Risk Compliance News September 2012
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Risk Compliance News September 2012

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    Risk Compliance News September 2012 Risk Compliance News September 2012 Document Transcript

    • _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.comDear Member,Modelling risks …… this is really one of the most interestingtopicsAgathe Côté: Modelling risks to the financial systemRemarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, tothe Canadian Association for Business Economics, Kingston, Ontario, 21August 2012.***IntroductionIt has become a summer tradition for the Bank ofCanada to address the Canadian Association forBusiness Economics.This year it is my pleasure and I thank you for the kind invitation.An audience of colleagues and fellow economists offers me anopportunity to delve into a complex subject, and one that is particularlytimely: financial system risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • We continue to see today the enormous costs to the global economy of thefinancial crisis that started five years ago.Of the many lessons we have learned from the crisis, a key one is this: weneed to pay more attention to the stability of the financial system as awhole.This means understanding better how risks get transmitted acrossfinancial institutions and markets, and understanding better the feedbackloop between the financial system and the real economy.From a policy perspective, this means taking a system-wide approach tofinancial regulation and supervision.Major reforms of the global financial system now under way address thisneed.System-wide risk has been a focus of attention at the Bank of Canada, andat other central banks, for some time.Ten years ago, the Bank issued the first edition of its semi-annualFinancial System Review in which it identifies key sources of risks to theCanadian financial system and highlights the policies needed to addressthem.A year later, in 2003, we organized our annual conference on the theme offinancial stability.In the wake of the global financial crisis, the Bank has intensified itsresearch efforts in this area.In particular, a priority is to improve the theoretical and empirical modelswe use to analyze elements of the financial system that can lead to theemergence of risks and vulnerabilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • With more finely tuned quantitative models and tools, the Bank will bebetter able to identify risks on a timely basis so that the private sector andpolicy-makers can take corrective action to support financial stability.Let me acknowledge upfront that this task is complex.While macroeconomic models have long been used to guide monetarypolicy decisions by central banks, models of financial stability andsystemic risk are much less advanced.In my remarks today, I want to talk about the progress that we have madeat the Bank in modelling risks to the financial system.I will start by briefly describing the notion of systemic risk and variousapproaches used to identify and measure it.I will then discuss two state-of-the-art quantitative models that we havedeveloped to improve our assessment of risks to the Canadian financialsystem.The multiple dimensions of systemic riskSystemic, or system-wide, risk goes beyond individual institutions andmarkets.It is the risk that the financial system as a whole becomes impaired andthat the provision of key financial services breaks down, with potentiallyserious consequences for the real economy.Systemic risk manifests itself in different ways.There is a time dimension, which refers to the accumulation ofimbalances over time, and a cross-sectional dimension, which refers tohow risk is distributed throughout the financial system at a given point intime. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Procyclicality is the key issue in the time dimension.It reflects the tendency to take on excessive risk during economicupswings – too much punch from the punchbowl, if you will – and tobecome overly risk averse during the downturns.Procyclicality makes the financial system and the economy morevulnerable to shocks, and increases the likelihood of financial distress.Risk concentrations and interconnections are the key issues in thecross-sectional dimension.Financial institutions can have similar exposures to shocks or be linkedthrough balance sheets.As a result, losses in one institution can lead to fears of contagion thatamplify the adverse effects of the initial shock.For instance, uncertainty about the viability of counterparties can lead tohoarding of liquidity, which may seem like an appropriate action for theindividual institution but can have disastrous consequences for thefinancial system as a whole.System-wide surveillance requires that we regularly assess the importanceof various types of systemic risk.How we judge a particular risk will be based on the probability that it willlead to financial system distress, and on the extent of its impact shouldthat distress materialize.Early-warning indicatorsA fundamental challenge is to detect the risks arising from both globaland domestic sources in an environment with a vast number of potentialindicators. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Therefore, one direction of research at the Bank has been to isolate thekey signals from this broad information set by identifying a smaller groupof variables that can serve as early-warning indicators of emergingimbalances.Since financial crises in Canada have been rare, international data areused to help establish numerical thresholds for each domestic indicator.For example, if international evidence suggests that credit growth above acertain rate tends to be associated with increased risk, then a period withcredit growth above the threshold would suggest an elevated probabilityof financial stress.Selecting the level of thresholds involves a difficult trade-off between falsealarms and failure to signal an event, so in practice the early-warningindicators are used mainly to identify areas where more detailedinvestigation may be warranted.They provide an objective, practical starting point to detect the buildup ofimbalances in the financial system.One early-warning indicator that we regularly track is the deviation of theaggregate private sector credit-to-GDP ratio from its trend (thecredit-to-GDP gap), which serves as a rough measure of excessiveleverage across the financial system (Chart 1). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This indicator has been shown to provide some leading information as apredictor of banking crises, and has been proposed by the BaselCommittee on Banking Supervision (BCBS) as a useful guide fordecisions about when to activate the countercyclical capital buffer – animportant macroprudential policy instrument in the Basel III agreement.Given the complexity of systemic risk, it is unrealistic to expect a singlemeasure or indicator to serve all purposes.Combining indicators can produce better signals with fewer false alarmsand undetected crises.For example, research shows that combining the Credit - to - GDP gapwith a measure of real estate prices produces an indicator that performsbetter than either variable on its own.Our own work at the Bank reinforces findings elsewhere that aggregateprivate sector credit and real estate prices are among the most reliableindicators of financial stress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Identifying sources of risk is essential, but so is determining thelikelihood that these risks will materialize.Therefore, another important aspect of ongoing research is thedevelopment of statistical models to help us forecast the probability that acrisis will occur based on a group of indicators.Macro stress testsEarly-warning indicators are useful to gauge the probability of financialstress, but a thorough assessment also requires an analysis of what couldhappen if the risk materializes.This is the goal of macro stress testing.A good part of the Bank’s efforts in recent years has been devoted todeveloping and refining stress-testing models.This class of models takes a large but plausible macroeconomic shock asa starting point and analyzes its impact on the balance sheets of banks orother sectors of the economy.The Bank now has two main stress-testing models to help monitor risksto the financial system.These models can also be used to assess the potential impact of policytools or regulatory actions in mitigating financial system risks.Assessing risks from elevated household debtThe first, the Household Risk Assessment Model, or HRAM, is amicrosimulation model that assesses how the debt burden of Canadianhouseholds can affect financial stability. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Using microdata from household balance sheets, the model allows us toestimate how various shocks would affect the distribution of debt withinthe household sector.The simulations take into account changes over time in individual debtlevels, as well as changes in household wealth from savings andfluctuations in the value of financial assets.Tracking the asset side of household balance sheets gives us a moreaccurate picture of systemic risk since changes in wealth affecthouseholds’ ability to pay their debt.Household vulnerabilities depend not only on the average level of debt,but also on how debt is distributed across individuals.One strength of the model is precisely its ability to account for thisdistribution.For instance, while record-low interest rates in recent years havecontributed to a relatively low aggregate household debt-service ratio, theshare of Canadian households that are considered most vulnerable –those with a debt-service ratio equal to or higher than 40 per cent – hasclimbed to above-average levels, as has the proportion of debt held bythese vulnerable households (Chart 2). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Using HRAM, we estimate that if interest rates were to rise to 4.25 percent by mid-2015, the share of highly indebted households would risefrom slightly above 6 per cent in 2011 to roughly 10 per cent by 2016, whilethe proportion of debt held by these households would rise from 11.5 percent to about 20 per cent over the same period.So while the aggregate household debt-service ratio paints a somewhatrosy picture, taking into account distributions gives us a clearer and morecautionary indication of how vulnerable our financial system actually is tohousehold debt.Another strength of the model is that it provides a flexible tool forsimulating the impact on household solvency of a wide range of potentialshocks, such as an increase in unemployment.HRAM indicates that household loans in arrears would more than doubleunder a severe labour market shock similar to that observed in therecession of the early 1990s. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Despite the model’s strengths, we continue to enhance our analysis byimproving HRAM.Expanding the behavioural aspects of the model is one way to do this.For instance, the model currently allows distressed households to paytheir debts by selling their liquid assets, but not their homes.Work is also under way to improve the design of the shock scenarios.Results of stress tests using HRAM are regularly reported in the Bank’sFinancial System Review and constitute an important element of ouroverall assessment of the risks associated with household finances.Assessing contagion effects in the banking systemHRAM provides invaluable information on vulnerabilities in thehousehold sector, but the Bank is also interested in assessing risks morebroadly within the Canadian financial system.To this end, we have been working for several years on developing aMacro Financial Risk Assessment Framework (or MFRAF).Drawing on detailed data from bank balance sheets, MFRAF is aquantitative model that tracks the contribution of individual banks tosystemic risk.Traditional stress-testing models focus exclusively on solvency risk, andestimate the overall risk to the financial system by simply aggregatingcredit (or other asset) losses that would materialize at individual banks inthe event of a severe shock.MFRAF goes beyond this traditional approach by taking into accountlinkages among banks arising from counterparty exposures – or networkspillover effects – as well as funding liquidity risk, that is, the risk ofmarket-based runs on banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The financial crisis illustrated the significant risks associated with adeterioration of funding liquidity.The collective reactions of market participants led to mutually reinforcingsolvency and liquidity problems at banks around the world.As funding liquidity evaporated, many well-capitalized institutions had totake writedowns on illiquid assets, or sell them at a loss, creatinguncertainty in the market about their solvency and adding to thedownward pressure on asset prices.MFRAF has been built to integrate funding liquidity risk as anendogenous outcome of the interactions between solvency concerns andthe liquidity profiles of banks.This strong microeconomic foundation constitutes a major innovation inmacro stress-testing models.MFRAF also incorporates network externalities caused by the defaults ofcounterparties, with the size of a counterparty’s interbank exposuresincreasing the likelihood of spillover effects.A key lesson from the model is that failure to account for either fundingliquidity risk or interbank exposures could lead to significantunderestimation of the risks to the financial system as a whole if thebanking system is undercapitalized and relies extensively on theshort-term funding market.Importantly, the loss distributions generated by the model exhibitfat tails, a key feature of the actual distribution of financial system risks(Chart 3). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The fact that the model is able to replicate this important stylized factdemonstrates that it has significant potential as a tool for assessingsystemic risk.Nevertheless, while MFRAF is already somewhat complex, the layers ofinteraction will need to be further augmented.For instance, the model misses any negative feedback that could occurbetween heightened risks to the banking system and the real economy.The model could also be expanded over time to include other types offinancial institutions and markets.Compared with other approaches that use market-based data, such as theasset-pricing approach, the transmission channel in models like MFRAFis transparent, and this improves our interpretation of results.Because of this “story-telling” ability, many central banks have begun touse this type of framework in their financial stability analysis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In addition to assessing risks, MFRAF can be used to examine the meritsof policy or regulatory initiatives such as capital and liquidity rules.As the model becomes more refined, the objective is to use it more tocomplement other existing macro stress-testing exercises and to sharpenour analysis and communication of risks in the Bank’s Financial SystemReview.ConclusionLet me conclude.The Bank of Canada is conducting extensive research into findingmethodologies and tools to identify and measure systemic risk.While work in this area is extremely complex, the Bank has madesubstantial progress in recent years.We now have two state-of-the art models. And with HRAM, the Bank ofCanada is one of the few central banks at the leading edge of usingmicrosimulation models to assess vulnerabilities in the household sector.Our efforts to build these models have provided us with importantlessons.First, distributions matter – we cannot rely solely on aggregate data:distributional features and complex interactions are very important forassessing risks.This means developing models that capture these effects.Our household simulation model is aimed directly at understanding howthe distribution of debts, assets and income affects financial stability. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • MFRAF uses information about the interconnections of individualfinancial institutions because these can lead to non-linear network effectsthat are also important for assessing systemic risks.Second, predicting behaviour under stress conditions is very difficult.Models need to be able to handle a variety of “what-if” scenarioscorresponding to different assumptions about behaviours under stress.Finally, we need to consider the many different sources of risk to thefinancial sector and take into account their cumulative effects andinteractions; otherwise we may underestimate risks.Obviously, quantitative measures alone will never be enough to get acomplete picture, especially since the financial system evolves rapidly.Intelligence gathered from discussions with the financial sector, as wellas information shared with other policy-makers and supervisors here inCanada and in the international community, will always be critical to theoverall assessment of the risks.While we are making progress, it is important to remember that financialsystem modelling is still in its infancy.The goal – understanding, preventing, and reducing systemic |risk –deserves our attention, diligent research and hard work. It has been mypleasure to share some of the Bank’s efforts with you today. Thank youvery much. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Progress note on the Global LEIInitiativeThis is the first of a series of notes onthe implementation of the legal entityidentifier (LEI) initiative.The G-20 in Los Cabos endorsed the FSB recommendations and askedthe Board to take forward the work to launch the global LEI system byMarch 2013.Progress reports on the LEI initiative will be prepared approximatelyevery three weeks.Implementation Group: The FSB set up an Implementation Group (IG)to take forward the work.The IG comprises 55 experts from the global regulatory community, andincludes members from 20 jurisdictions, as well as representatives fromstandard setters and international financial institutions.There are three main workstreams:- legal and governance;- operations; and- corporate hierarchy data.A co-ordination group of 5-7 members guides each work stream,providing a geographic balance.Private Sector Preparatory Group (PSPG):A call for members of a private sector expert group to collaborate on thework solicited widespread interest – about 170 members from almost 30jurisdictions are participating actively in the group. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Following an inaugural meeting in New York on 25 July, working groupshave been set up to provide input in each of the three main areas,facilitated by members of the IG.A dedicated secure web based forum has been launched forcommunication and knowledge sharing, hosted by the Cleveland FederalReserve.Charter for the Regulatory Oversight Committee (ROC) and otherGovernance Issues:A key task for the IG is to prepare a draft Charter for the ROC for approvalby the FSB in October and G20 in November.A first full draft will be reviewed by the IG in early September, prior toreview by the Steering Committee in mid - September.The IG is working through a number of challenging issues, including:delivery of adequate regulatory enforcement power over the global systemby the ROC; membership criteria (including the treatment ofsub-national regulatory bodies and international bodies); decisionmaking if consensus cannot be reached; what is an appropriate minimumregionally balanced quorum of support from authorities to launch thesystem that ensures balanced representation of early, medium and latemovers; and the structure of the not-for-profit Global LEI Foundation(the legal form of the operational element of the LEI system).The choice of location and hence jurisdiction for the Foundation will havean important influence on the legal framework for the LEI system,including possibly the legal form of the ROC and the means available forexpressing governance: the FSB Secretariat is seeking pro bono advicefrom legal experts on the location issue by early September.To facilitate the ultimate acceptance of the Charter by the FSB Plenary,IG members are seeking feedback from legal staff on the document aswork proceeds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Operations:The private sector has a key role in the operational implementation of thesystem: the Central Operating Unit (COU) of the system will be formedvia the establishment of a not-for-profit global LEI foundation under theoversight of the ROC.A number of the PSPG Working Groups are focusing on operationalaspects – a structured framework (Enterprise Architecture) is being usedto organise the work.Early results will be reviewed in October. A number of potential LocalOperating Units (LOUs) are involved in the analysis of operationalsolutions to ensure that the proposed model is acceptable to participantsaround the world.Ownership and Hierarchy data:An important short term objective is to develop concepts and plans forextending the basic data on entity identification (which will be availablewhen the system is launched) to include information on corporateownership and other relationships.The extension is necessary to support risk aggregation and consolidationand thus capture the full benefits of the LEI system.Additional data, however, implies an expansion of scope and thus thebenefits and costs of any particular extension must be consideredcarefully.The IG is working closely with the PSPG to develop preliminaryrecommendations by end-2012.Early movers:The CFTC announced on July 24 that DTCC/SWIFT had beendesignated as the provider of CFTC Interim Compliant Identifiers(CICIs) for a limited period of two years.The CFTC also confirmed that the Commission plans to adopt the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • governance principles and LEI reference data requirements endorsed bythe FSB, and that once these steps are completed the CICI system willsubsequently transition into the global LEI.IG members are currently reviewing a number of technical issues toensure that decisions by early movers do not have an adverse impact onthe costs or operational flexibility of the global system, for instance bylocking the future global LEI system into early, local technical systemdesign choices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • OCC Updates Stress Testing ImplementationTimelineWASHINGTON — The Office of the Comptroller ofthe Currency (OCC) today announced it isconsidering changes to the implementation timelinefor the company-run stress testing required by theDodd-Frank Wall Street Reform and Consumer Protection Act.The changes under consideration would delay implementation untilSeptember 2013 for covered institutions with total consolidated assetsbetween $10 billion and $50 billion.On January 24, 2012, the OCC published in the Federal Register a noticeof proposed rulemaking to implement section 165(i) of the Dodd-FrankAct, which would require certain financial companies, including certainnational banks and federal savings associations, to conduct annual stresstests in accordance with regulations prescribed by the OCC.In the notice of proposed rulemaking, the OCC stated that “[a] nationalbank or federal savings association that is a covered institution shall besubject to this part on [the effective date of the rule] and will conduct itsfirst stress test under this part using financial statement data as ofSeptember 30, 2012, with results reported as required under this part inJanuary 2013.”The OCC received a number of comments on the proposed immediateeffective date identifying concerns about resources, readiness, and abilityto conduct stress tests given the likely short period between publication ofa final rule and the start of the stress-testing process.A key priority in implementing this section of the Dodd-Frank Act is toensure that banks have robust systems and processes to conduct thestress tests.In response to the concerns expressed in comments, the OCC isconsidering delaying the effective date of the rule to conduct the annualstress tests for certain institutions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The proposed delay would help ensure that all covered institutions havesufficient time to develop sound stress testing programs.Specifically, the OCC is considering a timeline under which coveredinstitutions with assets from $10 to $50 billion would be required toconduct initial stress tests in accordance with the rule in late 2013.The OCC is considering requiring covered institutions with assets greaterthan $50 billion to begin conducting annual stress tests under the rule thisyear, although the OCC would maintain its reservation of authority toallow covered institutions above $50 billion to delay implementation on acase-by-case basis where warranted.As part of efforts among the federal banking agencies to coordinate theimplementation of Dodd-Frank stress test requirements, the OCC hasconsulted on this proposed implementation delay with the FederalReserve Board (Board) and the Federal Deposit Insurance Corporation(FDIC).The Board and FDIC are considering similar changes to timelinesincluded in their proposed rules implementing Dodd-Frank stress testrequirements.The final implementation timeline for all covered institutions will bespecified in the final rule.Note:Section 165(i) of the Dodd-Frank Act created two types of stress testingrequirements: stress tests conducted by the company and stress testsconducted by the Board of Governors of the Federal Reserve System(“Board”).Section 165(i)(2) requires certain financial companies, including nationalbanks and Federal savings associations, to conduct stress tests andrequires the primary financial regulatory agency of those financialcompanies to issue regulations implementing the stress testrequirements. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A national bank or Federal savings association is subject to the stress testrequirements if its total consolidated assets are more than $10 billion.Under section 165(i)(2), a financial company is required to submit to theBoard and to its primary financial regulatory agency a report at suchtime, in such form, and containing such information as the primaryfinancial regulatory agency may require.The primary financial regulatory agency is required to define “stresstest,” establish methodologies for the conduct of the company -conducted stress test that must include at least three different sets ofconditions (baseline, adverse, and severely adverse), establish the formand content of the institutions report, and compel the institution topublish a summary of the results of the Dodd-Frank institutional stresstests.In general, section 165 of the Dodd-Frank Act sets forth a number ofrequirements and responsibilities for the Board related to supervisionand prudential standards for nonbank financial companies and bankholding companies with total consolidated assets equal to or greater than$50 billion.In addition to the company stress tests required under section 165(i)(2),section 165(i)(1) requires the Board to conduct annual analyses ofnonbank financial companies supervised by the Board and bank holdingcompanies with total consolidated assets equal to or greater than $50billion to determine whether such companies have the capital, on a totalconsolidated basis, necessary to absorb losses as a result of adverseeconomic conditions.The Board published a proposed rule implementing this supervisorystress testing on January 5, 2012.As required by section 165(i)(2), this proposed rule implements thecompany-conducted stress test requirements for national banks andFederal savings associations. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Under this proposed rule, a national bank or a Federal savingsassociation with total consolidated assets of more than $10 billion,defined as a “covered institution,” would be required to conduct anannual stress test as prescribed by this proposed rule.The OCC is developing this rule in coordination with the Board and theFederal Insurance Office, as required by section 165(i)(2)(C).The Board and Federal Deposit Insurance Corporation (“FDIC”) areplanning to issue separate proposed rules with respect to theirsupervised entities.For purposes of this rule, the proposed rule defines a stress test as aprocess to assess the potential impact of hypothetical economicconditions (“scenarios”) on the capital of a covered institution over a setperiod (the “planning horizon”), taking into account the currentcondition of the covered institution including its material risks,exposures, strategies, and activities.The Purpose of Stress TestsThe OCC views the stress tests conducted by covered institutions underthe proposed rule as providing forward-looking information tosupervisors to assist in their overall assessments of a covered institutionscapital adequacy and to aid in identifying downside risks and thepotential impact of adverse outcomes on the covered institutions capitaladequacy.In addition, the OCC may use stress tests to determine whetheradditional analytical techniques and exercises are appropriate for acovered institution to employ in identifying, measuring, and monitoringrisks to the financial soundness of the covered institution, and mayrequire a covered institution to implement such techniques and exercisesin conducting its stress tests. