDirective 2010/76/EU, to calculate a Stressed VaR measure calibrated to a continuous12-month period of financial stress relevant to an institution’s portfolio, is the mostmaterial element determining the output of the model and is therefore subject toapproval by the competent authorities.5. Number of stressed periods to use for calibration1. For the purposes of approval of the choice of the stressed period by institutions, acompetent authority is the competent authority responsible for the exercise ofsupervision on a consolidated basis of this EU institution and, in the case of aninternal model also recognised at a subsidiary’s level, the competent authorityresponsible for the exercise of supervision of this EU institution’s subsidiary.2. When the competent authorities approve the stressed period defined at group levelaccording to Article 37(2) of Directive 2006/49/EC referring to Article 129 of Directive2006/48/EC, a single stressed period should only be required to be defined at grouplevel.3. As an exception from the above, the competent authorities should require an EUinstitution to determine a different stressed period at a subsidiary’s level if the stressedperiod defined for the group is not considered relevant to the subsidiary’s portfolio. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 248. Where a single group-wide stressed period is used in an institution that has asubsidiary with a locally approved VaR model, institutions should provide proof thatthis group-wide stressed period is relevant to the subsidiary’s portfolio.6. The approach for identifying the appropriate historical period1. In order to choose a historical period for calibration purposes, institutions shouldformulate a methodology for identifying a stressed period relevant to their currentportfolios, based on one of the following two ways:i. judgement-based approaches; orii. formulaic approaches.2. A judgement-based approach is one that does not use a detailed quantitativeanalysis to identify the precise period to use for calibration, but rather relies on ahigh-level analysis of the risks inherent in an institution’s current portfolio and pastperiods of stress related to those risk factors.Where this judgement-based approach is used by institutions, it should includequantitative elements of analysis.3. A formulaic approach instead is one that applies, in addition to expert judgement, amore systematic quantitative analysis to identify the historical period representing asignificant stress for an institution’s current portfolio.This more systematic approach could be employed in a number of ways:i. A risk-factor based approach: an institution identifies a restricted number of riskfactors which are considered to be a relevant proxy for the movement in value of itsportfolio.The historical data for these risk factors can then be fully analysed to identify the moststressed period (for example, through identification of the period of highest volatilityof the risk factors), in the historical data window.ii. A VaR based approach: the historical period is identified by running either the fullVaR model or an approximation over a historical period to identify the 12-monthperiod which produces the highest resulting measure for the current portfolio.4. This approach should be employed to determine a historical period that wouldprovide a conservative capital outcome rather than just selecting the period of highestvolatility. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 249. 5. While either approach may be used by institutions, the use of the formulaicapproach, where possible, should be preferred for the identification of the historicalperiod.6. Institutions may also combine the above two approaches to limit the computationalburden of the formulaic approach.This can be done by using the judgement-based approach to restrict the historicaldata periods to be considered in the formulaic approach.7. Irrespective of the approach used, institutions should provide evidence that thestressed period is relevant for their current portfolio and that they have considered arange of potential historical periods in their analyses.The institutions should also have to prove that the portfolio on which theidentification of the stressed periods is based is representative of the institutions’current portfolio, e.g. by applying the approach to identify the stressed period to othertypical or previous portfolios.As an example, for many portfolios, a 12-month period relating to significant losses in2007/2008 would adequately reflect a period of such stress, but, in addition to that,other periods relevant to the current portfolio should also be considered byinstitutions.8. In all cases no weighting of historical data should be applied when determining therelevant historical period or when calibrating the Stressed VaR model, as theweighting of data in a stressed period would not result in a true reflection of thepotential stressed losses that could occur for an institution’s portfolio.9. Finally, competent authorities may require institutions to use antithetic data whencalibrating the Stressed VaR model, especially where an institution’s portfolio ischaracterized by frequent position changes.7. Documentation to support the approach used to identify thestressed period1. Irrespective of the approach applied, institutions must produce robustdocumentation justifying the choice of approach made.This should in all cases include quantitative assessments to support the currentchoice of the historical period and its relevance for the current portfolio. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 250. This should also include documentation of the modelling of risk factors’ returns.2. Where institutions apply a formulaic approach to identify the stressed period thefollowing issues should, as a minimum, be addressed in the related documentation:i. Justification for the choice of risk factors used if a risk-factor based approach isapplied and where fewer than the modelled risk factors are selected.ii. Justification of any simplifications where a simplified VaR model is used to identifythe historical period.3. Where a formulaic approach is applied, which is based on a simplified VaR model,an institution should also provide adequate evidence that the simplified measure givesdirectionally the same VaR results as the full VaR model (and therefore is accurate indetermining the most stressed period).This evidence should include empirical analysis.4. Where a formulaic approach is applied, which aims at identifying the most volatileperiod for a set of risk factors, an institution should provide adequate evidence that aperiod of high volatility is a suitable proxy for a period in which the VaR measurewould be high and that the lack of inclusion of correlations or other factors that wouldbe reflected in the VaR measure does not result in rendering this proxy unsuitable.B. Review of the stressed period8. Frequency1. The requirement of the CRD, for the review of the identified 12-month period ofsignificant stress to be performed at least yearly by institutions, means that differentcircumstances, including a very high turnover in the trading book or specific tradingstrategies, may require a review of the stressed period with a higher frequency.2. Any changes to the choice of the historical period following the outcome of thereview of the stressed period should be communicated to the competent authoritybefore the intended implementation date of the proposed changes.9. Monitoring the stressed period1. In addition to