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Further, these stress tests are expected to support ongoing improvementin a covered institutions stress testing practices with respect to itsinternal assessments of capital adequacy and overall capital planning.The OCC expects that the annual stress tests required under theproposed rule would be only one component of the broader stress testingactivities conducted by covered institutions.In this regard, the OCC notes that the federal banking agencies haverecently issued for public comment proposed joint guidance on “StressTesting for Banking Organizations with More Than $10 Billion in TotalConsolidated Assets.”These broader stress testing activities should address the impact of arange of potentially adverse outcomes across a set of risk types affectingaspects of the covered institutions financial condition other than capitaladequacy.In addition, a full assessment of a covered institutions capital adequacymust take into account a range of factors, including evaluation of itscapital planning processes, the governance over those processes,regulatory capital measures, results of supervisory stress tests whereapplicable, and market assessments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • FSA statement regarding CRD IV implementationThe draft European Union legislation to update thecapital requirements framework, known as CRD IV, hasbeen under discussion between the European Parliament,European Commission and Council of Ministers.These discussions originally aimed to finalise an agreed position by endJune 2012 enabling adoption by the European Parliament plenary in earlyJuly 2012.Following the delay of the Parliament’s plenary vote and the recentstatement by the Rapporteur of the European Parliament and thediscussion of the Council of Economic and Finance Ministers, it is clearthe legislation will not be adopted earlier than autumn 2012.Following adoption it is necessary for verification, translation andsignature of the EU legislation to take place before it can be published inthe Official Journal of the European Union.Publication in the Official Journal is a necessary pre-cursor of EUlegislation entering into force.On this basis it does not appear feasible that the legislation can enter intoforce in line with the implementation date of 1 January 2013 as included inthe original European Commission proposal of July 2011.No alternative date has yet been communicated by the EU institutions.Furthermore, reflecting the delay in the negotiation process, theEuropean Banking Authority (EBA) issued a press release on 31 Julysetting out the potential need to phase-in or flexibly apply certaintechnical standards to ensure a practical approach to implementation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In light of these developments the FSA will keep the situation underactive review and continue to support the European institutions in theirefforts to reach a conclusion on the final version of the legislation.The FSA will continue to undertake all preparatory work that is possiblein the absence of finalised legislative text, in full expectation that the EUlegislation will follow the Basel III implementation timetable.We expect all firms in scope of CRD to do likewise.Banks must remain mindful of the vital importance of the direction set byBasel III for banking system stability.In particular the FSA will continue to undertake its supervision of banksin a manner consistent with the recommendations of the 22 June meetingof the interim Financial Policy Committee (FPC) of the Bank of England.The interim FPC recommended that: taking into account eachinstitution’s risk profile, the FSA works with banks to ensure they build asufficient cushion of loss-absorbing capital in order to help to protectagainst the currently heightened risk of losses; that cushion maytemporarily be above that implied by the official transition path to BaselIII; and banks should continue to restrain cash dividends andcompensation in order to maximise the ability to build equity throughretained earnings.The FSA reminds those investment firms that are currently subject to theCapital Requirements Directive that they will be impacted by the CRD IVlegislation and that they too should prepare accordingly.The introduction of Common Reporting, which is incorporated into therequirements in CRD IV, is dependent on delivery of the necessarytechnical systems and on implementing technical standards to be draftedby EBA under CRD IV and adopted by the European Commission. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The FSA is proceeding with the necessary preparatory work to be ready tobegin collecting data under Common Reporting for the period beginning1 July 2013, should the legislation and related standards be finalised bythis date.In line with the press release issued by EBA, the FSA will take account ofany phase-in plans incorporated into the implementing technicalstandards on supervisory reporting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • An interesting article about China. We will beglad to discuss other opinions in our nextnewsletter.China’s Slowdown May Be WorseThan Official Data Suggestby Janet Koech and Jian WangIn the months following the 2008–09 economiccrisis, emerging-market economies robustlyrebounded.Output in China and India expanded more than10 percent in 2010, and Brazil’s gross domestic product (GDP) growth of7.5 percent was its best performance in 25 years. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Emerging-market economies retraced their precrisis level of industrialproduction by 2009, while advanced economies remained below theirprecrisis levels in 2012 (Chart 1).But the strong emerging-market rebound—most significantly in China—hasn’t endured.When China’s average GDP growth remained above 9 percent in 2011,hopes rose that a sustained recovery would prop up the world economyamid the European sovereign debt crisis and subpar growth in the U.S.However, China’s economy deteriorated rapidly in 2012, with GDPgrowth slowing to 8.1 percent in the first quarter from 8.9 percent atyear-end 2011.Second quarter GDP growth slid further, to 7.6 percent, the lowestreading since the height of the global financial crisis in early 2009.Even with the decline, there is speculation that these figures may stillunderstate economic slowing.Economists have long doubted the credibility of Chinese output data.For example, some studies indicate that GDP growth was overstatedduring the 1998–99 Asian financial crisis, when official figures reportedthat China’s GDP grew on average 7.7 percent annually.Alternative estimates using economic activity measures such as energyproduction, air travel and trade data ranged from 2 percent to 5 percent.The dubious character of the official figures is no secret in China.Senior government officials, including Vice Premier Li Keqiang, dismissofficial GDP data as “man-made” and “for reference only” because ofpolitical influence, particularly at the local level, on data reporting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Data ReliabilityTo get a more accurate picture of China’s economy, economists examineother measures of activity that closely track growth but are less prone topolitical interference than output data.Industrial electricity consumption, a major production input, serves assuch a proxy.If industrial output grows at a slower pace, electricity consumptionshould behave similarly.China’s year-over-year growth rates of industrial electricity consumptionand industrial production are shownfor 2011 and 2012 in Chart 2. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Red dots, illustrating 2012 activity, are below the blue dots, depicting 2011,which indicates that the growth rate of industrial electricity consumptionis relatively lower this year.This is consistent with China’s recent economic slowdown.The chart also shows fitted linear trends—a way of extrapolating activityover a longer period—computed using 2011 data only (solid line) and 2011and 2012 data (dashed line).This depiction relies on just these two years because of limitedelectricity-consumption reporting by the China Electricity Council.Hence, these results should be viewed with caution.As expected, Chart 2 shows that there is a tight relationship betweenindustrial electricity consumption and industrial output.As industrial production growth expands, China’s industries consumemore electricity, and vice versa.However, a closer look at the chart raises questions.Consider a scenario in which electricity consumption doesn’t increase.To illustrate this, we extend the linear trend lines to the horizontal axis(representingno change in electricity consumption).The lines intercept the axis at 5 and 7.5, implying that China’s industrialproduction continues to grow 5 percent or 7.5 percent annually(depending on which trend line we use) even when electricityconsumption remains constant.Although heightened electricity consumption efficiency could inducepositive industrial production growth, a 7.5 percent growth rate seems toolarge to attribute to efficiency gains alone. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The solid line computed using just 2011 data is flatter than the dashed linecomputed using both 2011 and 2012 data.Extrapolating from the trend line that includes just 2011 data points yieldsa lower, more reasonable industrial production growth rate of about 5percent when the electricity consumption growth rate is zero.The same data are shown in Chart 3, with only the 2011 trend linedepicted.Suspiciously, all 2012 data (red dots) lie below the trend line.This suggests that given the amount of electricity consumed, China’sofficial industrial production figures for 2012 are higher than thoseimplied by the 2011 data trend. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • For instance, China’s industrial electricity consumption grew 5.6 percenton a year-over-year basis in March 2012.Using the trend from 2011 data, the estimate for March’s industrialproduction growth is about 9.3 percent rather than the 11.9 percentreported in the official data.This discrepancy could be due to unintentional, random survey errors.However, it is hard to imagine that all available 2012 data erred on the sideof overstating industrial production growth.Rather, it suggests that China might have overstated its 2012 industrialproduction data to mask the economy’s weakness.In other words, the slowdown in China could be worse than the officialdata indicate.Composition of ProductionOf course, other factors may explain why all red dots lie below the trendline in Chart 3.For example, growth of industrial production varied across sectors whoseconsumption of electricity per unit of output differs.For a unit of output, a company involved in steel production will generallyconsume more electricity than a factory making T-shirts.If the growth rate of the steel industry slowed more than that of the textileindustry, we would expect to see the growth in electricity consumptiondecline faster than the growth of total industrial output.To address this industry composition effect, we include output growth oftwo different sectors in our data: the heavy and light industrial sectors. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The heavy industrial sector (for example, the steel industry) usuallyconsumes more electricity than the light sector (the textile industry).The relationship between electricity consumption and industrial outputcan be more accurately estimated by analysing the two sectors separatelythan by using aggregate industrial output data.Accounting for the sectoral difference yields more sensible results when2011 data are analyzed.When industry electricity consumption remains constant—that is, itshows a zero growth rate—light industrial sectors grow at an annual rateof 2.8 percent, a much smaller reading than the 5 percent for aggregateoutput.On the other hand, the heavy industrial sectors contract 1.9 percent,reflecting this industry’s relatively heavy reliance on electricity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Chart 4 plots actual electricity consumption growth in China (purple line)together with estimated electricity consumption using 2011 output datafor light and heavy industries (orange line).The two lines track each other closely, indicating a tight relationshipbetween electricity consumption and output in the heavy and lightindustries.The blue line shows the forecast growth of electricity consumption in2012, computed from the relationship estimated from 2011 data.The official industrial production data square well with electricityconsumption in March 2012; predicted consumption data almost perfectlymatch the reported data. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • During March, growth in heavy industries declined sharply to 11.2percent from 13 percent in December 2011, while growth in the lightindustries increased to 13.9 percent from 12.6 percent over the sameperiod.The difference in growth between the heavy and light industries explainsthe overall sharp decline in electricity consumption, while overallindustrial output growth remained strong in March 2012.In the subsequent months, however, the out-of-sample forecasts divergesubstantially from the actual data.Given the official industrial production numbers, our model suggests thatChina should have consumed about twice as much electricity as itactually did.This is not surprising after closer examination of the data.From April to June, growth in the light industries declined more than inthe heavy industries, a reversal of March’s activity.Given such a pattern in China’s official industrial production data,electricity consumption growth should have dropped only moderately.However, China’s actual electricity consumption continues to declinesharply from April to June, raising doubts about the accuracy of theofficial industrial production figures.Improving Data ReportingAlthough China’s economic growth has slowed sharply in recent months,evidence suggests that the situation may be worse than reported.Several factors contributed to China’s slowdown. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Demand for China’s exports in Europe and the U.S. has weakened amidthe deepening European sovereign debt crisis and sluggish U.S.economic activity.Additionally, China’s policy response following the global financial crisisis having unintended effects on its economy.China loosened monetary policy and undertook a massive fiscal stimulusprogram in response to 2008–09 developments.These policies, which cushioned the economy from the impact of fallingdemand for exports, had the unintended consequence of generatinghigher inflation and rising asset prices, particularly in the real estatesector.These developments forced China to reverse course and institute tightermonetary policy last year, creating another round of effects on theeconomy that continue this year.China’s abrupt policy changes during the past two years are nothistorically unusual and have been criticized as a source of the country’sbig economic swings, which hurt long-run growth.Future policymakers will need more, high-quality quantitative (asopposed to qualitative) economic research to avoid overshooting policytargets and to better stabilize the economy.A critical first step is acquiring highquality economic data, a processalready in the works.China’s National Bureau of Statistics started a new data-collecting systemunder which businesses report industrial production data online directlyto the national statistics agency in Beijing, reducing the chance ofmanipulation by local authorities.As the world’s second largest economy, China plays an increasinglyimportant role in the global economy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Acquiring accurate economic data isnot only useful to China’spolicymaking, but also helpful to other nations, allowing them to betterunderstand China’s current economic conditions and design theirpolicies accordingly.Koech is an assistant economist and Wang is a senior research economistin the Research Department at the Federal Reserve Bank of Dallas. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Some Thoughts on Global Risks and MonetaryPolicyCharles L. Evans, President and Chief Executive OfficerFederal Reserve Bank of ChicagoIntroductionThank you for the invitation to speak to you today. I amvery happy for the opportunity to participate in Market NewsInternational seminar and to offer my thoughts on the U.S. and worldeconomies.We live in an amazingly interconnected world — a world in whichfinancial markets are linked by the instantaneous transmission ofinformation and business activity is intertwined among nations.For a long time, U.S. consumers and firms have been an important sourceof demand for Asian economies.This comes with pluses and minuses: Without the robust growth in theU.S. in 1997–98, the Asian financial crisis may well have been much worsethan it actually was; in contrast, the recession and sluggish growth in theU.S. over the past five years have weighed heavily on the demand forproducts from Asia.My comments today will focus primarily on the outlook for the U.S., butwith an eye on its potential impact on Asian economies.Of course, here I have to cover the substantial downside risks to theforecast stemming from both the European debt situation and the U.S.fiscal cliff.I will also discuss how this outlook and other economic analyses shapemy views for the appropriate stance of monetary policy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Before I turn to the focus of today’s discussion, I would like to remind youthat the views expressed are my own and do not necessarily representthose of the Federal Open Market Committee (FOMC) or the FederalReserve System.OutlookLet’s start with the economic outlook.We are all too familiar with the fact that the financial crisis that unfoldedin 2007 and 2008 precipitated a global recession that was unusually deepand lengthy in the U.S. and other advanced economies.Perhaps this shouldn’t have been surprising.The detailed analysis by Carmen Reinhart and Kenneth Rogoff (2009)concludes that recessions caused by financial crises generally are severeand are followed by anemic recoveries.By any yardstick, this certainly describes the U.S. recovery to date:Output growth has averaged only 2-1/4 percent annually, and resourcegaps remain huge.In particular, the unemployment rate remains over 8 percent — wellabove the 5-1/4 to 6 percent rate most FOMC participants view as beingconsistent with a fully employed labor force over the longer run.Both public and private sector forecasts see relatively modest rates ofgrowth over the next few years.For example, most recent forecasts by the private sector have 2012 grossdomestic product (GDP) growth at less than 2 percent; a pace that maynot even be enough to keep up with potential.Growth in 2013 is expected to be only moderately higher.Moreover, both the European debt situation and the looming U.S. fiscalcliff impart substantial downside risks to the forecast. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Even absent any negative shocks, such tepid growth rates would close thelarge existing resource gaps only very gradually.Indeed, I expect that we will face unemployment well above sustainablelevels for some time to come.Implications for AsiaIn the aftermath of the Great Recession, most Asian economies enjoyed areturn to solid levels of growth.Today, however, growth in Asia faces some new challenges.One of these challenges is that Asian economies will not be immune tothe tepid growth prospects facing the world’s advanced economies.Forecasts for growth in Asia have been marked down over the past year,reflecting in part the impact of the downgrade in the outlook for Asianexports for the U.S. and the euro area.For example, the U.S. and the euro area account for about one-third ofChina’s merchandise exports.The recession and weak recoveries in those economies were big factors inthe Chinese current account surplus falling from about 10 percent of GDPin 2007 to less than 3 percent in 2011.This weakness remains a consideration as we look forward; indeed, it isan important reason why the International Monetary Fund (IMF) isprojecting that the Chinese current account surplus will fall even more by2013.International trade is an excellent thing: Exploiting comparativeadvantages raises living standards for all nations.However, all countries can’t simultaneously export their way out of theirproblems. For the world as a whole, the current account has to balance.Thus, countries with large external surpluses face risks to their economiesposed by slowdowns in their trading partners. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Aggregate world growth must reflect aggregated domestic demands. So ifdemand is going to be sluggish in a large share of the world economy,other nations must take up the slack, or world growth will fall.InflationWith regard to inflation, as you know, the FOMC’s long-run inflationobjective is 2 percent as measured by the price index for personalconsumption expenditures (PCE).For a number of reasons, I don’t foresee much risk that inflation will riseabove reasonable tolerance levels relative to this objective.First, we see evidence of low expectations for inflation and growth in thetoday’s historically low Treasury yields.If there were warning signs of dangerous inflationary pressures, theten-year rate wouldn’t be in the neighborhood of 1-3/4 percent!Second, even with the latest increase in oil prices, energy and commodityprices remain well off their recent peaks as the global outlook dims.Third, as I just noted, the output gap remains large and is likely to closeonly slowly.In this economic environment, wage pressures are practicallynonexistent.And it is hard to envision how major persistent inflation pressures willemerge without a parallel increase in wage costs. Such parallel price andwage increases were a big part of the 1970s inflation, a scenario some fearrepeating today.Fourth, inflationary dynamics depend in large part on the momentumgenerated by people’s expectations of future inflation; currently, inflationexpectations are well anchored, which will tend to keep inflation frommoving either up or down.Putting all of these factors together along with the fact that core inflationaveraged 1.8 percent over the past year, I conclude that inflation will likelyremain near or below our 2 percent target over the medium term. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Sources of Risk and Their ImplicationsI would now like to turn to two important downside risks to the outlookfor growth.This will be a bit of a U.S.-centric view, but clearly these risks also haveimportant implications for growth here in Asia and the rest of the world.EuropeLet me begin with the European debt situation.Obviously, the developments in Europe pose a significant downside riskto the U.S. economy and world economic growth more broadly.The direct effects of slower European growth on the U.S. economy wouldbe relatively small.The eurozone nations account for less than 15 percent of U.S.merchandise exports.Thus, according to standard elasticity estimates, even a moderateeurozone recession would reduce U.S. exports by only a couple of tenthsof GDP.The indirect effects of eurozone developments could, however, be moresevere, both in the U.S. and Asia. One possible channel would be throughfinancial contagion.If losses on euro-centric assets put a large enough dent in the balancesheets of financial institutions that lend to U.S. households andbusinesses, the increases in the cost and availability of credit wouldreduce growth in the U.S. with possible spillover effects into Asia as well.Clearly, this is a risk worth monitoring.Fortunately, though, U.S. financial institutions are in much better shapeto handle such potential losses than they were in 2008.Recognizing the risks posed by the European debt situation, U.S.institutions have reduced their direct exposure to European assets andtightened lending standards to European banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • On the regulatory front, the most recent stress tests made large U.S.banks demonstrate that they would have adequate capital even in theevent of a sharp European recession with contagion to global financialmarkets.A second possible channel would be through the effects of uncertainty oncurrent demand.Throughout the recovery, U.S. business and household sentiment hasbeen very fragile.Every hint of bad news seems to generate a wave of increased caution andan associated pullback in spending as firms and families seek to protecttheir individual balance sheets.After what the U.S. economy went through in the Great Recession, thisskittishness is understandable — particularly if one can envision a verylarge downside to the news event.And, as I just noted, given developments in Europe, there certainly aresome serious downside scenarios one can envision, even if they are notthe most likely outcomes.So it would be no surprise if yet another wave of uncertainty put a furtherdent in consumption and investment.U.S. fiscal cliffAnother risk to the U.S. economy comes from the so-called fiscal cliff.Under current U.S. law, numerous tax and spending provisions enacted invarious stimulus packages dating as far back as 2001 are scheduled toexpire on January 1, 2013.In addition, if no budget agreement is reached by Congress, there will besignificant automatic spending sequestration and other spending cuts inJanuary.According to projections made by the Congressional Budget Office(CBO), if all these things took place, real GDP growth would be reducedby about 4 percentage points in 2013. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I’m not saying that a pullback of this magnitude should be the base-casescenario.The orders of magnitude are just too big to be a base case.But when you go through the various items and make guesses at whichmay stay and which may go, it is easy to envision scenarios that include amarked increase in fiscal restraint in 2013.In addition, given the political process, it seems unlikely that we willknow much about the size or composition of the cuts until late in theprocess.It’s also easy to see how the rhetoric of public negotiating stances couldproduce an atmosphere that causes already jittery households andbusinesses to put some spending plans on hold.In sum, a messy resolution to the fiscal cliff problems presents animportant downside risk to U.S. growth prospects and, by extension, toworld economic growth.And even the possibility of such an outcome could be a drag in the secondhalf of the year.Policy ChoicesLet me now switch gears and talk about my views regarding the choicesfacing monetary policymakers in the U.S.Yes, we have substantial liquidity already in place in our financial system.On the surface, this looks like substantial monetary accommodation.But as a large body of economic theory tells us, for this liquidity to besufficiently accommodative, the public needs to expect that we will keepit in place for as long as is necessary to restore the economy to a soundfooting.This is why I believe we should clarify the Fed’s forward guidance withregard to the future course of policy. Let me now go into the detailsbehind these thoughts. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • An explicit economic state-contingent policyIn weighing alternative policy approaches, I think the best way to provideforward guidance is by tying our policy actions to explicit measures ofeconomic performance.There are many ways of doing this, including setting a target for the levelof nominal GDP.But recognizing the difficult nature of that policy approach, I have a moremodest proposal: I think the Fed should make it clear that the federalfunds rate will not be increased until the unemployment rate falls below 7percent.Knowing that rates would stay low until significant progress is made inreducing unemployment would reassure markets and the public that theFed would not prematurely reduce its accommodation.Based on the work I have seen, I do not expect that such policy wouldlead to a major problem with inflation.But I recognize that there is a chance that the models and other analysissupporting this approach could be wrong.Accordingly, I believe that the commitment to low rates should bedropped if the outlook for inflation over the medium term rises above 3percent.The economic conditionality in this 7/3 threshold policy would clarify ourforward policy intentions greatly and provide a more meaningful guide onhow long the federal funds rate will remain low.In addition, I would indicate that clear and steady progress towardstronger growth is essential.Because we are not seeing that now, I support further use of our balancesheet to provide even more monetary accommodation.In June we decided to continue our Maturity Extension Program, whichputs downward pressure on long-term interest rates by extending theaverage maturity of the Federal Reserve’s securities portfolio. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I thought that was a useful step.However, I believe it is time to take even stronger steps, such as thepurchase of more mortgage-backed securities, to increase the degree ofmonetary support for the recovery.As suggested recently by my colleagues Eric Rosengren and JohnWilliams, these could be open-ended purchases, meaning that they wouldcontinue at a certain rate until there was clear evidence of improvement ineconomic conditions.To me, one example of clear evidence would be a resumption of relativelysteady monthly declines in unemployment for two or three quarters.Once this momentum was confidently established, the Fed could stopadding to our balance sheet but keep the funds rate at zero.The funds rate would remain unchanged in my thinking, until theunemployment rate hit at least 7 percent or the medium-term inflationoutlook deteriorated dramatically and rose above 3 percent.Later, reductions in the Fed’s balance sheet assets would occur sometimeafter the first increase in the funds rate.This corresponds to the general exit principles the FOMC agreed uponlast year.Presumably, the pace of asset reductions would be measured andconsistent with a continued, robust recovery in the context of pricestability.Accommodation in the Context of a Symmetric Inflation Targetand Balanced PolicyI can’t tell you how often people look at me in horror when I say that weshould adopt a conditional policy that tolerates the risk of inflationexceeding our target by as much as 1 percentage point.How can I accept inflation rising above our stated target? Isn’t thisblasphemy for a central banker? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In January, in the same framework document that announced our 2percent inflation target, we also stated a number of principles for theconduct of monetary policy.One was that policy would take a balanced approach in achieving the twolegs of the Federal Reserve’s dual mandate — maximum employmentand price stability.An explicit real-side mandate makes the Federal Reserve different thanmost central banks.While just about all central banks follow a flexible inflation targetingapproach, in which they seek to minimize real-side fluctuations in pursuitof their inflation objective, most are explicitly charged only with aninflation objective.But for the Fed, maximum employment is an explicit part of our policymandate.I strongly support the policy principles document we released in January.But we’re still hearing questions about whether our inflation goal issymmetric and about the specifics of how policy will be implementedunder the balanced approach articulated in this framework.As Chairman Bernanke (2012) stated at his April press conference, the 2percent inflation goal is a symmetric objective and not a ceiling oninflation.Symmetry means that inflation below 2 percent should be viewed as thesame policy miss as if inflation overran 2 percent by equal amount.We need to take symmetry seriously.If we disproportionately recoil at inflation a little above 2 percent versus alittle below, then we are not symmetrically weighing policy misses.And we will not average 2 percent inflation, which is our goal.There is some risk of this misperception taking hold. Consider theFOMC’s latest Summary of Economic Projections (SEP), which includesthe projections of all FOMC participants, voters and non-voters alike. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In it, several forecasts have the funds rate rising before 2014, even thoughthroughout the projection period most see inflation at or below 2 percentand unemployment well above the sustainable rate indicated by thelong-run projections.Without further explanation, it’s difficult to see how this is consistent witha symmetric inflation goal and a balanced approach to achieving the twolegs in our dual mandate.I believe the FOMC can do better at describing our thinking with respectto tolerance bands around our long-run inflation and unemploymentgoals.Clarification would increase both transparency and accountability.Importantly, it would reassure economic agents that Fed policy would nottighten prematurely.To me, a symmetric inflation goal and a balanced approach to policymean that if we are missing our employment mandate by a large amount,but are close to our inflation target, then we should be willing toundertake policies that could substantially reduce the employment gapeven if they run the risk of a modest, transitory rise in inflation thatremains within a reasonable tolerance range of our target.I believe such actions, such as the 7/3 threshold policy I have beenadvocating, would produce smaller net losses relative to our dual mandategoals than would current policy.Conclusion: The Need for a Vibrant Economy to Cushion RisksFinding a way to deliver more accommodation — whether it is monetaryor fiscal — is particularly important now because delays in reducingunemployment are costly.An unusually large percentage of the unemployed have been withoutwork for quite an extended period of time; their skills can become lesscurrent or even deteriorate, leaving affected workers with permanent scarson their lifetime earnings. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • And any resulting lower aggregate productivity also weighs on potentialoutput, wages and profits for the economy as a whole.The damage intensifies the longer that unemployment remains high.Failure to act aggressively now could lower the capacity of the economyfor many years to come.Such potential costs would come with the continuation of a subpar paceof economic recovery.The significant risks I discussed earlier – financial disruption from aworsening of the situation in Europe or a messy resolution of U.S. fiscalpolicy – raise the specter of an even more worrisome outcome.At the moment economic growth is not much above stall speed.Another negative shock could send the economy into recession.And if a recessionary dynamic takes hold, it would be especially difficultto regain momentum.I have outlined some policy actions that I think can take us in thedirection of a more vibrant and resilient economy.Given the risks we face, I think it is vital that we make such moves today.I don’t think we should be in a mode where we are waiting to see what thenext few data releases bring.We are well past the threshold for additional action; we should take thataction now.Thank you.NoteCharles L. Evans is the ninth president and chief executive officer of theFederal Reserve Bank of Chicago. In that capacity, he serves on theFederal Open Market Committee (FOMC), the Federal Reserve Systemsmonetary policy-making body. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banksacross the country. These 12 banks — along with the Board of Governorsin Washington, D.C. — make up our nations central bank.As head of the Chicago Fed, Evans oversees the work of roughly 1400employees in Chicago and Detroit who conduct economic research,supervise financial institutions, and provide payment services tocommercial banks and the U.S. government.Before becoming president in September of 2007, Evans served asdirector of research and senior vice president, supervising the Banksresearch on monetary policy, banking, financial markets and regionaleconomic conditions. Prior to that, Evans was a vice president and senioreconomist with responsibility for the macroeconomics research group.His personal research has focused on measuring the effects of monetarypolicy on U.S. economic activity, inflation and financial market prices. Ithas been published in the Journal of Political Economy, AmericanEconomic Review, Journal of Monetary Economics, Quarterly Journal ofEconomics, and the Handbook of Macroeconomics.Evans is active in the civic community. He is a board member at ChicagoMetropolis 2020 and the Metro Chicago Information Center, and a trusteeat Rush University Medical Center.Evans has taught at the University of Chicago, the University of Michiganand the University of South Carolina. He received a bachelors degree ineconomics from the University of Virginia and a doctorate in economicsfrom Carnegie-Mellon University in Pittsburgh. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • EBA, EIOPA and ESMAJoint Consultation Paper on Draft Regulatory Technical Standards on theuniform conditions of application of the calculation methods underArticle 6.2 of the Financial Conglomerates Directive (JC/CP/2012/02)I. Responding to this ConsultationEBA, EIOPA and ESMA (the ESAs) invite comments on all matters inthis paper and in particular on the specific questions stated in theattached document “Overview of questions for Consultation” at the endof this paper.Comments are most helpful if they:- respond to the question stated;- indicate the specific question to which the comment relates;- contain a clear rationale;- provide evidence to support the views expressed/ rationale proposed; and- describe any alternative regulatory choices EBA should consider.II. Executive SummaryThe CRR/CRD IV proposals (the so-called Capital RequirementsRegulation - henceforth ‘CRR’- and the so-called Capital RequirementsDirective – henceforth ‘CRD’) set out prudential requirements for banks _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • and other financial institutions which are expected to apply from 1January 2013.In anticipation of the finalisation of the legislative texts for theCRR/CRD IV, the EBA, EIOPA and ESMA (hereafter the ESAs) throughthe Joint Committee, have developed the draft RTS in accordance withthe mandate contained in Article 46(4) of the CRR and Article 139 ofCRDIV (amending Article 21 a (2a) of the Directive 2002/87/EC) on thebasis of the European Commission’s proposals.This Article provides the ESAs through the Joint Committee, to developdraft Regulatory Technical Standards (RTS) with regard to the conditionsof the application of the Article 6(2) of the Directive 2002/87/EC(hereafter the Directive).Further the ESAs have developed the draft RTS having regard to Article230 in connection with Articles 220 and 228 of the Directive2009/138/EC2.To the extent that the texts may change before their adoption, the ESAsshall adapt its draft RTS accordingly to reflect any developments.The RTS included in this consultation have to be submitted to the EUCommission by 1 January 2013.Please note that the ESAs have developed the present draft RTS based onthe European Commission’s legislative proposals for the CRR/CRD IV.They have also taken into account major changes subsequently proposedby the revised texts produced by the Council of the EU and the EuropeanParliament, during the ordinary legislative procedure (co-decisionprocess).Following the end of the consultation period, and to the extent that thefinal text of the CRR/CRD IV changes before the adoption of the RTS,the ESAs will adapt the draft RTS accordingly to reflect anydevelopments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Main features of the RTSThis consultation paper puts forward draft RTS in order to ensure thatinstitutions that are part of a financial conglomerate apply the appropriatecalculation methods for the determination of required capital at the levelof the conglomerate.They are based in particular on the following elements:General Principleso Elimination of multiple gearing;o Elimination of intra-group creation of own funds;o Transferability and availability of own funds; ando Coverage of deficit at financial conglomerate level having regard todefinition of cross-sector capital.Technical calculation methods1. Method 1: “Accounting consolidation method”:The FICOD provides in relation to Method 1 that the own funds arecalculated on the basis of the consolidated position of the group.According to this general provision, the calculation of own funds shouldbe based on the relevant accounting framework for the consolidatedaccounts of the conglomerate applicable to the scope of the Directive.The use of “consolidated accounts” eliminates all own funds’ intra-groupitems, in order to avoid double counting of capital instruments.According to the Directive provisions, the eligibility rules are thoseincluded in sectoral provisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 2. Method 2: “Deduction and aggregation method”.This method calculates the supplementary capital adequacyrequirements of a conglomerate based on the accounts of solo entities.It aggregates the own funds, deducts the book value of the participationsin other entities of the group and specifies treatment of the proportionalshare applicable to own funds and solvency requirements.All intra-group creation of own funds shall be eliminated.3. Method 3: “Combination of methods 1 and 2”.The use of combination of accounting consolidation method 1 anddeduction and aggregation method 2 is limited to the cases where the useof either method 1 or method 2 would not be appropriate and is subject tothe permission by the competent authorities.III. Background and rationaleThe supplementary supervision of financial entities in a financialconglomerate is covered by the Financial Conglomerates Directive2002/87/EC, hereafter known as the Directive.This Directive provides for competent authorities to be able to assess at agroup-wide level the financial situation of credit institutions, insuranceundertakings and investment firms which are part of a financialconglomerate, in particular as regards solvency (including the eliminationof multiple gearing of own funds instruments).The nature of RTS under EU lawDraft RTS are produced in accordance with Article 10 of the ESAsregulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • According to Article 10(4) of the ESAs regulation, they shall be adoptedby means of Regulations or Decisions.According to EU law, EU regulations are binding in their entirety anddirectly applicable in all Member States.This means that, on the date of their entry into force, they become part ofthe national law of the Member States and that their implementation intonational law is not only unnecessary but also prohibited by EU law,except in so far as this is expressly required by them.Shaping these rules in the form of a Regulation would ensure alevel-playing field and would facilitate the cross-border provision ofservices.Background and regulatory approach followed in the draft RTSThese draft RTS are produced in accordance with CRD IV/CRRproposals, which provide that the EBA, ESMA and EIOPA (hereafter theESAs), through the Joint Committee, shall develop draft regulatorytechnical standards with regard to the conditions of the application of thecalculation methods with regard to Article 6(2) of the Directive and shallsubmit those draft regulatory technical standards to the Commission by 1January 2013.The proposed draft RTS covers the uniform conditions for the use of themethods for the determination of capital adequacy of a financialconglomerate under the Directive.They elaborate on Technical principles applying to all of the threemethods provided for by Directive; and also contain an Annex providingfurther detail for Method 2.The requirements contained in the draft RTS are mainly directed atinstitutions, although some of them are directed at competent authorities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • IV. Draft Regulatory Technical Standards on the uniformconditions of application of the calculation methods underArticle 6.2 of the Financial Conglomerates DirectiveCommission Delegated Regulation (EU) No XX/2012supplementing Directive xx/XX/EU [CRD] of the European Parliamentand of the Council of [date], Regulation (..) No xx/XXXX [CRR] of theEuropean Parliament and of the Council of [date] and Directive2002/87/EC [Financial Conglomerates Directive] of the EuropeanParliament and of the Council of [date] with regard to regulatorytechnical standards for the uniform conditions of application of thecalculation methods under Article 6.2 of the Financial ConglomeratesDirective of XX Month 2012THE EUROPEAN COMMISSION,Having regard to the Treaty on the Functioning of the European Union,Having regard to the [proposal for a] Regulation (...) No xx/xxxx of theEuropean Parliament and of the Council of dd mm yyyy on prudentialrequirements for credit institutions and investment firms Regulationxx/xxxx [CRR] and in particular Article 46 (4) thereof.Having regard to the [proposal for a] Directive (...) No xx/xxxx of theEuropean Parliament and of the Council of dd mm yyyy on the access tothe activity of credit institutions and the prudential supervision of creditinstitutions and investment firms [CRDIV] and in particular Article 139thereof.Having regard to the Directive 2002/87/EC, as amended, of theEuropean Parliament and of the Council on the supplementarysupervision of credit institutions, insurance undertakings and investmentfirms in a financial conglomerate (hereinafter “the Directive”) and inparticular to Article 6(2) and Annex 1 thereof.Whereas: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (1) Directive 2002/87/EC provides in Chapter II, Section 2, rules oncapital adequacy of financial conglomerates, such that the elements ofown funds are available at the level of a Financial Conglomerates arealways at least equal to the capital adequacy requirements as calculated inaccordance with Annex I of the Directive.(2) Regulation (...) No xx/xxx (‘CRR’) provides in Article 46, within PartII, Chapter 2, Section 3, Sub-Section 2 and in the context of commonequityTier I rules, requirements for deduction where consolidation orsupplementary supervision are applied.This section of the CRR provides empowerments to the EuropeanCommission to adopt delegated acts (regulatory technical standards) inaccordance with articles 10-14 of the Regulation (EU) No 1093/2010establishing the European Banking Authority (‘EBA’), Articles 10-14 ofthe Regulation (EU) No 1094/2010 establishing the European Insuranceand Occupational Pensions Authority (‘EIOPA), and Articles 10-14 of theRegulation (EU) No 1095/2010 (‘ESMA), establishing the EuropeanSecurities and Markets Authority.These acts will complete the EU single rulebook for institutions in thearea of own funds.(3) Directive (...) No xx/xxx (‘CRDIV’) provides in Article 139 that theDirective 2002/87/EC shall be amended, such that the EBA, EIOPA andESMA through the Joint Committee, to develop draft RegulatoryTechnical Standards (RTS) with regard to the conditions of theapplication of the Article 6(2) of the Directive.(4) For effective supervision of Financial Conglomerates, supplementarysupervision should be applied to all such conglomerates, thecross-sectoral financial activities of which are significant, which is thecase when certain thresholds are reached, no matter how they arestructured. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Supplementary supervision should cover all financial activities identifiedby the sectoral financial legislation and all entities principally engaged insuch activities should be included in the scope of the supplementarysupervision, including asset management companies and alternativeinvestment fund management companies.(5) Without prejudice to sectoral rules, supplementary supervision of thecapital adequacy rules is necessary to bring more convergence in theapplication of the calculation methods listed in Annex 1 of the Directive.(6) For financial conglomerates which include significant banking orinvestment business and insurance business, multiple use of elementseligible for the calculation of own funds at the level of the financialconglomerate (multiple gearing) as well as any inappropriate intra-groupcreation of own funds must be eliminated.(7) The financial conglomerate should seek an acceptable timeframe forthe transferability of funds across entities within the financialconglomerate, which shall depend on whether the specific entity issubject to the Directive 2009/138/EC or the CRDIV/CRR.Moreover for an entity subject to the CRD IV/CRR this timeframe shouldbe expediated based on the fact that due to the nature of their activities,they are more vulnerable to a rapid deterioration in confidence and/orsudden resolution situation.(8) In addition any non-sector-specific own funds, in excess of sectoralrequirements, need to originate from entities which are not subject totransferability/availability impediments.(9) It is important to ensure that own funds are only included atconglomerate level if there are no impediments to the transfer of assets orrepayment of liabilities across different conglomerate entities, includingacross sectors. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (10) If there is a deficit of own funds at the level of the financialconglomerate, the financial conglomerate should inform the coordinatoron the measures taken to cover this deficit.(11) Further convergence in the way that financial conglomerates applythese rules shall ensure the robust and consistent application of themethods of calculation.(12) For bank-led conglomerates it is necessary to apply the most prudentmethod of calculation for the treatment of insurance holdings to avoidregulatory arbitrage.(13) It is important that sector-specific own funds cannot cover risksabove sectoral requirements.The financial conglomerate should first count sector-specific own fundsagainst their requirements (while respecting sectoral rules and limits) foreach relevant entity or group of entities. If there is an excess ofsector-specific own funds, this should not be recognised at conglomeratelevel.(14) When calculating supplementary capital adequacy of a financialconglomerate, in respect to non-regulated financial entities within thefinancial conglomerate, both a notional capital requirement and anotional level of own funds shoud be calculated.(15) Under Solvency II, method 1 is applied on the basis of consolidateddata which are set out at Level 2 and not on the basis of consolidatedaccounts.(16) Further changes to the capital adequacy rules may be addressed inthe European Commission’s review of Directive 2002/87/EC.(17) It is necessary that the new regime for treatment of methods ofconsolidation enters into force the soonest possible following the entryinto force of the CRR/CRD IV and Solvency II. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (18) This Regulation is based on the draft regulatory technical standardssubmitted jointly by the EBA, EIOPA and ESMA to the Commission.(19) The EBA, EIOPA and ESMA have conducted open publicconsultations on the draft regulatory technical standards on which thisRegulation is based, analysed the potential related costs and benefits, inaccordance with Article 10 of Regulation (EU) No 1093/2010, Article 10 ofRegulation (EU) No 1094/2010, Article 10 of Regulation (EU) No1095/2010,and requested the opinion of the Banking Stakeholder Groupestablished in accordance with Article 37 of Regulation (EU) No1093/2010, Insurance Stakeholder Group and the OccupationalStakeholder Group established in accordance with Article 37 ofRegulation (EU) No 1094/2010, and the European Securities and MarketsStakeholder Group established in accordance with Article 37 ofRegulation (EU) No 1095/2010.HAS ADOPTED THIS REGULATION:TITLE ISubject matter and definitionsArticle 1Subject matterThis Regulation lays down rules of the uniform conditions of applicationof the calculation methods under Article 6.2 of the Directive.Article 2Definitions1. Definitions of the CRD IV/CRR, Directive 2002/87/EC and Directive2009/138/EC shall apply to this Regulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 2. Capital instruments are those capital instruments eligible under CRR(Regulation 2012/…./EC) and those capital instruments referred to as“own funds” in Directive 2009/138/EC.3. Ultimate responsible entity is the entity within the financialconglomerate that is responsible for determining the capital for thefinancial conglomerate having regard to the following minimum criteria:control, the dominant entity from the market’s perspective (market listedentity) and the ability to fulfill specific duties towards its subsidiaries andits supervisor.4. ‘indirect holding’ as defined under definition 17 of Article 22 of CRR [tobe added if not in final CRR text].5. Insurance-led financial conglomerate is a financial conglomeratewhose most important sector is insurance as defined under Article 3(2) ofthe Directive.6. Bank-led financial conglomerate is a financial conglomerate whosemost important sector is banking as defined under Article 3(2) of theDirective.7. Investment firm-led financial conglomerate is a financial conglomeratewhose most important sector is investment services as defined underArticle 3(2) of the Directive.TITLE IITechnical PrinciplesArticle 3Elimination of multiple gearing and the intra-group creation ofown fundsThe ultimate responsible entity shall ensure that own funds, which havebeen created by intra-group transactions, be it direct or indirect, shall be _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • eliminated for the purpose of determining the required capital on aconsolidated basis.Article 4Transferability and availability of own funds1. For all entities of a financial conglomerate, own funds, in excess ofsectoral solvency requirements, shall be considered available to absorblosses elsewhere in the financial conglomerate provided that all of thefollowing conditions are fulfilled:(a) There are no practical, legal, regulatory, contractual or statutoryimpediments to the transfer of funds or repayment of liabilities acrossconglomerate entities in due course.This is the case when the transfer of own funds from one conglomerateentity to another is not barred by a restriction of any kind and there are noclaims of any kind from third parties on these assets.The ultimate responsible entity of the financial conglomerate shallconfirm to the satisfaction of the coordinator that the conditions set out inthis point are met.(b) For the purpose of assessing the transferability of funds to entitiessubject to 2009/138/EC, “in due course” shall mean no later than 9months;for the purpose of assessing the transferability of funds to entitiessubjected to CRR, “in due course” shall mean no later than, threecalendar days with no impediments on the coordinator requiring a fastertransfer if necessary.2. Own funds, in excess of sectoral solvency requirements, which do notmeet the criteria under point 1 shall be excluded from the conglomerate’sown funds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 3. The financial conglomerate shall demonstrate that measures have beentaken to mitigate the risk that transfer of funds would have a materialeffect on the transferor’s solvency.EXPLANATORY TEXT for consultation purposesThis text is consistent with Annex 1 of the Directive which states “whencalculating own funds at the level of the financial conglomerate,competent authorities shall also take into account the effectiveness of thetransferability and availability of the own funds across the different legalentities in the group, given the objectives of the capital adequacy rules”.Point 1(a) aims to ensure that own funds are only included atconglomerate level if there are not impediments to the transfer of assets orrepayment of liabilities across different conglomerate entities, includingacross sectors.If the conglomerate cannot confirm to the satisfaction of the coordinatorthat there are no inherent impediments in relation to a given entity, thatentity’s own funds in excess of its sectoral requirements cannot beincluded at conglomerate level.The impediments to be considered include practical, regulatory,contractual or statutory ones.Point 1(b) establishes an acceptable timeframe for the transferability offunds across conglomerate entities.There is a differentiation based on the fact that entities subject to CRR,due to the nature of their activities, are more vulnerable to a rapiddeterioration in confidence and/or sudden resolution situation.Article 5Deficit of own funds at the financial conglomerate level _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 1. When the difference calculated according to method 1, 2 or 3 as detailedin Annex 1 of the Directive is negative, the financial conglomerate shallensure that the deficit is remedied with cross-sector own funds elementsas defined in point 2 below.2. When calculating own funds at the level of the financial conglomerate,cross sector own funds are elements eligible for:(a) Common Equity Tier 1 in accordance with Regulation …/2012/EC[or Tier 1 Unrestricted Basic Own Funds in accordance with Directive2009/138/EC], or(b) Elements that meet both sets of rules for Additional Tier 1 inaccordance with Regulation …/2012/EC and Tier 1 [Restricted BasicOwn Funds in accordance with Directive 2009/138/EC], or(c) elements that meet both sets of rules for Tier 2 in accordance withRegulation …/2012/EC and for Tier 2 in accordance with Directive2009/138/EC.3. Cross-sector own funds elements mentioned in point 2 shall only betaken into account if their transferability and availability across thedifferent legal entities in the financial conglomerate meet the conditionsset out in Article 4.EXPLANATORY TEXT for consultation purposesThe text is based on the Technical principles in Annex 1 of the Directive“Whichever method is used, when the entity is a subsidiary undertakingand has a solvency deficit, or, in the case of a non-regulated financialsector entity, a notional solvency deficit, the total solvency deficit of thesubsidiary has to be taken into account.Where in this case, in the opinion of the coordinator, the responsibility ofthe parent undertaking owning a share of the capital is limited strictly andunambiguously to that share of the capital, the coordinator may givepermission for the solvency deficit of the subsidiary undertaking to betaken into account on a proportional basis.” _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In line with the Directive only cross-sector own funds are allowed as aremedy to a conglomerate deficit.That is, from the point at which a conglomerate deficit is observed, thatshortfall amount shall be covered by the issuance of cross-sector ownfunds, regardless of the cause of the conglomerate deficit.The financial conglomerate shall inform the coordinator about the deficitand the measures to cover this deficit without delay.Article 6Consistency1. The Method of Calculation selected from those methods defined inAnnex 1 of the Directive shall be applied in a consistent manner over time.2. For the purpose of Article 6(2) and Annex 1 of the Directive, for abanking led conglomerate, where Article 46 (1) of the CRR is applied, thecoordinator, after consulting with other competent authorities concerned,shall decide the most prudent method to be applied by the financialconglomerate.Article 7ConsolidationFor the purpose of Art 6(2) and Annex 1 of the Directive, Method 1 of theDirective 2009/138/EC shall be considered as equivalent to theconsolidation as defined under Method 1 of the Directive, forinsurance-led financial conglomerate.The equivalence assessment is valid provided that the scope of the groupunder Solvency II is the same under the Directive or the difference in thescope is not material.EXPLANATORY TEXT for consultation purposes _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This text is based on the Directive 2009/138/EC, Article 230 inconnection with Articles 220 ss.The Solvency II Implementation measures will need to be consideredonce they have been published.According to Directive 2009/138/EC, for the calculation of group ownfunds all the multiple use of eligible own funds and intra-group creationof capital should be eliminated.Moreover, own funds of other financial sectors should be calculatedaccording to the relevant sector rules.As a result, both Method 1 of the Directive 2009/138/EC and Method 1 ofthe Directive are consistent with the main objectives of thesupplementary supervision since they ensure that: all double-counting isremoved; own funds are calculated in accordance with the definitions andlimits established in the relevant sectoral rules.The equivalence assessment is valid provided that the scope of the groupunder Solvency II is the same under the Directive or the difference in thescope is not material.Article 8Solvency requirement1. For the purpose of the calculation of the supplementary capitaladequacy requirements of the regulated entities in a financialconglomerate, a solvency requirement shall satisfy either of the pointslaid down in (a) and (b):(a) Where the rules for the insurance sector are to be applied, solvencyrequirement means the Solvency Capital Requirement as defined byArticle 100 or 218 of Directive 2009/138/EC as applicable, including anycapital add-on applied in accordance with Articles 37, 231(7) or 232 of the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • same directive as applicable, and any other capital or own fundsrequirement applicable under Union legislation.(b) Where the rules for the banking or investment services sector are to beapplied, solvency requirement means the sum of own funds requirementsas defined by Articles 87 to 93 of CRR, combined buffer requirements asdefined by Article 122 of CRD IV, and specific own funds requirements asdefined by Article 100 of [CRDIV], and any other requirement applicableunder European Union law.Article 9The financial conglomerates own funds and capitalrequirements1. Except where expressly stated in this Regulatory Technical Standard,the financial conglomerates own funds and capital requirements shall becalculated in accordance with the definitions and limits established in therelevant sectoral rules.2. The own funds of asset management companies shall be calculatedaccording to Article 2 (l) of Directive 2009/65/EC; the capitalrequirements are calculated according to Article 7(1) (a) of Directive2009/65/EC.3. The own funds of alternative investment fund managers shall becalculated according to Article 9 of Directive 2011/61/EU.Article 10Sector specific own funds1. Sector specific own funds, are recognised for the coverage of risks at thesectoral level only and cannot be used to cover risks of another sector andshall not be included (above or) beyond the sectoral level.Sector specific own funds are own funds recognised under sectoral rulesthat do not fall within one of the following categories: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (a) Common Equity Tier 1, Additional Tier 1 and Tier 2 own funds under[CRR]; or(b) Tier 1 unrestricted basic own funds, Tier 1 restricted basic own funds,and Tier 2 basic own funds under Directive 2009/138/EC.2. Risks originating from the other sector shall not be covered by sectorspecific own funds.EXPLANATORY TEXT for consultation purposesArticle 10 sets out that sector-specific own funds cannot cover risks abovesectoral requirements.In practice, this means that, for each relevant entity or group of entities,conglomerates need to first count sector-specific own funds against theirrequirements (while respecting sectoral rules and limits).If there is an excess of sector-specific own funds, this shall not berecognised at conglomerate level.In addition, as stated in Article 4, any non-sector-specific own funds inexcess of sectoral requirements need to originate from entities which arenot subject to transferability/availability impediments.Article 11Treatment of cross sector holdings for the calculation of capitalrequirementsWhere an insurance holding of a bank-led financial conglomerate or aninvestment firm-led financial conglomerate is eliminated pursuant toArticles 14.3 and 14.4 or Article 15.2 or the application of these Articles aspart of Method 3, no capital charge for that holding shall be applied at thefinancial conglomerate level for the purpose of supplementarysupervision, even if a capital charge is applied at sectoral level. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • EXPLANATORY TEXT for consultation purposesAt sectoral level, holdings may receive a risk weight or capital charge.At the financial conglomerate level, the same holding may be deducted oreliminated from own funds through consolidation, making the riskweight or capital charge superfluous.This capital charge shall thus not be applied for the purposes of thecalculation of the conglomerates solvency requirements.Article 12Non-regulated financial entities1. For a non-regulated mixed financial holding company and for anon-regulated entity held by a mixed financial holding company, the ownfunds and the capital requirements attributable to the non-regulatedfinancial sector entities shall be calculated according to the mostimportant sector in the financial conglomerate in accordance with Article3(2) of the Directive.2. The own funds and the solvency requirements attributable to othernon-regulated financial entities shall be calculated according to thesectoral rules of the sector (insurance or banking) to which the nonregulated entity is designated.EXPLANATORY TEXT for consultation purposesA “mixed financial holding company” is defined under Article 2(15) of theDirective.Whichever method is used, for the purpose of the calculation of thesupplementary capital adequacy of a financial conglomerate, both anotional capital requirement and notional level of own funds should becalculated for non-regulated financial entities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • These should be calculated according to the rules of the sector to whichthe non regulated entity belongs, or according to the most importantsector in the conglomerate, having regard to Annex 1 of the Directive “Inthe case of a non-regulated financial sector entity, a notional solvencyrequirement is calculated in accordance with section II of this Annex,notional solvency requirement means the capital requirement with whichsuch an entity would have to comply under the relevant sectoral rules as ifit were a regulated entity of that particular financial sector; the notionalsolvency requirement of a mixed financial holding company shall becalculated according to the sectoral rules of the most important financialsector in the financial conglomerate”.Article 13Transitional and grandfathering arrangementsThe sectoral rules applied in the calculation of conglomerate own fundsand solvency requirements shall take into account any transitional orgrandfathering arrangements in force at sectoral level.TITLE IIITechnical calculation methodsArticle 14Method 1 Calculation criteria1. The own funds of a financial conglomerate shall be calculated on thebasis of the consolidated accounts (according to the relevant accountingframework) applied to the scope of supplementary supervision of theDirective.2. The calculation of own funds shall take into account the removal ofintra group balances, transactions and income and expenses related tothe process of accounting consolidation.3. For bank-led and investment firm-led conglomerates, unconsolidated _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • significant investments in a financial sector entity pursuant to Article 40of the CRR shall be fully deducted, if the entity belongs to the insurancesector as defined in Article 2(8) of the Directive.4. Unconsolidated non significant investments are deducted inaccordance with the treatment described in Article 43 of CRR.5. For bank-led and investment firm-led conglomerates, the sectoraltreatment in Part 2, Title II of the CRR shall apply to all unconsolidatedinvestments, participations and holdings of a conglomerate entity,provided that:(a) The conglomerate entity is a credit institution or an investment firm;and(b) The investment, participation or holding is in a credit institution or inan investment firm.6. Without prejudice to points 3 and 4, any other own funds issued by oneconglomerate entity and held by another, if not already eliminated in theaccounting consolidation process, shall be deducted.7. Joint controlled entities shall be treated in accordance with sectoralrules.8. The valuation of assets and liabilities calculated for the purposes ofDirective 2009/138/EC shall be used at the level of the financialconglomerate.9. Where asset or liability values are subject to the calculation ofprudential filters and deductions in accordance with those required underCRR, the asset or liability values used shall be those attributable to therelevant entities under CRR, excluding assets and liabilities attributableto other entities of the financial conglomerate.Where calculation of a threshold or limit is required in order to respectsectoral rules, the threshold or limit shall be calculated on the basis of the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • consolidated data of the financial conglomerate and after the removal ofholdings called for by these standards.10. Where credit institutions/investment firms and related entities areconsolidated under CRR, the same entities shall be considered together.11. Where insurance and related entities are consolidated under Directive2009/138/EC, the same entities shall be considered together.12. Conglomerate entities that are not consolidated under CRR orDirective 2009/138/EC shall be treated separately.13. For the purpose of the calculation of solvency requirements, eachsector shall respect the requirements as calculated under the relevantsectoral rules.When summing the relevant sectoral solvency requirements there shall beno adjustment other than as foreseen by Article 11 of Title II or as causedby adjustments to sectoral thresholds and limits pursuant to point 9 ofthis Article 14.EXPLANATORY TEXT for consultation purposesACCOUNTING CONSOLIDATION AND JOINTCONTROLLED ENTITIES (Points 1, 2 and 7)Under Method 1, the Directive requires the calculation of the own fundsof the conglomerate on the basis of the consolidated position of thegroup.In addition, any inappropriate intra-group creation of own funds must beeliminated.In order to ensure these provisions are respected, points 1 and 2 of Article14 requires the conglomerate to use consolidated accounts (applied to thescope of the conglomerate) as the starting point for the calculation of the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • own funds.In doing so, the conglomerate must allow all eliminations of own fundsarising from the process of accounting consolidation to take place.Joint-controlled entities are to be proportionally consolidated in line withpoint 6.OTHER INTRA-GROUP CREATION OF OWN FUNDS(Point 6)In line with the Directive’s principles, Article 3 of this Regulation calls forthe elimination of all own funds that have been created by intra-grouptransactions, be it direct or indirect.For the avoidance of doubt in the context of Method 1, point 5 furtherspecifies that all intra-group creation of own funds should be eliminatedon top of accounting consolidation, if not already eliminated as part of theaccounting consolidation process.Such additional elimination may be required in particular where thetreatment of the participation called for by the Directive is different fromthat provided for by accounting rules, considered that accounting rulesdoesn’t consider the multiple gearing issue.CROSS SECTOR HOLDINGS AND OTHER HOLDINGS(Points 3, 4 and 5)For bank-led and investment firm-led conglomerates, the calculation ofown funds at the level of the conglomerate should also take into accountthat the sectoral rules allow institutions to risk weight and not deductsome cross-sector holdings.For this reason, in order to ensure the elimination of multiple gearing atthe level of conglomerate, point 3 of Article 14 requires the deduction ofholdings that are neither consolidated nor eliminated (by deduction) atsectoral level, where those holdings are in entities belonging to the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • insurance sector.Point 4 describes the treatment of unconsolidated non-significantinvestment holdings where those holdings are in entities belonging toinsurance entities.Point 5 describes the treatment of other holdings, specifying that otherholdings are treated according to sectoral rules (see the table in AnnexII).SOLVENCY 2 VALUATION CRITERIA (Points 8)For insurance parts of the conglomerate, given that Article 75 of Directive2009/138/EU sets out specific valuation rules for assets and liabilities,point 8 of Article 14 specifies that assets and liabilities for those entitieswithin the conglomerate should follow the valuations calculated for thepurpose of Directive 2009/138/EU.This point is aimed at ensuring that the calculation of the elements ofown funds at the level of conglomerate is consistent with sectoral rules.RECALCULATION OF LIMITS AND THRESHOLDS,TAKING INTO ACCOUNT REMOVAL OF HOLDINGS(Points 9)Once the accounting consolidation has been carried out, as well as theother provisions already mentioned, amounts of CET1 attributable toconglomerate entities that are subject to CRR at sectoral level, as well asamounts of holdings belonging to such entities that are neither deductednor consolidated, will change.So the calculations based on CET1 in Article 45 of CRR, which measurethe threshold for the deduction of deferred tax assets and significantinvestments, should be recalculated.The recalculation should take into account the effect on CET1 of the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • conglomerate accounting consolidation process, proportionalconsolidation in accordance with point 7, the removal of holdings in point3, and any other factors stemming from the conglomerate calculation thathave led to a change in CET1 .In the calculation according to Article 45 of CRR for an entity or group ofentities, the deferred tax assets and significant investments to be takeninto account are only those belonging to that entity or group of entitieswithin the conglomerate.These rules are provided for in point 9.MULTI-LAYER CONGLOMERATES (Points 10, 11 and 12)This Regulation recognises that financial conglomerate structures maybe very complex and involve different layers (see graph example below).In cases like this, where a banking group controls an insurance group,which – in turn – controls a bank, in order to calculate the limits orthresholds provided at sectoral level, the data of the banking group at the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • top of the group shall not be calculated jointly with the data belonging tothe bank (B) controlled by the insurance group.In this case, bank (B) calculates a threshold on its Deferred Tax Assets.Bearing in mind that the Directive states the elements eligible for thecalculation of the own funds are those that qualify in accordance with therelevant sectoral rules, point 10 calls for the relevant groupings at sectorallevel to be maintained also at the conglomerate level for the purposes ofcalculating limits and thresholds.SOLVENCY REQUIREMENTS (Point 13)Finally, point 13 specifies that the calculation of solvency requirements isbased on the sum of sectoral and notional requirements, except for theprovision included in Article 11 (no capital charge for holdings that areconsolidated or deducted at the conglomerate level).See also the Annex - Summary of the treatment of holdings andparticipations for the purpose of the calculation of the own funds of theconglomerate.Article 15Method 2 Calculation criteria1. For the purpose of calculating Method 2 as set out in Annex I part II ofthe Directive:(a) The proportional share applicable to own funds and solvencyrequirements shall relate to the proportion of the subscribed capital whichis directly or indirectly held by the parent undertaking or undertakingwhich holds a participation in another entity of the group;(b) The book value of participations in other entities of the group shall bethe book accounting value for the parent undertaking or for theundertaking that holds a participation in another entity of the group; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (c) Where the own funds of a holding is subject to a prudential filter, thefiltered amounts shall be:i) Added to the book value mentioned in b), if the filtered amountincreases regulatory capital; orii) Deducted from the book value mentioned in b), if filtered amountdecreases regulatory capital.(d) For the purpose of point (c), the filtered amounts pertains to the netamount affecting own funds of the holding.2. For bank-led and investment firm-led conglomerates, significantinvestments in a financial sector entity pursuant to Article 40 of the CRR,if the entity belongs to the insurance sector as defined in Article 2(8) ofthe Directive, shall be:(a) Fully deducted, where the holding is not a participation as defined inArticle 2(11) of the Directive, and(b) Treated according to Method 2, where the holding is a participation asdefined in Article 2(11).3. For insurance-led conglomerates, participation as defined in Article2(11) of the Directive shall be considered for the application of point 1.4. For the purpose of the first point, to eliminate the intra-group creationof own funds, the eligible amount of intra-group investments in anycapital instruments that are eligible as regulatory capital, respectingrelevant sectoral limits, shall be eliminated.EXPLANATORY TEXT for consultation purposesPoint 1(c) addresses cases where prudential filters affect the own funds ofa participation for prudential purposes by adding back unrealised lossesor subtracting unrealised gains, for example in the case of a holding held _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • in the Available For Sale category.If this is the case, the effect of the prudential filter should be reversed [byadjusting the book value of the participation to be deducted].Without this reversal the filtering of unrealised gains would undulyreduce own funds after deduction of accounting book value, while thefiltering of unrealised losses would unduly flatter own funds after thededuction of accounting book value.Referring to the formula in the Annex: if, because of the application of aprudential filter the Own Funds term xi(OFi-REQi) changes, then itseffect should be neutralized by an offsetting adjustment in the book valueterm: BVi.See also the Annex - Summary of the treatment of holdings andparticipations for the purpose of the calculation of the own funds of theconglomerate.Article 16Method 3 Calculation criteria1. The competent authorities may permit the financial conglomerate touse a combination of methods 1 and 2, only where the financialconglomerate can demonstrate to the competent authorities that itsrequest has been made:(a) Further to its best effort to apply either, Methods 1 or 2; and(b) Having regard to the cases in Article 6 (5) of the Directive.2. If several entities are collectively of non neglible interest, the competentauthorities shall take this into account in assessing the request to useMethod 3.3. The application of the specific combination of Methods 1 and 2 to _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • entities within the financial conglomerate that was permitted bycompetent authorities shall be applied in a consistent manner over time.4. The coordinator shall consult the other relevant competent authoritiesbefore taking a decision on whether to permit the use of the combinationof methods 1 and 2.EXPLANATORY TEXT for consultation purposesArticle 6 (5) (a) (b) and (c) of the Directive states:“(a) If the entity is situated in a third country where there are legalimpediments to the transfer of the necessary information, withoutprejudice to the sectoral rules regarding the obligation of competentauthorities to refuse authorisation where the effective exercise of theirsupervisory functions is prevented;(b) If the entity is of negligible interest with respect to the objectives ofthe supplementary supervision of regulated entities in a financialconglomerate;(c) If the inclusion of the entity would be inappropriate or misleadingwith respect to the objectives of supplementary supervision.However, if several entities are to be excluded pursuant to (b) of the firstsubparagraph, they must nevertheless be included when collectively theyare of non-negligible interest.”TITLE IVFinal provisionsArticle 17This Regulation shall enter into force on the twentieth day following thatof its publication in the Official Journal of the European Union. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This Regulation shall be binding in its entirety and directly applicable inall Member States.Done at Brussels,For the CommissionThe President[For the CommissionOn behalf of the President[Position]ANNEX ICalculation methodology for Method 2 – Deduction andaggregation method1. General principlesThe calculation of method 2 shall be carried out on the basis of theregulatory reporting required under the applicable accounting frameworkof each of the entities in the group following the formulaic expressionbelow:where own funds (OFi) exclude intra-group capital instruments.The supplementary capital adequacy requirements (scar) shall thus becalculated as the difference between:(1) The sum of the own funds (OFi) of each regulated and non-regulatedfinancial sector entity (i) in the financial conglomerate; the elementseligible are those which qualify in accordance with the relevant sectoralrules; and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (2) The sum of the solvency requirements (REQi) for each regulated andnon-regulated financial sector entity (i) in the group (G); the solvencyrequirements shall be calculated in accordance with the relevant sectoralrules; and the book value (BVi) of the participations in other entities (i) ofthe group.In the case of non-regulated financial sector entities, a notional solvencyrequirement shall be calculated according to Article 11. Own funds andsolvency requirements shall be taken into account for their proportionalshare (x) as provided for in Article 6(4) and in accordance with Annex I.The difference shall not be negative.ANNEX II- Summary of the treatment of holdings andparticipations for the purpose of the calculation of the own fundsof the conglomerate _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • V. Accompanying documentsa. Draft Cost- Benefit Analysis / Impact Assessment1. IntroductionAccording to CRDIV/CRR proposals, the EBA, EIOPA and ESMA(hereafter the ESAs) through the Joint Committee, shall develop draftregulatory technical standards with regard to the conditions of theapplication of the Article 6(2) of the Directive, and shall submit thosedraft regulatory technical standards to the Commission by 1 January 2013.The Technical Standard describes how institutions following theconsolidation methods set out in this Directive shall calculate own fundsin the parent institution in a financial conglomerate.The standard introduces restrictions on which elements of own funds in _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • subsidiaries and other participated entities of a financial conglomeratecan be used in the calculation of own funds.The main rationale underpinning this Technical Standard is to avoid an“inflated” calculation of own funds of cross-sector financialconglomerates.This Technical Standard focuses on harmonising the calculation offinancial conglomerates’ own funds.2. Problem definitionA lesson learned from recent financial crises is that the regulation ofsupplementary supervision, in particular the current set of rules ondetermining own funds at the conglomerate level, deserves a thoroughrethink.For example, in the recent past it became clear that parent institutionscould report strong levels of own funds, giving an impression of a robustsolvency.In some cases that impression turned out to be misleading as significantamounts of own funds were, in practice, locked-in in the subsidiaries.This consequently rendered the Directive’s assumption of availability offunds at the conglomerate level rather uncertain - because of a lack ofharmonisation of rules on conglomerate own funds.This affects the ability of conglomerates’ own funds to absorb losses,which makes financial conglomerates more fragile than figures on ownfunds would suggest.Multiple gearingUncertainties in the application of the methods for determining ownfunds at the conglomerate level may have led to undesirable levels of _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • multiple gearing.This Technical Standard therefore builds upon the Directive andcontributes to achieving its objective to eliminate the multiple use ofelements eligible for the calculation of own funds at the level of thefinancial conglomerate (see for example Recital 7, Article 31 point 2, andAnnex I, section I of the Directive).Methods to determine Own funds at the FinancialConglomerate Level.Uncertainties in the guidance about the choice of methods fordetermining own funds at the conglomerate level may have led to anarbitrary combination of the methods that are offered under Annex I ofthe Directive.This Technical Standard therefore provides additional clarity on thecalculation methods for conglomerate own funds.3. Objectives of the Technical StandardThe objective of this Technical Standard is to achieve a more consistentharmonisation of the calculation methods of Own Funds listed in Annex Iof Directive.This should translate in increased efficiency and