the above-mentioned regular review, an institution should have inplace procedures which ensure, on an on-going basis, that the specified stressed _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 251. period remains representative, including when ,market conditions or portfoliocompositions have been subject to significant change.2. In order to put in place sound procedures for the ongoing monitoring of therelevance of a stressed period, an institution should document the soundness of theimplemented approach.Monitoring may be based on a variety of factors which may differ among institutions.Factors to be considered include changes in market conditions, in trading strategiesor also in portfolio composition.These factors may be analysed by comparing them to changes in the allocation ofmarket values or notionals, in risk factor loadings, in the level of VaR or sensitivities,in the repartition of VaR or sensitivities over portfolios and risk categories, in the P&Land back-testing results or also by the impact of newly approved products on the riskprofile.3. In addition to the above-mentioned procedures, monitoring of Stressed VaR relativeto VaR should be performed on an on-going basis, because, while in theory, due todifferences in parameterisation, Stressed VaR can exceptionally be smaller than VaR,also at inception, this should not structurally be the case.The ratio between Stressed VaR and VaR at the moment of identification of therelevant stressed period should be used as a reference value for ongoing monitoring.Significant decreases in the ratio should be considered as indications for a potentialneed for review of a stressed period.A ratio between Stressed VaR and VaR below one should be considered as a warningsignal triggering a review of the stressed period.C. Stressed VaR methodology10. Consistency with VaR methodology1. The Stressed VaR methodology should be based on the current VaR methodology,with specific techniques required, where applicable, in order to adjust the current VaRmodel into one that delivers a Stressed VaR measure. Any risk factor occurring in theVaR model should therefore be reflected in the Stressed VaR model.2. With respect to standards used in both measures, and further to the ones prescribedby the Directive (e.g. the 99% confidence level), institutions may consider the use of‘square root of time’ scaling to calculate a 10-day Stressed VaR measure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 252. Nevertheless, given some known limitations of the scaling factor, an analysis todemonstrate that the assumptions underlying the use of the ‘square root of time’ ruleare appropriate, should form part of the internal model validation process.3. While the Stressed VaR model should share some of the current VaR standards,others may diverge due to explicit Directive requirements or to methodologicalincompatibilities related to the Stressed VaR concept.In particular, this is the case in the following areas:(i) Length of the stressed PeriodGiven the length of the stressed period must be 12 months, any action to reduce orincrease the stated stressed period based on the need for consistency between VaRand Stressed VaR should not be permitted.(ii) Back-testing requirementThe multiplication factor ms used for capital requirements should be at least 3 and beincreased by an addend between 0 and 1 depending on the VaR backtesting results.Nevertheless, backtesting is not a requirement in itself for determining the StressedVaR measure.(iii) Periodicity of the Stressed VaR calculationAs the CRD provides that the calculation of the Stressed VaR should be at leastweekly, institutions may choose to compute the measure more frequently, forinstance, daily, to coincide with the VaR periodicity.If, for example, institutions decide on a weekly Stressed VaR computation, andassuming a one-day Stressed VaR scaled up to 10 days, for the daily calculation ofcapital requirements based on internal models the following would apply:a) The same Stressed VaR number would be used for 5 subsequent business daysfollowing the running of the Stressed VaR model;b) With respect to the calculation of the average Stressed VaR numbers during thepreceding sixty business days, institutions should use the previous 12 Stressed VaRnumbers to compute that average;c) An institution should be able to prove that, on the day of the week chosen forStressed VaR calculation, its portfolio is representative of the portfolio held during the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 253. week and that the chosen portfolio does not lead to a systematical underestimation ofthe Stressed VaR numbers when computed weekly.For example, proof that the VaR is not systematically lower on the day of the weekchosen for Stressed VaR calculation could be considered sufficient.4. Stressed VaR standards may diverge from VaR standards in other circumstanceswhere there could be methodological incompatibilities between the current VaR andthe Stressed VaR model.One example includes changes in the current VaR methodology that cannot betranslated into the Stressed VaR measure and the use of local valuation (sensitivityanalysis/proxies) as opposed to full revaluation, which is the preferred approach forStressed VaR.5. As a general rule, changes in an institution’s VaR model or VaR methodologyshould be reflected in changes to the model/methodology used to calculate theStressed VaR charge.6. Under exceptional circumstances, if an institution can demonstrate that it cannotincorporate enhancements to the current VaR methodology in the Stressed VaR, suchsituations should be documented and the institution should be able to demonstratethat the impact (for example, in terms of VaR or capital requirements) resulting fromthe current VaR developments which are not implemented in the Stressed VaRmeasure is limited.7. Where sensitivities rather than full revaluation are used within a VaR model, theinstitution concerned should demonstrate that this approach is still appropriate forStressed VaR where larger shocks are applied.A sensitivity-based approach for Stressed VaR may require that higher orderderivatives/convexity are factored in.8. Any revaluation ladders or spot/volatility matrices employed should be reviewedand extended to include the wider shocks in risk factors that occur in stressfulscenarios.It is preferable that full revaluation be used for Stressed VaR with shocks appliedsimultaneously to all risk factors.9. In terms of calibration to market data, the process of ‘de-meaning’ is not considerednecessary for Stressed VaR. If there is a significant drift in market data, the use ofantithetic data is preferable to ‘de-meaning’. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 254. 10. The table below summarises the main issues described above concerning the levelof consistency between the methodological aspects of the current VaR and StressedVaR measure.11. Estimation of proxies for Stressed VaR1. Given that the data constraints that make necessary the use of proxies for VaR,become even more relevant for Stressed VaR and that it is expected that any proxiesused in VaR will also be necessary for Stressed VaR, while additional ones may also beneeded, whereas any new risk factor not present in the historical data should naturallyrequire the use of a proxy for VaR calculation, but only on a ‘temporary’ basis (e.g.after one year there would be enough real information to complete a 12-month dataseries), the same proxy should be more ‘permanent’ for Stressed VaR purposes (due tothe more constant nature of the historical time series).2. If a risk factor is missing in the stressed period because it was not observable duringthat period (for example for a newly listed equity) the institution may use another riskfactor (in this example, another equity from the same sector and with a similar riskand business profile) for which there is information available and for which a highlycorrelated behaviour with the factor that the institution is trying to capture can bedemonstrated. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 255. Where these proxies are used, institutions should consider whether an assumption of100% correlation between the risk factor and its proxy is appropriate.3. Institutions may alternatively map the missing factor to another one similar interms of volatility (though not necessarily correlated). If this approach is used,institutions should demonstrate that it is conservative and appropriate.4. If a VaR model is enhanced by incorporating a risk factor, an institution should alsoincorporate it into its Stressed VaR calculations.In certain cases, this may mean reviewing the historical data series for the risk factorsand introducing an appropriate proxy.For example where a new risk factor used for valuation purposes is incorporated intothe VaR model as required under Annex V point 12 first Paragraph of Directive2006/49/EC as amended by Directive 2010/76/EU.5. In all cases, the use of these proxies, including simplifications and any omissionsmade, will only be acceptable provided they are well documented and their limitationsare taken into account and addressed in the institution’s capital assessment.12. Validation of proxies1. Whereas validation of a proxy should be broadly performed in the same way for VaRand Stressed VaR, any proxy validated for the day-to-day VaR is not automaticallyacceptable for Stressed VaR.Proxies in use should be reviewed periodically to assess their adequacy and ensurethat they provide a conservative outcome.2. Regarding those proxies which might be used for Stressed VaR purposes only (forinstance, due to lack of data in the selected period), an institution should ensure thatthe risk factor used as proxy is conservative.13. Validation of model inputs/outputs1. All qualitative standards defined for the control of consistency, accuracy andreliability of data sources of VaR also apply to Stressed VaR.2. Underlyings for which institutions do not have a history of data complete enough tocover the reference period, should be shocked by approximation, using closely relatedunderlyings (same market, similar structure and characteristics). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 256. Following the same process that has been approved for the institutions’ internalmodels, in order to ensure the quality of historical data used for the reference period,institutions should document the methodology followed for identifying and forproxying missing data.Institutions should also perform tests of the potential impact of the use of theseproxies.3. With a view to preserving arbitrage inequalities, institutions may need to apply datacleaning for Stressed VaR.Where this is the case, the removal of outliers from historical data series should beappropriately justified and documented, as it should not end up decreasing themagnitude of extreme events.4. As Stressed VaR entails, by definition, the application of highly stressed scenariosto current market parameters, which may lead to incoherent market conditions (e.g.negative forward rates) more frequently than within a VaR computation, institutionsshould monitor the calibration failures that may materialise.Institutions using full revaluation when estimating their Stressed VaR may be morefrequently confronted with those calibration failures than institutions not using fullrevaluation, not because failures will not happen, but because their methodology willnot enable them to spot these calibration failures when they occur.D. Use test14. Use test1. The Stressed VaR model should be subject to a use test through use of Stressed VaRoutput in risk management decisions.Stressed VaR output should be in place as a supplement to the risk managementanalysis based on the day-to-day output of a VaR model.The results of Stressed VaR should be monitored and reviewed periodically by seniormanagement.2. Where Stressed VaR outputs reveal particular vulnerability to a given set ofcircumstances, prompt steps should be taken to manage those risks appropriately. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 257. Title III – Final Provisions and Implementation15. Date of applicationCompetent authorities should implement these Guidelines by incorporating themwithin their supervisory procedures within six months after publication of the finalGuidelines.Thereafter, competent authorities should ensure that institutions comply with themeffectively.IV. Accompanying documentsa. Feedback on the public consultation and on the opinion ofthe BSG1. The European Banking Authority (EBA) officially came into being on 1 January2011 and has taken over all existing and ongoing tasks and responsibilities from theCommittee of European Banking Supervisors (CEBS).2. On 16 November 2011, the draft Guidelines on Stressed VaR were presented to theEBA’s Banking Stakeholder Group (BSG).The BSG provided broad comments and suggestions, to be considered by the EBA,when finalizing the Guidelines.3. On 30 November 2011, the EBA submitted the draft Guidelines on Stressed Value atRisk (Stressed VaR) for public consultation.The consultation period ended on 15 January 2012.Ten responses were received.In addition, a public hearing was held on 13 December 2011 at the EBA’s premises inLondon, to allow interested parties to share their views with the EBA.4. The responses to the consultation paper were generally positive and supportive ofEBA’s work and required only some clarification; however, on some paragraphs in theconsultation paper, the majority of the respondents disagreed or requested significantclarification. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 258. 5. A detailed account of the comments received and the EBA´s responses to them isprovided in the feedback table below.The feedback table is divided between general remarks and specific commentsreceived from respondents and includes a section with EBA’s point of view on themand the changes made in the final guidelines to address them.6. In some cases, several respondents made similar comments.In such cases, the comments, and EBA’s analysis of them are included in the sectionof the detailed part of this paper where EBA considers them most appropriate. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 259. Models and tools for macroprudential analysisBCBS Working Papers No 21, May 2012The Basel Committees Research Task Force Transmission Channel project aimed atgenerating new research on various aspects of the credit channel linkages in themonetary transmission mechanism.Under the credit channel view, financial intermediaries play a critical role in theallocation of credit in the economy.They are the primary source of credit for consumers and businesses that do not havedirect access to capital markets.Among more traditional macroeconomic modelling approaches, the credit view isunique in its emphasis on the health of the financial sector as a critically importantdeterminant of the efficacy of monetary policy.The final products of the project are two working papers that summarise the findingsof the many individual research projects that were undertaken and discussed in thecourse of the project.The first working paper, Basel Committee Working Paper No 20, "The policyimplications of transmission channels between the financial system and the realeconomy", analyses the link between the real economy and the financial sector, andchannels through which the financial system may transmit instability to the realeconomy.The second working paper, Basel Committee Working Paper No 21, "Models andtools for macroprudential analysis", focuses on the methodological progress andmodelling advancements aimed at improving financial stability monitoring and theidentification of systemic risk potential.Because both working papers are summaries, they touch only briefly on the resultsand methods of the individual research papers that were developed during the courseof the project. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 260. Each working paper includes comprehensive references with information that willallow the interested reader to contact any of the individual authors and acquire themost up-to-date version of the research that was summarised in each of these workingpapers.The Research Task Force Transmission Channels ProjectThe Research Task Force Transmission Channel (RTF-TC) project was conceivedbefore the onset of the recent global financial crisis.From the beginning, RTF-TC was intended to be a long-term project that wouldinvolve many RTF member institutions.The primary goal was to generate new research on various aspects of the creditchannel linkages in the monetary transmission mechanism.Under the credit channel view, financial intermediaries play a critical role in theallocation of credit in the economy.They are the primary source of credit for consumers and businesses that do not havedirect access to capital markets.Among more traditional macroeconomic modelling approaches, the credit view isunique in its emphasis on the health of the financial sector as a critically importantdeterminant of the efficacy of monetary policy.Subsequent to the start of the RTF-TC, the onset of the global financial crisis focusedpolicymakers’ attention on the health of the financial sector.While the RTF-TC did not anticipate the financial crisis, its work did progress as thefinancial crisis unfolded.Many of the research papers produced in this project made use of new data andinsights gained from the work that many RTF member institutions undertook duringthe course of the financial crisis.Six workshops hosted by the Bank of Italy, by the Bank of France and the FrenchPrudential Supervisory Authority, by the UK Financial Services Authority, by the Bankof Canada and the Canadian Office of the Superintendent of Financial Institutions, bythe US Office of the Comptroller of the Currency, and by the Central Bank of Norwayprovided venues to present innovative research studies, but also, importantly, toreceive feedback from RTF member institution colleagues. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 261. The research papers and findings produced by the RTF-TC are in most casespreliminary and still undergoing revision and refinement.Still, RTF-TC research has produced many new insights and analysis that help us tobetter understand the linkages between the financial sector and real economy.The work of the RTF-TC included detailed econometric analysis of credit data frommany RTF member countries, theoretical modelling contributions, dynamicstochastic general equilibrium calibration exercises and experiments, and theinvestigation of new analytical approaches for financial stability monitoring andsystemic risk analysis.The results of these projects should help to inform macroprudential policydevelopment.The final products of the RTF-TC project are two working papers that summarise thefindings of the many individual research projects that were undertaken and discussedin the course of the project.The first working paper, Basel Committee Working Paper No 20, “The policyimplications of transmission channels between the financial system and the realeconomy”, analyses the link between the real economy and the financial sector, andchannels through which the financial system may transmit instability to the realeconomy.The second working paper, Basel Committee Working Paper No 21, “Models andtools for macroprudential analysis”, focuses on the methodological progress andmodelling advancements aimed at improving financial stability monitoring and theidentification of systemic risk potential.Because both working papers are summaries, they touch only briefly on the resultsand methods of the individual research papers that were developed during the courseof the project.Each working paper includes comprehensive references with information that willallow the interested reader to contact any of the individual authors and acquire themost up-to-date version of the research that was summarised in each of these workingpapers.Paul Kupiec, FDIC and Chairman of the Basel Committee Research Task Force _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 262. Models and tools for macroprudential analysisIntroductionThe findings of the Research Task Force Transmission Channel (RTF-TC) projectare reported in two summary papers.The role that the financial system played in transmitting instability to the real sector ofthe economy is examined in the first report of the RTF-TC (Basel CommitteeWorking Paper No 20).This report focuses on the methodological progress and modelling advancementsuseful for improving the existing financial stability analytical framework – that is theframework to identify, assess and monitor systemic risk.Systemic risk is defined as the risk of disruptions in the provision of key financialservices that can have serious consequences for the real economy.The RTF-TC contributing member institutions conducted new research that waspresented at international workshops organised by the group. This research allowedthe group to study the interactions between the financial system and the real economyand, more generally, those interactions that have the potential for producing systemicrisk.The workshops facilitated communication among member institution researchers.In summarising the findings of the group, this report acknowledges the jointcontribution of the members of the group and of all the other participants at theworkshops (both authors and discussants).The Appendix lists the papers presented and the workshop participants.We caution that this document is not a comprehensive literature review, but reflectsthe specific contributions and insights of the RTF-TC members.This summary of the RTF-TC’s findings is organised into four sections.Section 1 discusses analytical methods used to measure the impact of macro-financialshocks on the real economy.This section includes studies that use dynamic stochastic general equilibrium models(Section 1.1) as well as studies that use more traditional macro stress testing methods(Section 1.2). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 263. Section 2 discusses developments in modelling financial sector liquidity riskincluding the potential for contagion.Section 3 discusses methods for measuring the potential for systemic risk.Section 4 summarises RTF-TC studies that quantify bank behavioural responses tochanging central bank and macroprudential policies and macroeconomic conditions.Each section includes a summary of the remaining gaps in the literature.1. What are the impacts of a macro-financial shock on thefinancial sector and the real economy?How should the transmission of a macro-financial shock on thebanking sector, the macroeconomy, and the possible feedbackbetween the two sectors be measured?The recent global financial crisis highlighted some key features that need to beincorporated into operational macroprudential models.One feature models must take into account is the importance of the credit andmaturity transformation mechanism that lies at the heart of banking. In normal times,banks fund themselves with short-term liquid contracts and invest in illiquid creditinstruments with longer maturity duration.Financial sector shocks have the potential to disrupt the normal credit intermediationprocess and may result in a widespread curtailment of credit to bank dependentcustomers.A second important modelling feature identified by the crisis is the ability to accountfor interdependencies (both linear and non-linear) among key financial andmacroeconomic variables and for feedback effects between the financial and realsectors.Models should also account for the fact that, for a set of interconnected, highlyleveraged financial institutions, systematic risk is likely to play a more important rolethan idiosyncratic risk.These two modelling features, in addition to the lessons learned from the recent crisis,emphasised the need to build a model that can incorporate out-of-equilibriumdynamics, learning, herding behaviour, and contagion. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 264. The RTF-TC research included studies using two different methods formacroprudential modelling that encompasses those aspects: dynamic stochasticgeneral equilibrium (DSGE) models and traditional econometric macro stress testingmodels.DSGE models are computable general equilibrium models built frommicroeconomic-consistent foundations.These models are calibrated to mimic historical data patterns but are not estimated inthe traditional econometric sense.While DSGE models can be designed to include interesting behavioural features intheir representative agents, they do not generate time-series forecasts.DSGE models are instead designed to answer comparative static or “what if”exercises.In contrast, traditional macroprudential stress testing methods rely on reduced formeconometric model specifications that are estimated using historical data.These models need not be linked to an underlying model of a rational optimisingrepresentative agent.The ideal macro-financial model would incorporate features of both of theseapproaches, but the development of operational hybrid models is unlikely in the nearterm.Additionally, an important challenge is that this ideal model cannot be overlycomplex.Model results must be intuitive and their logic accessible for financial stabilityauthorities to better understand the most important features of the transmissionchannels between the financial sector and the real economy during periods of extremewidespread stress.At present, there is no single “best” approach for macroprudential modelling; theapproach must be tailored to the data available and to the question at hand.1.1 Are dynamic stochastic general equilibrium (DSGE) models useful for understanding the channels of transmission of financial sector shocks? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 265. Can they be used to quantify the impact of a financial sector shock on the real economy?Can DSGE models help identify whether macro prudential regulations will attenuate or amplify a shock?How do monetary and macroprudential policies interact?Can DSGE models be used to optimise macro prudential regulation?DSGE models are complex, non-linear systems of equations.Initially, DSGE models were developed in the Real Business Cycle literature.Enhanced DSGE models that included market imperfections and nominal rigiditieswere developed in the so-called New Neoclassical Synthesis which created models inwhich monetary policy is no longer neutral in the short run.DSGE models have three distinguishing features.First, they are constructed from microeconomic foundations assuming rationalforward-looking optimising behaviour of individual economic agents.Secondly, DSGE models are constructed to be internally-consistent with theirassumptions and can capture the behavioural interactions between households, firms,and policymakers.As such, DSGE models assume the existence of a stable equilibrium and the risks inthese models are purely exogenous shocks that drive the economy temporarily awayfrom the steady state to which it dynamically converges according to the optimisingbehaviour of the different agents.Thirdly, typical DSGE methods cannot easily incorporate irrationality, inefficientmarkets, and the formation of asset price bubbles.DSGE models can be used to analyse and understand the mechanisms through whichexogenous shocks are transmitted to the real economy as the real economy adjuststowards a new equilibrium.In this capacity, DSGE models have been used to explain: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 266. (i) How macro variables react to aggregate shocks, either real (eg productivity,exogenous demand, etc) or monetary shocks,(ii) The transmission channels of different economic policies, and(iii) The role of different real and nominal rigidities that may be sources of theobserved dynamics of the macroeconomy.In this context, systemic risk is represented by macroeconomic instability, which isoriginated either by a real or a financial exogenous shock, and is propagated throughexcessive lending and excessive GDP growth in booms, and vice versa in downturns.In the aftermath of the recent global financial crisis, DSGE models have beencriticised for relying too heavily on the assumption of a perfectly competitive capitalmarket.Indeed, under this assumption, the Modigliani-Miller (M-M) theorem holds, andmodels are incapable of capturing credit channel effects.Because these models lacked a realistic financial sector, they were of little use duringthe crisis.In this section, we discuss RTF-TC research efforts to attempt to include an accuratefinancial sector into a DSGE framework and how this research has made DSGEmodels more useful in answering questions regarding financial sector shocks andregulation.The original models of banking activities are too simplistic to use for policy analysison the effects of capital regulation on credit intermediation.RTF-TC studies have attempted to improve existing models by developing a stylisedmodel of the banking sector that recognises financial frictions on the borrowing andlending side and thereby including a role for bank capital.Micro-founded financial frictions are modelled by assuming imperfect informationbetween lenders (interbank market or depositors) and borrowers (financialintermediaries).Credit contracts in the funding market for banks are not perfect, due to the possibilityfor banks to be impacted by shocks and the impossibility for their creditors to fullyobserve these shocks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 267. In some cases, the modelling approach allows for banks to default in equilibrium, aswell.Once the model includes financial frictions, there is a natural economic role for bankcapital. Several papers analyse how frictions in the financial sector can influence thebank balance sheet and endogenously create an optimal bank capital structure.RTF-TC research uses bank capital to mitigate asymmetric information frictionsbetween lenders and borrowers (financial intermediaries).This endogenous resolution of the agency problem results in constraints on banks’leverage ratios and implies that equilibrium credit flows will depend on the banks’equity positions.Any unexpected movement in asset prices – either endogenously, via demand forinvestment, or exogenously via a financial shock – will affect the banks’ balance sheetand risk premium.The shock will endogenously alter the demand for bank capital to attenuate the riskpremium and the set of feedbacks that augment the initial change in investment andasset prices.Banks’ endogenous demand for capital also interacts with the interbank market indetermining loan supply.In these models, the introduction of a binding regulatory constraint has importantimplications for the dynamics of the macroeconomic variables, because a costlytrade-off arises between equity issuance and a decrease in lending.With these enhancements, DSGE models are better able to address fundamentalpolicy issues, such as the overall importance of financial sector shocks in explainingthe business cycle and the role of monetary policy and/ or prudential regulation toavoid or mitigate financial crises.For example, one RTF-TC study shows that, in the presence of financial frictions,aggressive interest rate cuts are required to offset adverse financial shocks.Another RTF-TC study uses an enhanced DSGE model to assess the interactionbetween monetary and macroprudential policies and the design of an optimal mix ofthese policies.A comparison of the effects of countercyclical capital requirements, maximumloan-to-value ratios, and maximum leverage ratios with traditional monetary policy _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 268. instruments shows that countercyclical financial-sector regulation may prove useful inmitigating the business-cycle fluctuations in the aftermath of a technological or amonetary shock, but might as well have an amplification effect if the banks’ capitalunexpectedly drops.Even though DSGE models cannot be used to examine the endogenous creation ofbubbles, an RTF-TC study attempts to model how the economy is affected by the lifecycle of bubbles.The results suggest that ownership of the over-valued asset is an important issue.The boom-bust cycle is strongly amplified when the asset experiencing the pricebubble is held by banks, but the economy is much less affected if the bubble asset isheld by unleveraged agents.Such research may help develop early warning indicators of dangerous bubbles,discussed further in Section 3, and an evaluation of credit conditions that mayproduce such bubbles.The findings of many of the RTF-TC DSGE studies are preliminary and subject tofurther refinement.The studies tend to each focus on a particular financial shock in isolation (eg a shockaffecting borrowers’ net worth, asset prices, or banks’ capital).Depending on the type of financial shock considered, its consequences and thetransmission mechanism can be very different.Second, and perhaps more fundamentally, the work of the RTF-TC group hashighlighted a key issue that macroprudential analysts must resolve when using DSGEmodels for policy analysis: they must strike a balance between simplicity andtransparency on the one hand, and reality and completeness on the other hand.Perhaps, the answer lies in the specific purpose for which the model is used in a giveninstance.In fact, when the focus is on the quantification of the impact of shocks and the roleplayed by banking regulation, a rich framework is needed in order to incorporatemeaningful behaviour of the financial system and feedback effects to themacroeconomy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 269. Some of the research conducted by RTF-TC introduced a banking sector in acomplicated manner which makes it difficult to fully understand the forces driving theinteraction between the real and financial sectors.In contrast, if the aim is to understand the transmission channels between the real andthe financial sectors, then simpler models appear to be more desirable.While the DSGE model findings reported in this summary are informative, furtherresearch and analysis is required.Since DSGE models assume forward-looking rational expectations equilibria, theymust be modified to include some type of market or information imperfection beforethey can accommodate fads, bubbles or the market pricing imperfections that shouldbe considered when analysing financial stability.Since the root causes of investment fads and market inefficiencies remain a mysteryfor the most part, there are potentially many ways that these features might beintroduced into DSGE models and in some cases there is little empirical basis for themechanism used to generate the financial sector inefficiency.More generally, such studies and the corresponding models, both theoretical andempirical, are but one input into regulatory (and monetary) policymaking, inconjunction with qualitative judgements and analysing trends in a broad range ofdata.The RTF-TC group has also highlighted several directions for future research onDSGE models:Appropriately enhanced, models can potentially be used to help assess theinteractions (and the possible trade-offs) between macroprudential, monetary andfiscal policies, since all policies have a bearing on financial stability.There is a need for a formal normative (welfare) analysis.What are the costs of a macroprudential policy (eg increased bank capitalrequirements) and how are they distributed among different agents?Can we compare the transition costs with the potential benefits in terms of decreasedswings in the business cycle? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 270. Do we need to consider the accompanying fiscal policy?- The very nature of financial intermediation is to assume financial risk due to balance sheet mismatch between assets and liabilities. The research of the RTF-TC group has modified and created models to incorporate a more accurate picture of the financial sector. However, maturity mismatch and the effects of market valuation on assets still need to be satisfactorily incorporated, especially since they represent an important aspect of the recent financial crisis. More generally, future research needs to focus on endogenising the systemic-risk exposures of banks.- DSGE models can be useful for understanding the bank capital channel, but they are limited by their solution method. DSGE models equilibria are approximated around the model’s steady state and such solutions may become inaccurate when considering large deviations from the steady path. These models also require a unique equilibrium and thereby cannot encompass models with multiple equilibria that allow movements between equilibria. It is an open issue whether local solution methods are useful for studying financial (in)stability and whether they are capable of producing reliable quantitative information in case of financial turmoil.- Disaggregated models of the economy that include different degrees of borrower riskiness could help address questions such as: At any given moment, which sectors are at risk? How interdependent are the sectors (in other words, what is the correlation among sectors)? By contrast, current DSGE models only consider the net worth of the borrowers independently of the sector to which the borrowers belong and individual risks they might face. Several research papers of the RTF-TC group represent early attempts at including sectoral diversification and matching different degrees of riskiness in capital requirements. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 271. More generally, there are a number of features that could potentially be useful to add to DSGE models (diversity of entities in the system and their interactions, risk appetite and expectations) that could help policymakers understand complex quantitative questions. Still, more research is needed in this area.1.2 How can traditional macro stress testing models (those using a suite-of-models approach) be improved to better measure the transmission and the lasting effects of a macro-financial shock?Macro stress testing refers to a range of analytical models and tools that are used bycentral banks and supervisory agencies to assess financial sector vulnerabilities tosevere but plausible scenarios of widespread exogenous shocks.For many central banks and supervisors, the practice of macro stress testing wasintroduced as part of the Financial Sector Assessment Programs conducted by theIMF and the World Bank.As such, macro stress tests can provide valuable information on the potential negativeeffects on the financial sector that are imposed by severe real sector shocks, and thushelp policymakers assess the soundness of the financial system.Ideally, macro stress tests could allow bank supervisors to identify institutions whosecurrent financial condition poses risks under alternative macroeconomic scenarios.Central banks and supervisors typically use a suite of models and tools in amulti-stage process to conduct macro stress testing of credit risk.The first stage involves projecting the dynamic paths of key macroeconomicindicators (such as GDP, interest rates, and house prices) under a certain stressscenario.The projections normally use some combination of structural macroeconometricmodels, VAR models and vector error correction models, or some other statisticalapproach.In the second stage, a credit risk satellite model is estimated using either loanperformance data (such as non-performing loans, loan loss provisions, or historicaldefault rates) or micro-level data related to the default risk of the household and/orcorporate sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 272. The satellite or auxiliary model is then used to link a measure of credit risk to thevariables from the macroeconomic model and to map the external macroeconomicshocks to a bank’s asset quality shocks.Finally, the last stage involves estimating the impact of the asset quality shocks on abank’s earnings and/or capital.One of the main limitations of traditional stress testing is that the satellite models thatare used treat the macroeconomic variables as exogenous and ignore the feedbackeffects from a situation of distress in the banking system to the macroeconomy.In conducting macro stress tests, the statistical relationship between macroeconomicvariables and indicators of the banks’ financial condition can change dramaticallyunder stressed conditions.Therefore, if the focus is only on the conditional mean of a risk measure (as is typicalof a traditional stress testing exercise), it can be an inadequate approach in assessingthe impact of an aggregate shock.During periods of extreme stress, it is especially important to focus on unexpectedlosses in order to assess the tails of the loss distributions.The research of the RTF-TC group focused on the quantile regression (QR) methodto address this issue. The QR approach focuses on the tail events of conditional riskindicator distributions.It allows for the possibility of extreme events leading to changes in the statisticalrelationships between the risk indicators and macroeconomic variables across thequantiles of the distribution of a given stress indicator and by doing so, provides amore complete picture of covariate effects.For example, a covariates relationship with a stress factor can differ substantially atlower and upper quantiles of a dependent variable compared to its relationship at itsmean or median values.RTF-TC research showed that the QR approach is robust to extreme events and canalso be used to construct density estimates and forecasts of real activity and financialstress and expected shortfall measures of systemic real risk and systemic financialrisk.The QR approach produced more conservative results when compared with otherapproaches to modelling the macro-credit risk link.The method is very flexible and could have a variety of _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 273. additional applications in the area of stress testing, such as forecasting interestincome, fee income, profits, or loan loss provisions; or on probability of default (PD)estimates and loss-given-default (LGD) estimates which influence risk-weightedassets and capital adequacy ratios.To read the paper: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 274. The policy implications of transmission channels between thefinancial system and the real economyBCBS Working Papers No 20, May 2012The Basel Committees Research Task Force Transmission Channelproject aimed at generating new research on various aspects of the creditchannel linkages in the monetary transmission mechanism.Under the credit channel view, financial intermediaries play a critical rolein the allocation of credit in the economy.They are the primary source of credit for consumers and businesses thatdo not have direct access to capital markets.Among more traditional macroeconomic modelling approaches, thecredit view is unique in its emphasis on the health of the financial sectoras a critically important determinant of the efficacy of monetary policy.The final products of the project are two working papers that summarisethe findings of the many individual research projects that wereundertaken and discussed in the course of the project.The first working paper, Basel Committee Working Paper No 20, "Thepolicy implications of transmission channels between the financialsystem and the real economy", analyses the link between the realeconomy and the financial sector, and channels through which thefinancial system may transmit instability to the real economy.The second working paper, Basel Committee Working Paper No 21,"Models and tools for macroprudential analysis", focuses on themethodological progress and modelling advancements aimed at _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 275. improving financial stability monitoring and the identification ofsystemic risk potential.Because both working papers are summaries, they touch only briefly onthe results and methods of the individual research papers that weredeveloped during the course of the project.Each working paper includes comprehensive references with informationthat will allow the interested reader to contact any of the individualauthors and acquire the most up-to-date version of the research that wassummarised in each of these working papers.The policy implications of transmission channels between thefinancial system and the real economyIntroductionThe recent global financial crisis was a catalyst for regulatory change.Policymakers have strengthened existing micro-prudential tools, such asbank-specific capital and liquidity requirements, and introduced newmacro-prudential tools, such as countercyclical capital requirements,capital surcharges for systemically-important financial institutions, andloan-to-value caps to promote financial stability.In addition, stress testing has taken on new importance both as a meansfor helping policymakers decide on a course of action and as a tool forcommunication.At the same time, data emerging from the crisis provides new informationabout transmission channels between the financial system and the realeconomy.For example, it is