effectiveness ofconglomerate supervision by competent authorities, more clarity on theavailability and transferability of own funds for the conglomerate, as wellas tightly controlled levels of multiple gearing.4. OptionsAnnex I of the Directive, describes three methods to calculate aconglomerate’s own funds.This Technical Standard concentrates on the application of these _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • methods.There is not a wide selection of options available for this TechnicalStandard. Any choice made with respect to this Technical Standardderives from the text of relevant Directives, predominantly the sectoraldirectives, CRR/CRD4 and Solvency II.The guiding principles used by this Technical Standard to achieve moreconsistent harmonisation of calculation methods mentioned in Annex I ofthe Directive are:1. To offer clarity in rules regarding transferability and availability ofconglomerate own funds,2. To eliminate the multiple use of elements eligible for the calculation ofown funds at the level of the financial conglomerate,3. To avoid double deduction of items and amounts from own funds, and4. To respect sectoral rules.Method 1Method 1 is based on consolidated position of the conglomerate in orderto avoid multiple gearing.For this purpose, the RTS requires the elimination of all intra-groupcreation of own funds; the scope of the group is defined according toarticle 2, point 12 of the Directive.Adjustments are required to sectoral rules in the treatment of bankingcross holdings and some instructions not included in the Directive areprovided for unregulated entities.According to the Directive provisions, the capital requirements arecalculated as sum of sectoral requirements without the elimination of _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • intra-group transactions.Method 2The description of this method in its current form is already quiteprescriptive and unambiguous.However, this Technical Standard elaborates on two issues that may leadto disharmonised interpretations:i. The proportional share applicable to own funds and solvencyrequirements;ii. The interpretation of the book value of participations in other entitiesof the group.With respect to the latter issue, this Technical Standard uses the bookvalue from the accounts of the parent as a starting point, but appliesadjustments to any book values subjected to prudential filters in order tosafeguard consistency in the calculation of this method’s deduction ofbook value.The method requires, according to the general principle of avoidinginappropriate creation of intra-group own funds, the deductions of all theintra-group investments in capital instruments eligible according tosectoral rules.This provision ensure also an equivalence between this method ofcalculation of the own funds and the others allowed according to theDirective.Method 3The use of combination of methods 1 and 2 is limited only to the caseswhere the use of either method 1 or method 2 solely would not beappropriate due, for example, to the lack of information on specific _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • entities within the group.The use of method 3 shall need the permission of the competentauthorities or the coordinator after consultation of the relevant othercompetent authorities.The combination method 3 shall be applied in a consistent manner overtime.The supervisory consent is needed in order to prevent regulatoryarbitrage.5. ImpactsThis technical standard’s objective is to achieve a more consistentharmonization of the methods mentioned in Annex I of the Directive.This may limit the degree of freedom with respect to the ways ofcalculating own funds of conglomerates.The expected impact compared to the sectoral rules for insurance-ledconglomerate that apply method 1 of the Directive, where the scope of theinsurance group under Solvency II is not the same as the financialconglomerate under the Directive (see Article 7), is due mainly to the lineby line consolidation of the items of the banking subsidiaries andbanking joint controlled entities instead of the consolidation proceduresprovided under the Solvency 2 framework.In the case the scope is the same or difference is not material,insurance-led conglomerate applies Solvency 2 rules as they will bedefined in the implementing measures Solvency 2.For banking-led and investment firm-led conglomerate the mainexpected impact compared to the sectoral rules is due to theconsolidation of the insurance subsidiaries and joint controlled insuranceentities that are risk weighted or deducted according to CRR. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Both insurance and banking group shall also adjust, where applicable, theamount of the threshold and parameters used for their eligibility limits(for example, thresholds on Deferred Tax Assets and on deduction ofholdings under Article 45 of CRR), considering the effect of theconsolidation of cross sector holdings at conglomerate level.Insurance, bank and investment firm-led conglomerates shall take intoaccount of limits to transferability and availability of own funds asforeseen in the Technical Standard.A cost factor relates to the alignment of the entities to the requirements ofthis Technical Standard.Such costs may arise if current national regulations need to be amendedto comply with the Technical Standard.Another cost factor may arise in the cases where competent authoritiesare called upon to approve the use of Method 3.Lastly, this Technical Standard may also affect the business model for agroup to organize itself as a financial conglomerate.There are a number of expected benefits related to this TechnicalStandard. They are:i. More consistency in the selection and application of the methods ofAnnex I of the Directive;ii. Increased efficiency and effectiveness of conglomerate supervision;iii. More clarity on the amount, availability, and transferability of ownfunds within a financial conglomerate;iv. More effective loss absorption of the capital held by conglomerates;v. An increased standardization of the use of the methods, leading tolower costs of their application; and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • vi. A contribution to greater financial stability.b. Overview of questions for Consultation1. What are the cost implications of a requirement for conglomerates tofollow the clarifications for calculating own funds and solvencyrequirements described in this paper?If possible, please provide estimates of incremental compliance cost thatmay arise from the requirements, relative to following the Directive in theabsence of the Regulatory Technical Standards.2. How, in your opinion would the proposed clarifications impact onconglomerates’ business models?3. How far would the suggested clarifications change current marketpractices?4. Are the Technical Principles in Title II sufficiently clear? If not, whatareas require further clarification?5. Are there any areas of ambiguity in the way that the TechnicalPrinciples in Title II apply to the three consolidation methods?6. Are there any areas of ambiguity in the way that Method 1 needs to becarried out?7. How much of an operational burden is the use of consolidatedaccounts of the conglomerate as a starting point for Method 1? Is there analternative more straightforward method/way to eliminate theintra-group creation of own funds?8. Do you foresee any problems in applying sectoral rules to own fundsunder Method 1? If so, what refinements to the method would youpropose? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 9. Are they any areas of ambiguity in the way that Method 2 needs to becarried out?10.For the purpose of assessing the transferability of “funds” to entitiessubject to CRR, under Article 4, is “three calendar days” a sufficienttimeframe in a period of stress? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Dr Andreas DombretMember of the Executive Board of the DeutscheBundesbankForeign banks between financial crisis and financial stabilitySpeech held to mark the 30th anniversary of the Association of ForeignBanks in Germany1 IntroductionLadies and gentlemenLet me begin by offering theBundesbank’s warmcongratulations to you, Mr Winter,and all the members of theAssociation of Foreign Banks inGermany on its jubilee 30thanniversary.Thirty years is quite a long period of time – nearly one-third of a century –and something of a landmark.As the old saying used to go, “Never trust anyone over 30”.That catchphrase was popularised by the 1968 student movement – thestudents who used it are now themselves over 60!Trust is indeed the key word. Its importance is being learned bygovernments and banks alike as the sovereign debt and financial crisistightens.So it is a good thing that the day-to-day dealings between the bankingassociations and individual banks, on the one hand, and central banksand supervisory authorities, on the other, are characterised by mutualconfidence and trust – notwithstanding the necessary arm’s-lengthrelationship between central banks and supervisory authorities, on theone hand, and banks and their associations, on the other. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I can say that because I have worked in both camps.I was once a foreign banker myself. Since joining the Bundesbank in 2010,I have had a chance to see things from the other perspective.I would like to take this opportunity to thank you for the constructivecooperation I have been privileged to enjoy with all banking associationsover the past two years.I hope that this cordial relationship will continue in future – includingafter the possible emergence of a new, overarching single Europeansupervisory body.If it is carefully conceived and constructed, it could make an importantcontribution to safeguarding financial stability.And it might well refashion the current triangular relationship betweenbanks, supervisors and central banks.Let me nail my colours to the mast right away: I do not believe that it isabsolutely essential for the central bank to have ultimate supervisoryresponsibility in order to capitalise on the synergies provided by centralbanks’ macroeconomic and macroprudential expertise.The crucial requirement is the efficient exchange of information.2 Stimulating competitionIn his book Fault Lines - How Hidden Fractures Still Threaten the WorldEconomy, former IMF chief economist Raghuram Rajan argues that afault line is created when two different financial systems based ondifferent principles interact.He is referring to the contrasting cultures of the capital markets andrelationship banking.Financial market integration has certainly increased the possibilities ofcontagion.However, I do not believe that the “fault line” necessarily runs along theborder between the capital market and relationship banking. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Seen from the perspective of a universal bank, drawing a rigid distinctionbetween capital market orientation and a banking philosophy seems ahuge oversimplification.Germany’s universal banks came through the financial crisis pretty wellon the whole.And the contacts between foreign banks and German banks havestimulated and enlivened competition, benefiting both groups of banks.Moreover, it should be noted that the foreign banks operating inGermany, which each bear the specific hallmarks of their home country,are probably the most heterogeneous group of banks included in theBundesbank’s statistics.How important are foreign banks in Germany’s banking system? Formany foreign banks, traditional banking activities account for just a smallpart of their business.This makes their market share – currently 12.9% measured in terms oftotal assets – all the more remarkable.This trend has been driven by the arrival of new banks through mergers aswell as growth, particularly in deposit business and instalment loans.The approximately 30,000 members of staff employed by foreign banks atthe German financial centre do make quite a meaningful impact onemployment.These figures point to a significant influence.In some business lines, especially those involving the capital markets,foreign banks have a much more prominent position than in traditionalbanking fields.Today, it is hard to imagine M&A activity in Germany without theinfluence of the Anglo-American banking culture.Foreign banks play an important role in advising and assisting onGerman corporate bond issues; the same goes for IPOs and capitalincreases. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The financial crisis has naturally also led to the market withdrawal ofindividual foreign banks.On the whole, however, it has thankfully not triggered a mass exodus offoreign banks from Germany – unlike in some other countries.For a long time, foreign banks struggled to gain a foothold in the Germanmarket.Banks that accept deposits and grant loans normally had to begin bysetting up a branch network as a prerequisite for winning new customers.The creation of the single market in Europe has made things mucheasier.The European Passport made it possible to set up branches anywhere inthe EU without requiring additional authorisation.However, barriers to market entry still remained.These included the high overhead costs of creating a branch network, thechallenge of finding skilled staff, the continued strong importance ofbrand names, and the justifiably high reputation of German banks amongGerman clients.In this tough business environment, foreign banks wanting to expandinto Germany had to rely on innovation and cost-efficiency.They were given a helping hand by liberalisation and the technologicaladvances of the internet in the 1990s; this gave foreign banks a fast andlow-cost channel for communicating with customers.And they seized their chance. Some foreign banks therefore set up shopas online banks to conduct deposit business but also to engage inbusiness with standardised consumer loans.For retail customers this translated directly into a larger product range atlower prices.That is good both for customers and for competition. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Providing advice and expertise to enterprises is a key investment bankingservice, and one from which German firms have benefited.That requires putting down roots in the real economy and offering a realservice.And the last few years have taught us that foreign banks with roots in thereal sector are unlikely to pull out in times of financial crisis.Integrated financial markets per se enhance economic growth and ourprosperity.Foreign banks in Germany constitute a part of this financial marketintegration.The downside of integration is that market players are much moreinterconnected, which means that crises spill over more quickly from onecountry to another.This can lead to dislocations. However, that is simply the reality oftoday’s financial world.3 Capital: the key to greater trustHaving, or building up, sufficient capital is essential, particularly in thecurrent climate. And it is also crucial to restoring confidence and trust.In its last Financial Stability Review, the Bundesbank wrote that, in timesof systemic stress, “the task of restoring confidence is not merely theresponsibility of an individual bank but also a call to arms for the systemas a whole.”This demands not just adequate capitalisation of national bankingsystems but also convincing Europe-wide solutions.I’ll make no bones about it: a level of capitalisation that just meets theminimum supervisory requirements would fall far short of what is needed,in my view.I think it was the UK economist Charles Goodhart who told the followingtale to illustrate the dangers of minimalist compliance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A weary traveller arrives at a rural railway station.To his delight, he sees exactly one taxi waiting there and asks the driverto take him to his destination.To his amazement, the cabdriver tells him: “I would love to take you therebut cannot, I’m afraid.”“Why not?”, he asks, flabbergasted.“There is a local bye-law that says a taxi has to be here at all times.”“But a taxi is here.”“Ah yes, but if I take you home, there would no longer be a taxi waitinghere. That would violate the bye-law.”This is what can happen with statutory minimum requirements.Only capital in excess of the minimum requirements is available to trulyand independently absorb business risk.In an actual crisis, it is only this capital that can be used to buy the timeneeded, for instance, to write down impaired assets, adjust portfolios orrestructure business units.In an ideal world, of course, such buffers should be built up beforesystemic events occur.That is the rationale behind capital cushions. They provide a certainbreathing space before institutions are forced to unload risky assets andcurb their lending.If the buffers are too small, however, the pressure to deleverage during ashock can become overwhelming and cyclical movements may beamplified.This is where public capital assistance comes into play. In theory, itprovides a counterweight and reduces deleveraging pressure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 4 Getting the basics right: aspects of a European system ofbanking supervisionThe reality can be much rougher, however, for a euro-area country that isstruggling to cope with the close interlinkages between the sovereigndebt crisis and the banking crisis.The stability of the banking sector is then called into question becausethe country is no longer regarded as being fully capable of resolving itsbanking crisis unassisted.For such cases, the EFSF has clear rules according to which othereuro-area countries can step in to help that country. The affected countryremains the partner for the donor countries’ assistance.By providing such assistance, the donor countries are already taking onconsiderable risks.Extending this risk-sharing role, as is being proposed in connection witha banking union – in the form, for example, of a European restructuringfund or a European deposit insurance scheme – would necessitate farmore extensive intervention in countries’ national sovereignty and in theirfiscal and economic policies.I hope you will agree with me that joint liability must not be allowed to beintroduced covertly through the back door.Instead, joint liability must be predicated on two basic principles. One isthe unity of liability and control.As long as control rests with nation-states, liability must rest there, too.This is important to avoid promoting excessively risky business modelsthat threaten financial stability.Moreover, no incentives should be created to build a bloated financialindustry in individual countries that is way out of proportion to the size ofthe real economy.The other principle that must be observed is taking the appropriate stepsin the right order. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The logical sequence requires, first, further moves towards Europeancontrol, which in turn necessitate democratic legitimacy andaccountability.I am firmly convinced that all concrete proposals must be informed bythese considerations and guided by these principles.Moreover, many important details remain to be clarified. Theseremaining uncertainties have perhaps contributed to the intensity of therecent public debate on this topic.In a situation marked by uncertainty it can even happen that one or twoeconomics professors sign both a petition and the correspondingcounter-petition.And this does not even have to be a contradiction if the two countervailingpositions depart from different assumptions concerning the principlesand the details of their implementation.One of the questions regarding a possible pan-European bankingsupervision regime that still needs to be clarified is the range of countriesthat will be subject to it: should it cover all EU member-states or only theeuro-area countries?Given the interlinkages between financial institutions throughout the EUand against the background of the single market, I see merits inintegrating all EU member-states in a European supervisory structure.This would strengthen the single market, it would be consistent with theSingle Rule Book, and it would help to create a level playing field.Taking this logic further, it would make sense in principle for all banks tobe supervised by this European authority.In line with the principle of subsidiarity, the European supervisoryauthority could then delegate the supervision of systemically unimportantbanks to national authorities, subject to the proviso that such banks couldthen be brought back into the fold of European supervision on acase-by-case basis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I believe a Europe-wide prudential regime would definitely benefit fromthe operational involvement of national supervisory agencies.Such involvement, in fact, may well be essential.A key issue for central banks is the precise nature of their involvement inEuropean banking supervision.There can be little doubt that they ought to play a role, given their wealthof macroeconomic and macroprudential expertise, as this is the only wayto exploit synergies.The question, however, is how this can be best accomplished. I believethat central banks do not necessarily need to assume ultimateresponsibility for supervision.The key imperative is, rather, for supervisory agencies and central banksto cooperate efficiently and, above all, to exchange information.In my view, this would be consistent with central bank involvement inoperational supervision.In this manner, potential conflicts with ensuring the independence ofmonetary policy can be avoided and the credibility of central banksmaintained.It follows from this that an agency other than the ECB could be givenultimate responsibility for supervision. Supervisory powers implyextensive rights of intervention which, in turn, require direct democraticlegitimacy and accountability.Thus if the central bank were to have ultimate sovereign responsibility, itsindependence would have to be constrained.And let us not forget either that monetary policy decisions can alsoimpact on banks’ robustness.This might well cause a conflict of objectives.All of these arguments are, I believe, sound reasons not to transferultimate responsibility to the ECB but, instead, to a different authority _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • headed by a council in which the banks’ home countries are adequatelyrepresented.Such representation should reflect the size of each country’s bankingindustry.In such a set-up, the ECB would undoubtedly play a particularlyimportant and wide-ranging advisory role.Whatever solution is ultimately implemented, I am firmly convinced thatmonetary policy and prudential supervision should be kept as far apart aspossible.If a European supervisory regime is based on the right principles and itsdetailed workings are well thought out and implemented, it has a goodchance of making a major contribution to financial stability.5 ConclusionsThose are a few thoughts that I wanted to share with you going forward.Your anniversary has undoubtedly come at a critical juncture for theworld of finance.The sovereign debt and banking crisis will probably keep us occupied forquite some time to come.The problems are deep rooted. The future will tell how well we have beenable to cope with the challenges of our time.However, of this I am convinced: if the right measures are taken, a verygood solution will emerge in the end.On this note, I would like to congratulate you once again on yourlandmark anniversary and thank you for being such an attentiveaudience. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Market intelligence, market information andstatistics in central bankingKeynote Speech by Mr Kiyohiko G Nishimura, DeputyGovernor of the Bank of Japan, to the 6th Irving FisherCommittee Conference, Bank for InternationalSettlements, Basel, 29 August 2012.1. Introduction: statistics, market informationand Irving FisherIt is a privilege for me to address this keynote speech before thedistinguished members of the Irving Fisher Committee.I am particularly thrilled, since the name Irving Fisher strikes a chord inmy heart.Irving Fisher is an iconic figure at Yale University, where I earned mydoctorate.In fact, he received the first Ph.D. in economics ever granted by Yale,in the year 1891.I vividly remember his life-size portrait hung above the mantelpiece of the19th century mansion house, gazing solemnly at faculty members andgraduate students.No new words are needed to attest to his monumental contributions tomicroeconomics, macroeconomics and monetary theory.He was also influential in laying the foundations of economic statistics, asexemplified in his popular The Making of Index Numbers.In fact he was not content with just theory: he went on to found by himselfthe Index Number Institute that engaged in computing commodity price _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • indices, and thus became one of the most popular providers of marketinformation at the time.Unfortunately, however, he failed to recognize the significance of theStock Market Crash of 1929.Just three days before the crash, he wrote that stock prices were at apermanently high plateau.And even after the crash, he continued to assure investors that a recoverywas just around the corner.This might testify to his failure in “market intelligence”, in detecting thesigns of a fundamental change in the market place.In his latter days, though not immediately appreciated by the public andthe profession, he presented a remarkable theory of debt deflation as anexplanation of the Great Depression.In fact, this masterful piece of work is the precursor of the vast literatureconcerning financial stability, which is especially relevant in economicpolicy making in the aftermath of the financial crisis of 2008.What then can we central bank statisticians learn from these dramatic upsand downs in the life of Irving Fisher?In fact, this is the subject of this speech.In particular, I argue that, although reliable macroeconomic statistics areof course necessary for policy making, even good statistics are sometimesgrossly insufficient to guide economic policy, especially when a seismicchange occurs in the market and the economy.The recent financial crisis is an example of such change. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Thus, central bankers should incorporate “market intelligence”, which Iwill explain later, and non-statistical market information, into theirarsenal of statistics.So a central bank statistician should be more than simply a compiler ofwell-defined statistics: they should become a sort of sleuth or intelligenceagent, detecting signs of future developments that may change the world.I proceed as follows.Section 2 outlines the value of economic information from the perspectiveof policy decision making.A key theme here is “market intelligence”, which is the active gatheringand analysis of market information through central banking activities.To understand the importance of market intelligence, I present threeexamples, with respect to the past, the present, and the future.Section 3 presents a lesson from the past.I examine the so-called Paribas Shock of 2007, and argue for the absolutenecessity of “proactive” market intelligence to avoid this type of financialcrisis.Section 4 describes the current achievements of market intelligence in anarea of pressing importance: property price statistics.I show that it is possible to get reliable, unbiased information bycombining various existing market information sources, even thoughindividually they may have their own biases.Section 5 concerns the future: detecting problems in shadow banking.Shadow banking involves a complicated structure, so it is necessary tograsp its “interconnectedness” to gauge the magnitude of potentialproblems. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • As an example, I explain the Bank of Japan’s attempt to reveal theinterconnectedness of the Tokyo money markets.Section 6 contains some concluding remarks on market intelligence andcentral bank statistics.2. Economic information and policy makingContemporary central banking faces two major challenges; one related toaccountability, and the other to effective communication.First, central banks should be accountable for their policies.This is all the more important for those central banks that haveindependence in determining their monetary policy.Accountability means policy should be evidence-based, that is, based onclear reasoning relying on substantiated data.Second, central banks should be effective communicators.Markets and economies have become increasingly susceptible to changesin economic agents’ expectations.To ensure that policy is effective, central banks must communicate withthe public in a persuasive manner.Here again, data supporting policy decisions become important.Thus, for accountability and effective communication, “numbers” orstatistics become increasingly important.Moreover, data here means not only quantitative data; qualitative data areequally as important. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Knowns and unknowns in Central Bank policyTo understand the nature of the economic information central bankswant to know, the following three-way classification may be helpful.The first type of information concerns “known knowns”.Here “knowns” are whatever happened in the past.Thus, known knowns are information about what happened, and typicalknown knowns are contained in statistics.The second type is “known unknowns”.Here unknowns are those things that are happening at present or that willemerge in the future.They are known unknowns, since we already know that they arehappening or will happen.You may have come across the word “now-cast”, which is an “estimate”of what is happening now, used in contrast with a “forecast” whichpredicts future events.A “now-cast” is a typical example of a “known unknown”.Finally, there is the third type, called “unknown unknowns”, thingspreviously unknown but potentially having a significant effect on theeconomy.Here I quote Donald Rumsfeld, the former U.S. Secretary of Defense,whose enigmatic statement gives perhaps some indication of their nature:“But there are also unknown unknowns – the ones we don’t know wedon’t know. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • And if one looks throughout the history of our country and other freecountries, it is the latter category that tend to be the difficult ones.”Keeping in mind this three-way categorization, let me ask the followingquestion:What kind of information does a central bank policy maker want to knowwhen he or she decides on policy?And, in what way is it related to the three-way categorization?First of all, in contemplating appropriate aggregate demand managementpolicy, the central bank policy maker wants to know the momentum ofactivity in the economy and financial markets.However, this is not in itself sufficient.The experience of the recent financial crisis has shown that the centralbank policy maker should also be aware of the signs of previouslyunknown factors, unknown but potentially significant changes in theeconomy and financial markets.In fact, with respect to the former, i.e. macroeconomic momentum, wehave made significant progress.There have been improvements in the comprehensiveness, accuracy andtimeliness of macroeconomic statistics related to aggregate demandmanagement.We now have a rich array of data, both quantitative as in GDP and CPIfigures, and qualitative as in business surveys.Not only public but also private institutions produce and disseminatetheir own data.These are either known knowns (type 1), or known unknowns (type 2). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Statistics provide valuable information about known knowns, and theybecome the foundation for estimating known unknowns.However, statistics are grossly insufficient when it comes to detectingunknown unknowns (type 3).Central-bank policy makers are frequently frustrated by deficiencies inthe statistics available, which they find inadequate in helping them detectpotential problems in the economy.Perceived deficiency is especially keen in financial information.It should be noted that financial stability is now seen as a prerequisite foreconomic stability.Moreover, policy makers are alarmed by the increasingly strong negativefeedback seen in recent years between financial malaise and economicstagnation.The rapid development of financial factors confounds the problem ofdetecting malign symptoms.Thus, guarding against previously unknown but potentially devastatingfactors has become one of the most important issues for policy makers.Thus, in November 2009, the G20 Finance Ministers and Central BankGovernors requested statisticians to fill the so-called data gaps.Twenty recommendations were submitted in the G20 Data GapsInitiative (DGI) in order to establish timely reporting schemes fordetecting both known unknowns (type 2), and unknown unknowns (type3) .The key to guarding against unknown unknowns _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A central bank’s intelligence activities are the key to guarding againstunknown unknowns.These consist of two parts.The first is so-called “market intelligence”: the central bank’s dailytransactions with financial institutions, which provide various kinds ofinformation about market participants, developments in financialproducts, as well as other “news”.These pieces of market information are valuable in creating a timely andaccurate view of particular institutions and the market as a whole.The gathering and analyzing of this information is the core of “marketintelligence”.The second part of the central bank’s intelligence activities is monitoringand feedback.Qualitative or supervisory information can be obtained from regularsupervisory dialogue with regulated entities.They have valuable information, and by analyzing it thoroughly we get agrasp of the details of market information, which is then fed back to theseinstitutions if necessary.It should be noted here that information coming from individual financialinstitutions may include subjective or in some cases biased content,regardless of whether it is market information or information acquiredthrough regulatory monitoring.We should be aware of these biases, and good market intelligence isneeded to gauge the extent of such bias and to compensate for it.3. Lessons from the past: necessity of proactive marketintelligence _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Let me now turn to three examples of central bank intelligence.The first example is its failure in the past.This is the so-called Paribas Shock of August 9, 2007, the precursor of theglobal financial crisis of 2008.On July 10, 2007, S&P and Moody’s announced that they would bereviewing the ratings of several residential mortgage-backed securities(RMBS) backed by subprime housing loan assets.As a consequence, the AAA ratings of asset-backed commercial paper(ABCP) backed by these RMBS would also be downgraded accordingly.This looked like a minor change in a marginal market of the US financialsystem.Unfortunately however, within just one year, it became the epicenter of aglobal financial crisis.To understand the problem, we should be aware of the special role ofmoney market funds (MMFs) in the United States.US MMFs were considered to be extremely safe financial assets.One of the primary reasons for this was that MMFs were only allowed toinvest in AAA-rated assets.Therefore, when ratings were downgraded for ABCP, MMFs did notreinvest in ABCP.Then, funds that originated ABCP and used it to raise money foundthemselves in fund-raising difficulties: funds under the Bear Stearnsumbrella went bankrupt; BNP Paribas moved to freeze its affiliatedfunds’ new applications and redemptions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • These funds were the structured investment vehicles (SIV) created bybanks to issue ABCP.When these SIVs were unable to find funding sources, their parent bankswere forced to provide liquidity enhancement instead.At that time, nobody knew for certain which banks’ SIVs were on thebrink of extinction, and which banks had serious liquidity problems.Banks, which frequently lend each other money, suddenly became awareof counterparty risk, the risk that the other party in a transaction mightsuddenly go belly up.They began to worry that some bank somewhere might suddenly beunable to secure liquidity and fail.Indeed, on August 9, a liquidity crisis actually occurred, with liquiditydrying up quickly in the interbank market.Many European banks were among those facing liquidity difficulties.Chart 1 shows an unprecedented spike in the three month LIBOR-OISspread, showing the heightened risk premium in the European interbankmarket. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A liquidity crunch in interbank markets started, and it spreadimmediately to the United States (Chart 2).Confronted with this situation, the European Central Bank (ECB)promptly announced that it was prepared to supply massive amounts ofliquidity into the short-term money market.This was the event that came to be known as the Paribas Shock. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Lesson: necessity of proactive market intelligenceThe circumstances surrounding the Paribas Shock naturally beg thequestion: Was this event avoidable? Or at least, was there any telling signthat this type of event was just around the corner?As the description of the event shows, there are four important pieces ofinformation that the policy makers should have known and which wouldhave helped prevent this event.The first is the asset position of the MMFs: their composition and quality.MMFs held a large amount of AAA-rated ABCPs of SIVs whose parentswere European as well as US banks.These ABCPs were backed by US subprime loans, so that if the subprimeloans were downgraded then these ABCPs would also be downgraded.The second vital information is possible side effects of the legalconstraints upon the MMFs. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • MMFs could hold only AAArated assets so that, if US subprime loanswere downgraded, MMFs could not reinvest in ABCPs of the SIVs.The third and most crucial information policy makers should have had isknowledge of banks’ involvement in their SIVs.To what extent were those banks obliged to support their SIVs withliquidity injections?Here it was not only a question of contractual arrangements, butreputations were also at stake.The fourth piece of vital information is knowledge about theinter-connectedness among banks in the interbank market.It is clear that existing statistics and routine market intelligence weregrossly insufficient to gather the above four pieces of vital information.To my knowledge, few, if any, market participants flagged the alarms thatshould have been raised by any of these four points.No statistics ever pointed out the danger.However, there were several, though obscure, signs flagging a possibleproblem, so that a market intelligence unit alarmed by these signs mighthave detected the problem and could have helped policy makers avoid thedisaster.In particular, there was a telling sign in the statistics about US MMFs.Chart 3 shows an upward trend in the total assets of the US MMFs in thefirst half of 2007.The growth rate of MMFs was fast, though it did not look extraordinary.However, if you look at the share of “safe assets”, it actually declinedfrom the start of the year. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • So, this chart shows that by looking into these figures, one might havefound some sign of abnormal risk taking in non-safe assets, includingABCP.Thus, if in addition, the market intelligence unit had detected the heavyinvolvement of banks in their SIVs issuing these ABCP, the unit mighthave sensed a possible danger of liquidity crisis in the interbank market,and might have been able to help the authorities prevent the crisis.In fact, after the Paribas Shock, the safe asset share jumped considerablyand the total assets also skyrocketed, showing the strong flight to safetythat devastated the ABCP market, and the ABS market in general.To sum up, it is not clear whether the liquidity crisis in the summer of2007 could have been avoided.However, proactive market intelligence, that is, detection of possibleproblems in the market based on careful monitoring of marketdevelopments and thorough analysis of market statistics, might have _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • helped contain if not avoid the turmoil in the interbank market, and thusmight have ultimately lessened if not negated the severity of the financialcrisis of the following year.Bearing this in mind, the Fed and other central banks, as well as privateinstitutions, have begun to collect and compile a wide range of statisticsthat capture securitization.In particular, Chart 4 shows details of the asset composition of US MMFs.The chart indicates that MMFs may have already increased investment incommercial papers in 2006, the year before the Paribas Shock.4. Present achievement: best use of existing market informationLet me now turn to the second example, which is the present achievementof market intelligence.This is about property prices, and the issue is the timing of the availabilityof market information. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The financial crisis of 2008 was triggered by the bubble and subsequentbust in US house prices.There is a wealth of evidence detailing the close relationship betweenproperty price bubbles and financial crises.International panel studies show more than two-thirds of 46 systemicbanking crises were preceded by house price boom-bust patterns, while35 out of 51 house price-bust episodes were followed by a crisis.However, we have not had access to good property price indexes, basedon sound economic foundations and comparable between countries andjurisdictions.Frustrated by this deficiency, in November 2009, the G20 Ministers andCentral Governors designated property price indexes as one of the mostimportant data gaps to be filled.To rectify the problem, several conferences were held under theleadership of Eurostat, which gathered a wide range of experts onproperty prices from theory to data compilation.Based on these conferences and public comments, the Handbook onResidential Property Price Indices has been drafted, and the finalizedversion of the Handbook will be published very soon.Moreover, many countries and jurisdictions are now preparing their ownproperty price indexes in accordance with the recommendations of theHandbook.In fact, I have learned that Japan’s Ministry of Land, Infrastructure,Transport and Tourism has almost completed the development of a newseries of residential property price indexes using the procedurerecommended in the Handbook, and the Ministry is about to startpublishing new statistics just this morning. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Issue of timelinessThis is a great leap forward indeed towards having reliable and accurateproperty price information.However, from the policy maker’s viewpoint, the situation is still far fromsatisfactory.It should be emphasized that, for a policy maker, timely information is asimportant as, or in some cases more important than, reliable and accurateinformation.According to this criterion, many property price indexes are not helpful inimmediate policy making, since they inevitably lag behind marketmovements.To see why, let me give you the example of a typical Japanese propertytransaction.Property transactions follow a series of stages several weeks apart fromeach other, and each stage usually entails different prices, namely:the initial asking price, P1;the offered price, P2;the contract price, P3;and the price that is filed with the land registry office, P4.My collaborators and I have been able to get a unique data set of a largenumber of property transactions in Greater Tokyo which illustrates thesefour stages.Here I will present the results based on this data set. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Chart 5 depicts the timeline graphically. From P1 to P2 takes on averageten weeks, form P2 to P3 five and a half weeks, and finally from P3 to P4fifteen and a half weeks.Thus, from P1 to P4 takes almost thirty one weeks, more than a half year.We should also take into account the time taken to collect and compilethe information, which is itself likely to be substantial, as in the case ofGDP and CPI data.Thus, if the authorities use the most reliable transaction price data of P4,it will probably take almost a year.From the policy maker’s viewpoint, this is often too late.To get the timeliest information about property market conditions, earlierreporting of P1, the initial asking price, is preferable.However, this is the asking price, not the transaction price. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • There might be a substantial bias in this asking price data because aseller wants to sell at a higher price, even though it may take much longerto strike a deal or he is never able to sell.In fact, Chart 6 shows the price distribution of P1, P2, P3 and P4.As expected, the initial asking price P1 has a higher average than the priceP4 at the registry office (though there is the caveat that the samplepopulation of P1 is not exactly the same as that of P4).Thus, we face an apparent trade-off: if you want timely information thenyou use P1, but it has non-negligible bias.If you want accurate information, then you use P4, but it has alreadybecome somewhat stale information by the time it is available.Best use of market informationThere is, however, an important way around this dilemma.It should be noted that the Handbook recommends hedonic qualityadjustment in property price indexes based on detailed micro and macromarket information. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • There are various ways to conduct hedonic quality adjustment, amongwhich a hedonic quantile regression approach is one of the mostsophisticated and robust.Remarkably, after applying this quality adjustment to both P1 and P4 ofour data set, we find the quality-adjusted price distribution based on P1 isvery close to, and almost indistinguishable from, the quality-adjustedprice distribution based on P4.Let us look at Chart 7, the quantile-quantile plots of two distributions.In the quantile-quantile graph, if two distributions are identical then theplotted line is on the 45 degree line.The upper chart illustrates the result of raw or unadjusted data of P1(initial asking price) and P4 (registered transaction price).This chart clearly shows the upward bias in the initial asking price relativeto the registered transaction price. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • However, when quality is adjusted using a hedonic quantile regressionmethod, the bias seems almost to have vanished, as shown in the lowerchart.In a nut-shell, the result of this study shows that the initial asking pricedata, the timeliest of all price information, can be used as reliableinformation about property prices, so long as quality is appropriatelyadjusted using a hedonic quantile regression method.So we can benefit from the best use of market information, with respect toboth reliability and timeliness.5. Guarding against future problems: shadow banking and basicinformation gatheringSo far, we have examined the importance of market intelligence and thebest use of market information in the past and the present.I am now looking towards the future, and considering what is needed toguard against future problems.The pressing problem that comes first to mind is that of shadow banking,a problem in the past, but still a potential problem in the future.Since regulations on banks are to be tightened further, new types ofshadow banking may appear, little known at present but potentiallythreatening to financial stability in the future.Modern shadow banking activities are largely based on financial markets,and hence are likely to create innovation there.They change themselves rapidly in response to changes in marketconditions and regulations.Moreover, they have broad interconnectedness with banks and otherfinancial institutions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Given this situation, in what way should central banks gather valid andvital information about them?Here again, I believe that the key is to utilize various sources of marketintelligence alongside other sources of information.Furthermore, I would like to stress that the intelligence work should beproperly followed by the establishment of new statistics about shadowbanking.Various approaches of market intelligenceLet me explain the efforts of the Bank of Japan in this respect.The Bank monitors shadow banking entities and activities throughvarious channels.The nature and scope of the Bank’s monitoring are depicted in Chart 8. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Amongst these channels, direct monitoring of major shadow bankingentities is of course the most significant.Thus, the bank has increased the number of staff directly monitoringmajor securities companies.However, it is practically impossible to conduct dialogues with allfinancial institutions of a shadow banking nature, and moreover, shadowbanking activities tend to change rapidly with developments in financialmarkets.It should be noted that shadow banking entities are deeply involved infunding and investment with various financial institutions.So indirect monitoring through banks, monitoring through the paymentsand settlements system, and market intelligence through marketparticipants all become important.The Bank also closely watches shadow banking activities insecuritization, securities lending and repos.For instance, we have started direct monitoring of hedge funds andinvestment trusts as well using market intelligence through marketparticipants much more than before.Furthermore, although we do not directly monitor finance companies,since large finance companies are owned by banks, we monitor them bymonitoring the banks.It is then crucial to cross-check the information gathered. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Chart 9 illustrates the point.In this regard, it is important to monitor banks as counterparties ofshadow banking entities.This is because bank activities are interconnected with shadow bankingactivities.Market information in the financial markets is also particularly valuable.Central banks are especially well-positioned to collect valuableinformation on the activities of participants in financial markets, sincethey not only gather information relevant to monetary policy, but theyalso operate payment and settlement systems.Information on market practices and financial innovations can oftenprovide early warning of risks, and hence are especially important amongthe various kinds of market intelligence. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The case in point is found in the subprime mortgage crisis in the UnitedStates.Securitized products were originated with financial engineering anddistributed without appropriate risk assessment.This was partly due to an overly optimistic assessment of riskdiversification.However, this risk became increasingly visible in the market as themarket evolved into a new phase.Feedback of market intelligenceAnother important role of market intelligence is to feed information backto the market, and thus to find potential information gaps to be filled.For example, based on market intelligence, the Bank of Japan designsand compiles the “Tokyo Money Market Survey”, which providesan overall quantitative assessment of the money markets.The survey depicts, among other things, the current interconnectednessamong financial institutions through repo transactions, as is shown inChart 10. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This chart shows that securities companies borrow specific JGBs throughSC repos mainly to cover their short position in bond trading.Most of their short-term money is funded through GC repos from trustbanks, while some funds come from banks and money market dealers.This kind of quantitative understanding provides both new perspectivesfor central bank business and wider grounds for dialogue with financialinstitutions and market participants.In fact, the result of these dialogues will be examined and used byfinancial institutions to develop more sound business practices.Also, the feedback of any relevant information will be reflected in the nextsurvey data.Starting this year, we will begin to conduct this survey regularly.Overall, market intelligence is absolutely crucial for central banks inmaintaining the stability of the financial system. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I believe that this flexible system of monitoring shadow banking entitiesand activities, based on market intelligence, can provide a good pilotstudy for other central banks to consider when they want to identifyemerging risks and vulnerabilities in their own countries andjurisdictions.6. Concluding remarksLet me now come to my conclusion.As we all know and feel, central banks around the world have facedserious challenges, especially since the financial crisis of 2008.Financial stability is now clearly marked as an essential prerequisite foreconomic stability, and it is thus the responsibility of central banks tomaintain this stability.Moreover, the financial turmoil following the collapse of LehmanBrothers, and still lingering somewhat in the global market, has clearlyproved that existing statistics are not sufficient for policy making, inparticular policy making involving financial markets.Financial markets are fast moving and “mutate” in many ways in arelatively short period of time.Therefore, I have argued in this speech that gathering and thoroughlyanalyzing market information, which is often described as marketintelligence, is of the utmost importance and should be utilizedproactively alongside conventional economic statistics.The reason I have stressed market intelligence, or more specifically,central bank intelligence, is that central banks have a clear comparativeadvantage in extracting valuable and vital information, especially fromfinancial markets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Central banks are the unique organization that transacts with the widestrange of financial market participants.I have explained how this market intelligence works in the case of shadowbanking in Japan.The most important point is to extend these intelligence activities to newfinancial institutions and products to detect possible problems.The existing framework at the Bank of Japan is versatile and canincorporate new elements relatively easily.However, problems remain about the depth or intensity of theseintelligence activities: that is, the quantity and quality of informationcurrently available may not be sufficient for detecting possible risks.Thus, we are only at the starting line, and there is still a long way to go.Finally, I should emphasize that market intelligence has significantlyimproved central banks’ economic statistics, and will continue to do so inthe future.We have learned from the failures in the summer of 2007, that we mustextend the coverage and improve the quality of statistics concerningnon-depository financial institutions.We can also take advantage of new methods and new information sourcesto get the best use of market information in constructing timely statistics,as shown in the case of property prices.In closing, I would like to emphasize again the point I stated in theIntroduction, the point that I would most like to convey to you.Central bank statisticians should be more than good statisticians, simplymaintaining the quality of existing statistics. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • They should also be good sleuths or intelligence agents, detecting signsof future developments that may change those statistics, and thus maychange our world.Thank you for your kind attention. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • News Release - The dogand the frisbee – paper byAndrew Haldane31 August 2012In a paper given at the FederalReserve Bank of Kansas City’s 36th economic policy symposium inJackson Hole, Wyoming, Andrew Haldane – Executive Director forFinancial Stability and member of the Financial Policy Committee –explores why the type of complex financial regulation developed overrecent decades may be sub-optimal for crisis control.In doing so, he draws out a number of public policy lessons.The paper is co-written with a Bank colleague, Vasileios Madouros.Andrew Haldane presents evidence from a range of real-world settings todemonstrate that decision-making in a complex environment can benefitfrom the use of simple decision rules of thumb.He argues that complex rules often: have punitively high costs ofinformation collection and processing; rely on “over-fitted” models thatyield unreliable predictions; and can induce defensive behaviour bycausing people to manage to the rules.He argues that regulatory responses to financial crises, past and present,have been to increase complexity with: “...a combination of more riskmanagement, more regulation and more regulators”.As the Basel Accords have evolved over time, he notes, so has opacity andcomplexity associated with increasingly granular, model-basedrisk-weighting.Meanwhile, detailed rule-writing in the form of legislation has increaseddramatically, as has the scale and scope of resources dedicated toregulation.Andrew Haldane uses a set of empirical experiments to measure theperformance of regulatory rules, simple and complex. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • He finds that simple rules such as the leverage ratio and market-basedmeasures of capital outperform more complex risk-weighted models andmultiple-indicator measures in their crisis-predictive performance.He says that: “The message from these experiments is clear andconsistent.Complexity of models or portfolios generates robustness problems whenunderstanding a complex financial system over plausible sample sizes.More than that, simplicity rather than complexity may be better capableof solving these robustness problems.”Andrew Haldane considers five policy lessons that financial regulationcan draw from these findings.First, he suggests that the Basel framework could take: “...a moresceptical view of the role and robustness of internal risk models in theregulatory framework...simplified, standardised approaches to measuringcredit and market risk, on a broad asset class basis, could be used.”Second, he says the leverage ratio could be placed on an equal footingwith capital ratios, an approach taken by the Bank of England’s FinancialPolicy Committee, and market-based indicators of capital adequacyadded to regulators’ and investors’ indicator set.Third, Andrew Haldane calls for a fresh approach to financialsupervision, one which is less rules-focussed and more judgment-based.He notes that this approach: “...will underpin the Bank of England’s newsupervisory model when it assumes prudential regulatory responsibilitiesnext year.”To be effective, he says that will require more experienced regulatorsworking to a smaller, less detailed rulebook.He adds that greater simplicity and consistency in disclosure practicescould also strengthen market discipline.Fourth, he considers the case for tackling complexity directly and atsource. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • He says that recent events have re-demonstrated the problems that arisein risk-managing large, complex banks: “At present, no explicitregulatory charge is levied on those complexity externalities.Doing so would help protect the system against failure, while providingexplicit incentives to simplify balance sheets.”Finally, Andrew Haldane notes that, while quantity-based restrictionssuch as the Independent Commission on Banking proposals in the UKand the Volcker rule in the US are robust to complexity and uncertainty,they risk being mired in detail in their implementation.He argues that cleaner solutions could be considered, or that the marketcould lead by encouraging banks to sell-off assets and reduce complexity.Andrew Haldane says that: “Modern finance is complex, perhaps toocomplex...As you do not fight fire with fire, you do not fight complexitywith complexity.Because complexity generates uncertainty, not risk, it requires aregulatory response grounded in simplicity, not complexity.”That would require “...an about-turn from the regulatory community fromthe path followed for the better part of the past 50 years.”But when it comes to financial regulation, concludes Andrew Haldane,“...less may be more”. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Policymaking in an interconnectedworldLuncheon speech by Jaime CaruanaGeneral Manager, Bank for InternationalSettlementsThe Federal Reserve Bank of KansasCity’s 36th Economic Policy Symposiumon “The changing policy landscape”Jackson HoleLet me extend my thanks to PresidentGeorge and the organisers for theopportunity to address this gathering – atan event that is more keenly anticipated bypolicymakers and journalists with every passing year.My question today is: Is there scope for more international cooperation inmonetary policy?After all, we see international cooperation as essential for financialregulation.Why do we reject keeping one’s own house in order as a precept forfinancial regulation but accept it for monetary policy?The question is not a new one. In his famous Critical essays on monetarytheory, Sir John Hicks argued that individual central banks have onlylimited influence because:“… they have been national central banks. Only in a national economythat is largely self-contained, can a national central bank be a true centralbank; with the development of world markets, and (especially) of worldfinancial markets, national central banks take a step down, becomingsingle banks in a world-wide system …. Thus the problem that was _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (partially) solved by the institution of national central banks hasreappeared …. on the world level”.That was in 1967, during the waning days of Bretton-Woods.And financial integration over the past 45 years has made the problemthat Hicks identified even more intractable.The burden of my remarks today is that central banks need to take a moreinternational perspective, recognise their collective influence and takeinto account monetary policy spillovers.Monetary policy that contributes to financial stability needs more of thecooperation that we already practise in financial regulation.Let me break my main question into four questions and then turn to each:1. What was the state of cooperation infinancial regulation and monetary policybefore the crisis?2. Where does cooperation stand after thecrisis?3. Why is the scope for internationalcooperation in monetary policy oftenunderestimated?4. Do we need to improve the institutionalframework for monetary policycooperation? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Q1. What was the state of international cooperation in financialregulation and monetary policy before the crisis?Since the financial liberalisation of the 1970s, the cooperation onregulatory standards for large international banks as embodied in Basel Iand II extended well beyond any cooperation in monetary policy outsidethe euro area.This cooperation involved:(i) Exchange of information;(ii) Information-sharing based on a common understanding of how theworld works;(iii) Joint decision-making; and(iv) Standards set by an international committee.The very first papers circulated to the Basel Committee on BankingSupervision (BCBS) in 1975 surveyed the “Rules and practices to protectthe banks’ solvency and liquidity”.It turned out that these varied a great deal.Subsequently, regulators evolved a common intellectual framework andcame to speak a common language.In 1988, Basel I went one step further, to joint decision-making. It setdefinitions of capital, risk weights for assets, and, crucially, a minimumratio of capital to assets.These formulations were based on consensus, not enshrined in a treaty orin international law. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Instead, the original Basel accord was enacted in national law andenforced by national regulators.In fact, market pressure quickly made Basel I the standard even for banksin countries not represented on the BCBS.The driving forces for this cooperation are well known.As countries liberalised their capital accounts and moved to floatingexchange rates, banks seized the opportunity to intermediateinternational capital flows.Soon after, Bankhaus Herstatt and Franklin National collapsed.These banks were not globally systemically important financialinstitutions, in today’s parlance, but their messy failures did help to driveforward international cooperation on bank regulation.When, in August 1982, the big banks suddenly stopped lending to LatinAmerica, Congress increased the IMF’s resources but demanded highercapital levels for big US banks.Concerns about competitive neutrality then prompted the FederalReserve to pursue joint action in what became Basel I.Basel III, to be discussed in a moment, has marked an even more explicitshift towards internalising the externalities imposed by big banks andbanks’ collective behaviour.By contrast, monetary policy remained mainly national after thebreakdown of Bretton Woods.Attempts at cooperation were episodic, mainly relating to exchange rates.This gave monetary cooperation a bad name – especially in countries withcurrent account surpluses, which came under pressure to expanddemand.At the level of theory, monetary policy shifted from the 1930s focus oncompetitive devaluation, first to the post-war treatment of monetary _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • policy as just one instrument in overall macroeconomic stability policy,and then in the past 25 years to the guardian of domestic price stability.Flexible exchange rates, it was thought, would provide buffers againstexternal shocks while policymakers kept their own house in order.In fact, the largest economies not only remained relatively closed but alsohad banking systems with very low proportions of foreign currency assets.To be sure, the quality of global monetary policy discussions hasadvanced over the past generation, as a common intellectual frameworkevolved.Indeed, one could argue that monetary policymakers shared a morethoroughly elaborated intellectual framework than did their counterpartsin financial regulation.Even so, this shared framework could be indifferent (or even hostile) tocooperation in monetary policy.Q2. Where does cooperation stand after the financial crisis?The short answer is that we have agreed to cooperate more deeply on theregulatory/financial stability front.But on the monetary policy front, the pre-crisis convergence of views hasbecome strained.There is little doubt that, since the crisis, we have had the widest, deepestand most far-reaching regulatory cooperation in history.Participation has broadened, coordination has intensified, andimplementation will be peer-reviewed.Institutionally, all G20 members have joined the BCBS.Similarly, the Financial Stability Board’s membership has become moreinclusive. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Emerging market representatives bring useful macroprudentialexperience to the table.And attention is being paid to vulnerabilities in the shadow bankingsystem, outside the narrow scope of the regulated sector.Cooperation has intensified with Basel III’s requirement for more andbetter capital, backstopped by a simple leverage ratio and internationaloversight of weights and implementation.Cooperation has also widened with the inclusion of internationalstandards on liquidity management.Recognition of potential procyclicality in the operation of capitalstandards has led to the adoption of mutual recognition in the newcountercyclical capital requirement, which empowers host countryauthorities.Tougher solvency standards have been set for banks whose failure couldhave system-wide effects.We should not minimise the challenges ahead.I am acutely aware that, even as intended regulatory cooperation hasreached an all-time high, the risks of fragmenting banking along nationallines have grown.While there are long-standing differences in the tax treatment of loan-lossprovisions, national bank bonus taxes have been imposed and nowfinancial transaction taxes are being discussed regionally.While Dodd-Frank is improving the funding model of US-charteredbanks, other banks that rely on wholesale funding have gained marketsshare in dollar intermediation.While important advances have been made, serious obstacles remain inconcerting resolution regimes given different bankruptcy laws. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A particularly troubling source of fragmentation along country lines is theinclination to put up national barriers against contagion.As Mario Draghi has said, “even though each of them may be right,collectively they have been wrong”.While regulatory cooperation is the prerequisite for open financialmarkets and the free flow of funds, capital controls seem to be gainingacceptance as a response to the challenge of managing currencies whenyields are zero in most major money markets.These developments threaten to segment financial markets, not only inthe euro area but around the world.Nevertheless, I remain hopeful that the movement towards globalconsistency and more harmonisation will prevail over the forces workingto fragment international banking regulation and supervision.On monetary policy cooperation, there were notable steps during thecrisis.Widespread, and ultimately in some cases, open-ended, cooperation inforeign-currency funding through central bank swaps had both themonetary goal of controlling the relevant market rates like Libor and thefinancial-stability goal of providing emergency funding.Such arrangements are temporary.But the willingness of central banks – not least the Federal Reserve – toact quickly and massively averted what could have been a meltdown.The global nature of the crisis also saw episodic cooperation in policy ratesetting.For instance, on 8 October 2008, interest rates were simultaneously cut bythe Bank of Canada, the Bank of England, the ECB, the Federal Reserve, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • the Riksbank, the Swiss National Bank and the People’s Bank of China,in a concerted move that was strongly backed by the Bank of Japan.But a number of issues have strained the pre-crisis convergence of viewson monetary policy.What can monetary policy contribute to financial stability? And how doesmonetary policy work alongside macroprudential action?Q3. Why is the scope for international cooperation in monetarypolicy often underestimated?This question raises three more.First, do flexible exchange rates insulate economies as some theorysuggests?Second, are bond markets so globally integrated that policies affectingyields in major countries now have a bigger impact on yields in othercountries than they once did, possibly exerting an even larger effect thanlocal policies and conditions?And third, can central banks properly assess the aggregate impact of theiractions on global outcomes, or do they suffer from a fallacy ofcomposition?Starting with exchange rates, flexible rates do of course help to insulate acountry from inflationary or deflationary shocks coming from abroad. Butthey do it imperfectly.First, since major currencies are used internationally, the policy rates setby their issuers directly affect monetary conditions elsewhere.Borrowing in foreign currencies may be rare in the biggest economies,but it can be significant elsewhere. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • And common monetary and risk factors affect the flow of internationalbank credit and portfolio capital.Since the crisis, while credit to US households and businesses has barelyresumed its growth, dollar loans to such borrowers in the rest of the worldhas grown at up to 20% and has reached about $7 trillion.Second, the foreign exchange market’s behaviour does not always satisfythe textbook interest rate or purchasing power parity conditions.Exchange rate movements do not merely compensate for interest orinflation differentials.Instead, most of the time, currencies with an interest rate advantageactually appreciate against lower yielding currencies and can do so forsome time, making the domestic industry less competitive.The depreciation of higher-yielding currencies tends to happen fastduring episodes of stress in global asset markets, and many emergingmarket economies have found this destabilising.Next, there is the issue of international bond markets.As policy interest rates and official bond purchases affect bond yields,their effects ripple across globally integrated bond markets.This happens even with independent setting of policy rates and floatingexchange rates.Large-scale bond purchases can have global effects whether they are partof an explicit monetary policy or a side-effect of currency intervention.There is evidence that the large Japanese interventions of 2003–04lowered global bond yields, as dollars purchased in the foreign exchangemarket were invested in bonds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • There is also evidence that the Federal Reserve’s recent large-scalebond-buying has also reduced global bond yields.So the integration of global bond markets makes for a global interest inpolicies that, intentionally or not, affect bond yields in major markets.Turning to the possibility of a fallacy of composition, I believe that aninternational perspective is essential if we are to correctly assess theimpact of central bank policies on global outcomes.The price dynamics in commodity markets – which are increasinglysimilar to those in financial markets – could be taken as a signal of globaldemand pressure rather than being considered by central banks as asupply shock for each of them.Similarly, each emerging market central bank might hesitate to raiseinterest rates out of concern for capital inflows, given the very low interestrates prevailing in major currencies.Indeed, if central banks were to take an international perspective, theymight discover that they would all be better off by raising rates, therebysetting global average interest rates more appropriately.These questions are not easy to answer.How can we cope with these spillovers: the interconnections arising fromthe behaviour of exchange rates, the globalisation of bond markets, andthe collective impact of policies?John Hicks knew that the one simple answer to the limitations heidentified – a global central bank – would be totally unrealistic.National central banks have national mandates, and meeting these isalready difficult enough.We know less about the workings of international linkages than we doabout domestic linkages. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • How interest rates will affect the major centres in other countries dependsin part on those countries’ own policies and institutions.And it would not be difficult to add to this list.A number of factors combine to make nation states less than willing tocooperate on monetary policy.For instance, monetary policy can be redistributional, shifting wealth andincome between creditors and debtors.This makes it even more politically charged than regulatory policy – ifthat is possible.Nevertheless, I do not believe that monetary policy can be restricted tokeeping one’s “house in order” at all times.While such house-keeping is necessary, monetary policy does requireinternational perspective and cooperation, particularly when it providesthe backing for financial stability.Q4. Do we need to improve the institutional setting for monetarycooperation?We hope that the structural trend that deepens interdependence, namelythe globalisation of financial markets, continues.If it does, there will be periods, in good times and bad, when internationalspillovers will be substantial and highly relevant for monetary policy.If this notion and the underlying analysis are accepted, then the questionarises of how to strengthen cooperation in monetary policy.This does not necessarily mean monetary policy coordination at theglobal level, but it does require central banks to better appreciate, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • internalise and share the side effects that arise from individual monetarypolicies.This will require a shift to a more global analytical approach, one thatseeks to factor in collective behaviour, interactions and feedback effects.This would also help us to better frame international cooperation.I therefore tend to agree with the recent call from prominent academicsand practitioners for global considerations to play a more explicit role inmonetary policy frameworks.But I am more sceptical about their proposal to formalise cooperativearrangements.The major central banks would not be able to publicly outline the mutualconsistency of their policies.Drawing attention to areas of inconsistency and dissent would probablyundermine effective cooperation.Traditionally, the BIS and the various Basel committees have alwayssought to complement the domestic analysis at central banks with a moreglobal perspective.The informal but structured nature of the meetings that take place at theBIS has often facilitated analysis and discussion of the many internationaldimensions of monetary policies.For example, after providing support to a central bank review of globalliquidity we are working on regular indicators that seek to capture globalfinancial conditions.These and other global measures also serve as inputs to vulnerabilityanalysis and the early warning exercise conducted by the FinancialStability Board and the IMF. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The IMF is playing a role as well, with its spillover reports andmacroeconomic policies consistency analysisLet me conclude by saying that much needs to be done.Moving towards a more cooperative approach makes more sense thanreversing the internationalisation of markets and segmenting thosemarkets in the hope of protecting them against spillovers.We need more research on these questions and I hope that some of thepowerful analytic talents represented here at Jackson Hole will bebrought to bear on them. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Gabriel Bernardino, Chairman of EIOPACreating a global insurance supervisoryLanguageConference on Global Insurance SupervisionGood evening, ladies and gentlemen,On behalf of EIOPA I would like to thank theInternational Center for Insurance Regulation forthe cooperation and efforts in organising togetherwith us this Conference on Global InsuranceSupervision.I am very happy to see today so many colleagues from the supervisoryauthorities as well as prominent experts and executive officers of theinsurance industry.Our purpose with this Conference is to create a platform of discussionand exchange of views about the international context of insurancesupervision.Your presence and contribution to this event is key to its success and willcertainly contribute to a better understanding of the different regimes andwill foster further convergence of practices of insurance supervisionworldwide.Insurance markets are increasingly global.Many insurance groups have nowadays a huge part of their revenuescoming from business outside their home countries.This creates new opportunities but also new challenges for insurers, butalso for supervisors.The promotion of sound and stable insurance markets calls for moreinternational cooperation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • We firmly believe that the best way toreinforce financial stability and consumerprotection is to develop strong globalregulatory and supervisory standards.This will create a level playing field forinternational players, foster a commonlanguage between supervisors and improveinternational cooperation and informationexchange.I would like to share with you some views onthe ways of improving the efficiency ofsupervision from a global perspective.ComFrame ( Common Framework for theSupervision of Internationally ActiveInsurance Groups (IAIGs) - ComFrame is an integrated, multilateral andmultidisciplinary framework for the group(wide supervision ofinternationally active insurance groups.ComFrame was initiated in response to the recognition that, despite thegrowing relevance of IAIGs in the global insurance marketplace, nointernationally coherent framework exists for the supervision of suchlarge, global groups.I would like to stress that EIOPA is highly committed to contribute to theestablishment of such standards and, in this regard, we consider ourparticipation in the IAIS very important. EIOPA is actively contributingto the work of ComFrame.We consider it necessary to enhance regulatory capital requirements inorder to achieve adequate consumer protection on a global level.Of course, while calling for this measure, we take into account differentperspectives and developments worldwide. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Seen historically, the EU had experienced comparable discussions adecade ago.We fully support the move to enhanced group-wide supervision.Cooperation between supervisors in colleges is essential for the propersupervisory approach to Internationally Active Insurance Groups.We believe that information sharing and supervisory cooperation underconditions of professional secrecy is a key, determinative element ofeffective supervision.We need more shared supervision.Furthermore, Comframe should comprise a capital element, establishingstrong principles for group capital calculations concerning the risksincluded, the metrics used to assess them and the overall level ofconfidence.Without this consistency, there is no level playing field internationally.It is not about one unique system, but about a set of strong principles thatwould deliver a range of closer and compatible systems.Comframe should not be another regime on top of the already existentones.The local regimes should evolve to comply with Comframe.This is my vision. I recognize that we cannot deliver this immediately, butat the IAIS we need to set a timetable and concrete milestones to developthis concept in a step by step approach.We need to be courageous and open-minded.We need to be open to change and evolution because the industry realityis also evolving and changing. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • An extra effort needs to be done by all of us because like Charles Kettering(a famous American inventor) said one day: “People are very openminded about new things as long as theyre exactly like the old ones.”Systemic risk in insuranceThe crisis prompted a new look at systemic risk, including in theinsurance sector.The identification and regulation of Globally Systemically ImportantInsurers is currently being discussed under the umbrella of the FinancialStability Board and the IAIS.EIOPA is keen to contribute to a robust identification process of G-SIIsand to develop appropriate regulatory and supervisory tools to deal withtheir characteristics.Traditionally, systemic risk was a banking concept.However, the recent crisis showed us that certain activities developedunder the insurance sector can also pose systemic risk.Insurance companies or groups that engage in non-traditional, ornon-insurance, activities (for example: CDS, financial guarantees orleveraging assets to enhance investment returns through securitieslending are more vulnerable to financial market developments and,importantly, more likely to amplify, or contribute to, systemic risk.Of course, this assessment may change over time, depending on theinnovations and changes in insurance business models, especially in lifeinsurance, as well as in the complex interactions between insurancegroups and financial markets.We should be especially attentive to any kind of maturity transformationand leveraging occurring in the insurance sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • As a consequence, the identification of a systemically important insureras such, should be a direct reflection of its source of systemic importance.While the size of traditional insurance activity is still an important factor,it should not be the dominant factor in the identification process.Clearly, the non-traditional and non-insurance activities and the degree ofinterconnectedness with other components of the financial system aremore relevant from a systemic point of view.Consequently, the differences between insurers and banks in the impactof failures suggest that requirements for loss absorbency and resolutionregimes for insurers should accept these salient differences and proposesolutions that differentiate accordingly.As a conclusion I would like to underline that we should have no illusions:the creation of global insurance supervisory standards is a very longprocess that is complicated by the difference of cultures and unevendevelopment of supervisory systems in different countries.But it is important that the regulators all over the world are willing toreach mutual understanding and to develop a common supervisorylanguage, which will help us to promote stability of the financial markets,to enhance their transparency and to foster consumer protection.Together we can achieve these objectives. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Quarterly Banking Digest, Q2Important parts and Highlights- Capitalisation improved slightly as system-wide leverage declines. The aggregate risk asset ratio (RAR) increased to 22.1% during the quarter due to a decline in risk-weighted assets (down 0.7%) and an increase in capital (up 0.6%).- Some banks continue to experience significant asset quality challenges driven by the recessionary environment. Although non-performing loans (NPLs) relative to total loans declined from 8.3% to 8.1%, large exposures to the real estate sector have led to a rise in specific provisioning and charge-offs, which has affected the banks’ earnings capacity.- Sector earnings have been impacted by higher provisions. Provisions to NPLs increased from 16.2% to 26.2% in Q2 2012 as a result of prudent efforts aimed at mitigating the impact of future asset impairments. As a result, the annualised RoE declined from 8.9% in Q1 2012 to 1.2% in Q2 2012, and the annualised RoA fell from 1.0% in Q1 2012 to 0.1% in Q2 2012.- The Bermuda dollar funding gap widens further. The BD$ loan-to-deposit ratio increased to 154.0% (up from 151.0% in Q1 2012 and 142.0% a year earlier) as BD$-denominated customer deposits declined (down 1.3%). However, the large FX-denominated deposits, which declined by 5.1% during the quarter, continues to supplement the BD$ funding gap.- Lower investment activity and interbank lending have mitigated negative effects on domestic credit supply thus far. Lending remained stable despite de-leveraging during the quarter resulting from decreases in investment activity and deposits with other financial institutions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