now obvious that economic models and analysis mustaccount for the state of the financial system when forecasting theevolution of the macroeconomy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 276. Moreover, the crisis has shown that linear approximations based on datafrom normal economic times fail in periods of financial sector stress.Such issues highlight the need to improve our understanding of the roleof the financial sector in the monetary transmission channel.Over the past two years, a subgroup of the Research Task Force, theTransmission Channels (RTF-TC) project, has worked to produceoriginal research that addresses questions and outstanding issuesregarding the role the financial sector plays, both for economic growthand as a source of economic instability.During this period, research has been presented by the contributinginstitutions at several international workshops.These workshops have facilitated the communication of ideas and theinteraction of researchers working on the relevant topics.Many significant contributions have been made during this time.This document summarises the group’s findings.It is important to remember that most of this research is preliminary, andindividual authors will continue to refine their analysis and conclusions.So while we offer this summary of the group’s findings, we stress theirpreliminary nature, and caution against using these results to formulatepolicy without further research and supporting analysis.Moreover, we caution that this document is not a comprehensiveliterature review, but reflects the specific contributions and insights of theRTF-TC members.This report is designed as a reference document for policymakers, banksupervisors, and researchers alike and is organised around four topics:(1) The interactions between bank credit, monetary policy and growth inthe real economy;(2) Costs and benefits of bank capital and liquidity regulation; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 277. (3) Bank risk taking and monetary policy;(4) Asset price bubbles and cyclical properties of regulation.For each of these topics, several key questions have been identified fordiscussion.We conclude each section by highlighting the new issues and questionsthat have arisen and identify some remaining gaps in the literature.1. The interactions between bank credit, monetary policy andgrowth in the real economyBrief summary of literatureThis section focuses on the interactions between credit, economicgrowth, the banking sector and the real economy.It is well-known that monetary policy affects the supply of bank credit.Halvorsen and Jacobsen (2009), Hammerlsland and Traee (2010) andTabak et al (2010) all confirm that tighter monetary policy has a negativeimpact on bank lending.Moreover, this effect reflects at least in part a reduction in loan supply asshown by Ciccarelli et al (2010), Black and Rosen (2009), Jimenez et al(2010), Havro and Vale (2011) and Jimborean and Messonier (2010).The transmission channel of loan supply to the real economy isinvestigated in Hirataka et al (2010), Dedola and Lombardo (2009),Jimenez et al (2010), de Haas and van Horen (2010) and Black and Rosen(2009).These papers find that bank balance sheet conditions greatly influencethe transmission of shocks to the real economy as the health of bankbalance sheets affects bank lending and the credit available to bankdependent borrowers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 278. The efficacy of monetary policy may depend on market conditions. Havroand Vale (2011), Ciccarelli et al (2010), de Haas and van Horen (2010) andBoissay (2011) show that a drop in market liquidity weakens the creditchannel of monetary policy and leads to a negative contribution to GDP.Monnin and Jokipii (2010) find a positive link between measures ofbanking sector soundness and growth in the real economy.Some RTF-TC research focused on understanding the impact of leverageand liquidity on the provision of credit. The evidence appears to bemixed.Some authors do not find a clear direct effect of leverage on lending(Havro and Vale (2011)), while others provide evidence that bettercapitalised banks, to a varying degree, are more willing to lend(Berrospide and Edge (2010); Foglia et al (2010)).Further evidence of the importance of bank health is provided by Francisand Osborne (2009) who show that banks with capital in excess of theirown capital target lend more than their peers.The impact of liquidity on the provision of credit appears to be similar.Banks with more liquid portfolios appear more willing to lend (Havro andVale (2011)).Based on findings by the RTF-TC, this section of the report addresses thefollowing questions:(1) How does monetary policy impact the credit channel?(2) Do financial market conditions impact the credit channel?(3) What is the relative importance of the bank lending and borrowerbalance sheet channels in the financial transmission mechanism?(4) How do higher capital standards impact economic growth, creditavailability and financial stability? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 279. (1) How does monetary policy impact the credit channel?Empirical studies have found evidence that increases in the central bankpolicy rate have a negative impact on bank lending.Examples of such papers using macroeconomic data include Halvorsenand Jacobsen (2009) and Hammerlsland and Traee (2010) which studyboth the UK and the Norwegian economies.Similarly, at the micro (bank) level, Tabak et al (2010) find that banklending is reduced in response to an increase in the central bank policyrate in Brazil.While such an effect is consistent with the existence of credit channelinfluences on credit supply, these studies do not prove that credit channeleffects are present since they do not identify whether the amount of creditchanges because of a shift in credit supply or a change in credit demand.Several papers have tried to solve this identification problem.Ciccarelli et al (2010) use the confidential euro area Bank Lending Surveyand the publicly-available US Senior Loan Officer Survey to disentanglethe effects of loan supply from loan demand.They find loan supply to be more sensitive to monetary policy shocksthan loan demand.Black and Rosen (2009) use bank-level data on extensions of businesscredit to examine how monetary policy affects aggregate loan supply.They examine the distribution of loans across firms of different sizes, thematurity structure of loan originations and the supply of loans from smalland large banks.They find monetary policy affects aggregate loan supply by causingvariation in the maturities of new originations, with the impact being atleast as strong for large banks as for small banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)
  • 280. Jiménez et al (2010) use disaggregated data for analysing the banklending channel and conclude that the provision of loans is significantlyaffected by tighter monetary policy.Havro and Vale (2011) as well as Jimborean and Mésonnier (2010) providefurther evidence using Norwegian and French data, respectively.The empirical findings highlighted above suggest that at least part of theeffect on bank lending from tighter monetary policy is supply driven, iethere is a bank lending channel for monetary policy.(2) Do financial market conditions impact the credit channel?Financial market conditions appear to affect the strength of the creditchannel.More specifically, a decrease in market liquidity weakens the creditchannel of monetary policy and results in slower GDP growth for