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    • Table V shows the liquidity condition of the banking sector over the lastfive quarters.ProfitabilityQuarterly returns declined sharply as banks start absorbingnon-performing loan balances aggressively.Despite stable net interest income over the quarter, increases inprovisions resulted in lower profitability in the sector on average.Annualised RoE and RoA decreased to 1.2% (Q1 2012: 8.9%) and 0.1% (Q12012: 1.0%), respectively. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Government lays new MoneyLaundering regulations beforeParliamentOn 10 September the Government introduced legislation to Parliament toimplement important changes to the Money Laundering Regulations2007.The changes will reduce the regulatory burden imposed by the currentregulations, while strengthening the overall anti-money launderingregime. These proposals were set out in July 2012 following extensiveconsultation and are expected to save firms around £3 million a year.The changes to the Regulations will come into force on 1 October.NotesThe Government announced the changes it was bringing forward toMoney Laundering regulations in July 2012.TheMoney Laundering Regulations 2007 require regulated businesses tohave appropriate systems and controls in place to identify and verify theidentity of their customers and carry out ongoing monitoring asappropriate, based on their own assessment of the risk from moneylaunderingand terrorist finance.The Government’s approach to money laundering regulation is designedto make the UK financial system a hostile environment for moneylaundering and terrorist finance, while minimising the regulatory burdenimposed on UK businesses.Changes to Money Laundering Regulations to reduce burden onBritish businessesOn 17 July 2012 the Government published its response to a consultationon changes to the Money Laundering Regulations 2007 and the impactassessment of the proposed changes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Following the consultation the Government will now take forwardproposals to reduce the regulatory burden imposed by the currentregulations, while strengthening the overall anti-money launderingregime.The proposed changes to the regulations will apply to businesses that areat low risk of money laundering and terrorist financing and are thereforenot required to be regulated to the same extent as other institutions,under current global standards.The aim of the changes is to make the UK’s money laundering regimemore effective and proportionate, with the proposed changes saving firmsaround £3 million a year.The Government committed to performing a post-implementation reviewof the 2007 Regulations, which implement the European Union ThirdMoney Laundering Directive, two years after they came into force.This review was undertaken in 2009-10, in conjunction with the BetterRegulation Executive, and entailed an extensive call for evidence,meetings, conferences and interviews.The Government’s response to the review was published in June 2011 andcontained a consultation on seventeen proposals to improve the regime,reducing the impact of the regulations.The changes to the Regulations are intended to come into force on 1October. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Jumpstart Our Business Startups ActFrequently Asked QuestionsIn these Frequently Asked Questions(“FAQs”), the Division of Trading andMarkets (“staff”) is providing guidance oncertain provisions of the Jumpstart OurBusiness Startups Act (“JOBS Act”) as theyaffect firms and their obligations with respectto securities analysts (“analysts”) and researchreports.These FAQs are not rules, regulations or statements of the Commission.The Commission has neither approved nor disapproved these FAQs.The staff may update these questions and answers periodically.BackgroundThese FAQs address questions about certain research provisions in TitleI of the JOBS Act.These provisions include:Analyst Communications. Section 105(b) of the JOBS Act amends Section15D of the Securities Exchange Act of 1934 (“Exchange Act”) to prohibitthe Commission or a national securities association registered underSection 15A of the Exchange Act from adopting or maintaining any rule orregulation in connection with an initial public offering (“IPO”) of thecommon equity of an emerging growth company that: - Restricts, based on functional role, which associated persons of a broker, dealer, or member of a national securities association, may arrange for communications between an analyst and a potential investor; or - Restricts an analyst from participating in any communications with the management of an emerging growth company that is also attended by any other associated person of a broker, dealer, or _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • member of a national securities association whose functional role is other than as an analyst.Testing the Waters. Section 105(c) of the JOBS Act amends Section 5 ofthe Securities Act of 1933 (“Securities Act”) to permit an emerging growthcompany or any person authorized to act on behalf of an emerging growthcompany to engage in oral or written communications with potentialinvestors that are qualified institutional buyers or institutions that areaccredited investors as defined in Securities Act Rules 144A and 501(a) (orany successors to such rules) either prior to or following the date of filingof a registration statement with respect to such securities with theCommission, subject to the requirement of Section 5(b)(2) of theSecurities Act. Section 5(b)(2) of the Securities Act makes it unlawful forany person to, directly or indirectly, carry or cause to be carried throughthe mails or in interstate commerce any such security for the purpose ofsale or for delivery after sale unless accompanied or preceded by aprospectus that meets the requirements of Section 10(a) of the SecuritiesAct.Post Offering Communications. Section 105(d) of the JOBS Act prohibitsthe Commission or any national securities association registered underSection 15A of the Exchange Act from adopting or maintaining any rule orregulation that prohibits any broker, dealer, or member of a nationalsecurities association from publishing or distributing any research reportor making a public appearance, with respect to the securities of anemerging growth company, either: - Within any prescribed period of time following the IPO date of the emerging growth company; or - Within any prescribed period of time prior to the expiration date of any agreement between the broker, dealer, or member of a national securities association and the emerging growth company or its shareholders that restricts or prohibits the sale of securities held by the emerging growth company or its shareholders after the IPO date. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Responses to Frequently Asked QuestionsQuestion: Does the ability of an emerging growth company to “test thewaters” under Section 105(c) of the JOBS Act conflict with Rule 15c2-8(e)under the Exchange Act?Answer: Section 105(c) of the JOBS Act allows emerging growthcompanies to continue to “test the waters” after a registration statementhas been filed under the Securities Act.As described below, we believe that this activity can take place in amanner consistent with the requirements of Rule 15c2-8(e).Rule 15c2-8(e) states that it is a deceptive act or practice for a broker ordealer to participate in the distribution of securities with respect to whicha registration statement has been filed under the Securities Act unless,among other things, the broker or dealer takes reasonable steps to makeavailable a copy of the preliminary prospectus relating to such securitiesto each of that broker or dealer’s associated persons who are expected,prior to the effective date, to solicit customers’ orders for such securitiesbefore sales efforts by such associated persons.A broker or dealer participating in such a distribution also is required totake reasonable steps to make available to these associated persons acopy of any amended preliminary prospectus promptly after the filingthereof.The JOBS Act did not change the meaning of the term “solicit customersorders” for purposes of Rule 15c2-8(e).Whether an activity falls within the meaning of that term is based on therelevant facts and circumstances.An underwriter, for example, may wish to seek non-binding indications ofinterest from its customers in relation to a potential offering for thepurpose of gathering information from prospective investors.This information can assist in the underwriter’s determination of theappropriate price, volume and market demand for a potential offering. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In such circumstances, the underwriter might ask its customers howmany shares they might seek to purchase in the potential offering atvarious price ranges without requiring the customer to make anycommitment to order.Generally, if an underwriter is requesting from a customer a non-bindingindication of interest that includes the amount of shares the customermight purchase in the potential offering at particular price levels – butdoes not ask the customer to commit to purchase the relevant securities –the underwriter, absent other factors, would likely not be soliciting acustomer order for purposes of Rule 15c2-8(e).Finally, Rule 15c2-8 is applicable only where a registration statement hasbeen filed with the Commission under the Securities Act. Submitting aconfidential draft registration statement for staff review in accordancewith Section 106(a) of the JOBS Act does not constitute a “filing” of aregistration statement for these purposes.Question: In 2003 and 2004, the Commission, self-regulatoryorganizations (“SROs”), and other regulators instituted settledenforcement actions against 12 broker-dealers to address conflicts ofinterest between the firms’ research and investment banking functions(“Global Settlement”). Does the JOBS Act affect the structural reformsmandated by Global Settlement or any other part of that court order?Answer: The JOBS Act does not amend or modify the Global Settlement.If the settling firms were to seek an amendment or modification of theGlobal Settlement in light of the JOBS Act, one or more of the settlingfirms would have to make an application to the court.Under the terms of the Global Settlement, the Commission would have anopportunity to consider any such request and the Commission couldsupport or oppose a proposed amendment or modification afterconsidering whether it would be in the public interest.Any amendment or modification to the Global Settlement would have tobe approved by the court overseeing the Global Settlement. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Global Settlement also provides that a provision of the GlobalSettlement can be modified or removed if the Commission adopts a rule(or approves an SRO rule) “with the stated intent to supersede” thatprovision.Question: Section 105(b) of the JOBS Act prohibits the Commission or anational securities association from adopting or maintaining any rule orregulation in connection with an IPO of common equity of an emerginggrowth company restricting, based on functional role, which associatedpersons of a broker, dealer, or member may arrange for communicationsbetween an analyst and a potential investor. Does this “arranging”provision of the JOBS Act affect any existing Commission or SRO rule?Answer: Under Section 105(b) of the JOBS Act, an associated person of abroker-dealer, including investment banking personnel, may arrangecommunications between analysts and investors.This activity would include, for example, an investment bankerforwarding a list of clients to the analyst that the analyst could, at his orher own discretion and with appropriate controls, contact.In turn, an analyst could forward a list of potential clients it intends tocommunicate with to investment banking as a means to facilitatescheduling. Investment bankers can also arrange, but not participate in,calls between analysts and clients.Although neither the Commission nor the SROs have a rule that directlyprohibits this activity, the staff has been asked whether we wouldconsider such arranging activity, without more, to be a method forinvestment banking personnel to direct a research analyst to engage insales or marketing efforts or any communication with a current orprospective customer regarding an investment banking servicestransaction in violation of NASD Rule 2711(c)(6) and NYSE Rule472(b)(6)(ii). The staff would not read NASD Rule 2711(c)(6) and NYSERule 472(b)(6)(ii) to prohibit such activity.Firms should be mindful that other provisions of the Exchange Act andCommission and SRO rules were not changed by the JOBS Act, such asthe requirement that communications with current or prospective _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • customers related to an investment banking services transaction be fair,balanced, and not misleading taking into consideration the overallcontext in which the communication was made.Firms subject to the Global Settlement should also be mindful of therequirements of that court order as they remain in place, including therequirement to create and enforce firewalls between research andinvestment banking personnel reasonably designed to prohibit allcommunications between the two except as expressly permitted.Firms are also reminded that they need to have appropriate policies andprocedures to ensure compliance with the federal securities laws and SROrules.Question: Does Section 105 of the JOBS Act now allow analysts to attendmeetings with company management in the presence of investmentbanking personnel in connection with the IPO of an emerging growthcompany?Answer: Section 105(b) of the JOBS Act permits analysts to participate inany communication with the management of an emerging growthcompany concerning an IPO that is also attended by any other associatedperson of a broker, dealer, or member of a national securities associationwhose functional role is other than as an analyst.The staff interprets this section as primarily reflecting a Congressionalintent to allow analysts to participate in emerging growth companymanagement presentations with sales force personnel so that the issuer’smanagement would not need to make separate and duplicativepresentations to analysts at a time when senior management resourcesare limited.This approach is consistent with a recommendation in the October 20,2011 “Rebuilding the IPO On-Ramp” report issued by the IPO TaskForce.The Global Settlement was not affected by the JOBS Act. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Accordingly, analysts of Global Settlement firms are still subject to theprovisions of that court order, including the requirement to create andenforce firewalls between research and investment banking personnelreasonably designed to prohibit all communications between the twoexcept as expressly permitted in the court order.Unless an exception to this requirement is applicable, the analyst is notpermitted to participate in a communication in the presence ofinvestment banking personnel.In addition, other Commission and SRO rules regarding analystscontinue to apply.Prior to enactment of Section 105(b), SRO rules prohibited analysts ofnon-Global Settlement firms from attending meetings with issuermanagement that are also attended by investment banking personnel inconnection with an IPO, including pitch meetings.Pursuant to Section 105(b), analysts may now attend such meetings,provided that the issuer qualifies as an emerging growth company.Section 105(b) does not, however, permit analysts to engage in otherwiseprohibited conduct in such meetings. Section 105(b) does not, forexample, affect SRO rules that otherwise prohibit an analyst fromengaging in efforts to solicit investment banking business.Section 105(b) also does not affect other prohibitions as discussed below.Therefore, before a firm is formally retained to underwrite an offering,analysts of non-Global Settlement firms in attendance at such meetingscould, for example, introduce themselves, outline their research programand the types of factors that the analyst would consider in his or heranalysis of a company, and ask follow-up questions to better understand afactual statement made by the emerging growth company’s management.In addition, after the firm is formally retained to underwrite the offering,analysts at non-Global Settlement firms could, for example, participate inpresentations by the management of an emerging growth company toeducate a firm’s sales force about the company and discuss industry _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • trends, provide information obtained from investing customers, andcommunicate their views.Firms and analysts should be mindful of the antifraud provisions of thefederal securities laws, the Global Settlement, and any other Commissionor SRO rule that governs research analyst conflicts.An analyst, for example, remains prohibited from changing his or herresearch as a result of a communication in an effort to obtain investmentbanking business.In addition, an analyst continues to be prohibited from giving tacitacquiescence to overtures from the management of an emerging growthcompany that attempt to create an expectation of favorable researchcoverage if the analyst’s firm is chosen to underwrite the emerging growthcompany’s IPO.Further, an analyst remains prohibited from providing views that areinconsistent with the analyst’s personal views about the emerging growthcompany or its securities, or from making a statement that is misleadingtaking into consideration the overall context in which the statement wasmade.Moreover, investment banking personnel remain prohibited from directlyor indirectly directing a research analyst to engage in sales or marketingefforts related to an investment banking services transaction.Firms should ensure that they have instituted and enforce appropriatecontrols to make sure that analysts are not engaging in prohibitedconduct, such as solicitation, at any meetings with companymanagement that are also attended by investment banking personnel, orotherwise.The examples given above are not exhaustive.Question: Does the JOBS Act permit an analyst to participate in aroadshow or otherwise engage in communications with a current orprospective customer in the presence of investment banking department _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • personnel or the management of an emerging growth company about aninvestment banking services transaction?Answer: As discussed above, Section 105(b)(2) of the JOBS Act allows afirm to avoid the ministerial burdens of organizing separate andpotentially duplicative meetings and presentations among an emerginggrowth company’s management team, investment banking personnel,and research analysts.Section 105(b)(2) did not address communications where investors arepresent together with company management, analysts and investmentbanking personnel.This provision of the JOBS Act thus does not affect NASD Rules2711(c)(5)(A) and (B) and NYSE Rules 472(b)(6)(i)(a) and (b), whichprohibit analysts from participating in roadshows or otherwise engagingin communications with customers about an investment bankingtransaction in the presence of investment bankers or the company’smanagement.These rules – which are intended to reduce the pressure on analysts togive overly optimistic assessments of investment banking deals andguard against analysts being perceived as part of the sales and marketingteam for a transaction – apply to communications with customers andother investors and do not depend on whether analysts, investmentbankers, and management are participating jointly in suchcommunications.Moreover, as noted above, the Global Settlement is not affected by theJOBS Act, so firms subject to that court order must be mindful of itsprovisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Question: Does Section 105(d) of the JOBS Act affect the SRO rules thatestablish quiet periods after the expiration of a lock-up agreement? Whatabout the SRO rules that establish quiet periods before and after thetermination or waiver of a lock-up agreement and the SRO rules thatapply to quiet periods for secondary offerings?Answer: The JOBS Act permits the publication or distribution of aresearch report or public appearances with respect to the securities of anemerging growth company at any time after an IPO or prior to theexpiration date of any lock-up agreements.Although the JOBS Act does not explicitly permit publication ordistribution of a research report or public appearance relating to anemerging growth company before the termination or waiver of a lock-upagreement, the staff believes that the intent of Congress in adopting thisprovision was to fully address the quiet periods imposed by the SRO ruleson research relating to emerging growth companies prior to the end of alock-up agreement.Therefore, the staff interprets Section 105(d)(2) of the JOBS Act to applyequally to NASD Rule 2711(f)(4) and NYSE Rule 472(f)(4) no matter bywhich method the lock-up agreement ends – by termination, expiration,or waiver – prior to the termination, expiration, or waiver of theagreement.The JOBS Act did not explicitly permit publication or distribution of aresearch report or public appearance relating to an emerging growthcompany after the expiration, termination, or waiver of a lock-upagreement.It also did not expressly address quiet periods after a secondary offeringof an emerging growth company’s securities.The staff believes that the policies underlying the change in Section105(d) are equally applicable to quiet periods during these other timeperiods. We understand that FINRA is considering filing with theCommission a proposal to eliminate the remaining quiet periods imposedby NASD Rules 2711(f)(1), (2), and (4) and NYSE Rules 472(f)(1) through(4) with regard to an emerging growth company and its securities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • We expect this filing would eliminate these other quiet periods related toemerging growth companies not addressed by Section 105(d).Question: Does the definition of research report under the JOBS Actaffect the analysis of the types of communications that constitute aresearch report for purposes of Regulation Analyst Certification(“Regulation AC”)?Answer: No. In general, under Regulation AC the followingcommunications would not be research reports if they do not include ananalysis of, or recommend or rate, individual securities or companies: - Reports discussing broad-based indices, such as the Russell 2000 or S&P 500 index. - Reports commenting on economic, political, or market conditions. - Reports commenting on or analyzing particular types of debt securities or characteristics of debt securities. - Technical analysis concerning the demand and supply for a sector, index, or industry based on trading volume and price. - Reports that recommend increasing or decreasing holdings in particular industries or sectors or types of securities.The following communications would generally not be research reportseven if they recommend or rate individual securities or companies: - Statistical summaries of multiple companies financial data (including listings of current ratings) that do not include any analysis of individual companies data. - An analysis prepared for a specific person or a limited group of fewer than fifteen persons. - Periodic reports or other communications prepared for investment company shareholders or discretionary investment account clients discussing past performance or the basis for previously made discretionary investment decisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • - Internal communications that are not given to customers.The Commission stated in the adopting release for Regulation AC that“[i]t is not possible to provide a complete list of all types ofcommunications that would or would not fall within the definition ofresearch report. Whether a particular communication constitutes aresearch report for the purpose of Regulation AC will turn on theindividual facts and circumstances surrounding that communication.”Question: Is there anything else that firms should consider when makingchanges based on research provisions of the JOBS Act?Answer: We remind firms contemplating new activities based on theresearch provisions of the JOBS Act to review and update their policiesand procedures, as well as their educational and training efforts, to makecorresponding changes to promote compliance with Commission andSRO rules that are designed to minimize conflicts of interest and facilitatethe objectivity and reliability of research. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Bank for International SettlementsBIS, Core principles for effective bankingsupervisionSeptember 2012The Basel Committee on Banking Supervisionhas completed its review of the October 2006Core principles for effective bankingsupervision and the associated Core principlesmethodology.The revised Core Principles were endorsed bybanking supervisors at the 17th InternationalConference of Banking Supervisors held inIstanbul, Turkey, on 13-14 September 2012.Both the existing Core Principles and the associated assessmentmethodology have served their purpose well in terms of helping countriesto assess their supervisory systems and identify areas for improvement.While conscious efforts were made to maintain continuity andcomparability to the extent possible, the revised document combines theCore Principles and the assessment methodology into a singlecomprehensive document.The revised set of twenty-nine Core Principles has also been reorganisedto foster their implementation through a more logical structure,highlighting the difference between what supervisors do and what theyexpect banks to do:Principles 1 to 13 address supervisory powers, responsibilities andfunctions, focusing on effective risk-based supervision, and the need forearly intervention and timely supervisory actions.Principles 14 to 29 cover supervisory expectations of banks, emphasisingthe importance of good corporate governance and risk management, aswell as compliance with supervisory standards. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Important enhancements have been introduced into the individual CorePrinciples, particularly in those areas that are necessary to strengthensupervisory practices and risk management.As a result, certain "additional criteria" have been upgraded to "essentialcriteria", while new assessment criteria were warranted in otherinstances.Close attention was given to addressing many of the significant riskmanagement weaknesses and other vulnerabilities highlighted in thefinancial crisis.In addition, the review has taken account of several key trends anddevelopments that emerged during the last few years of market turmoil: - the need for greater supervisory intensity and adequate resources to deal effectively with systemically important banks; - the importance of applying a system-wide, macro perspective to the microprudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to address systemic risk; and - the increasing focus on effective crisis management, recovery and resolution measures in reducing both the probability and impact of a bank failure.The Committee has sought to give appropriate emphasis to theseemerging issues by embedding them into the Core Principles, asappropriate, and including specific references under each relevantPrinciple.In addition, sound corporate governance underpins effective riskmanagement and public confidence in individual banks and the bankingsystem.Given fundamental deficiencies in banks corporate governance that wereexposed during the crisis, a new Core Principle on corporate governancehas been added by bringing together existing corporate governance _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • criteria in the assessment methodology and giving greater emphasis tosound corporate governance practices.Similarly, the Committee reiterated the key role of robust marketdiscipline in fostering a safe and sound banking system by expanding anexisting Core Principle into two new ones dedicated respectively togreater public disclosure and transparency, and enhanced financialreporting and external audit.As a result of the Committees review, the number of Core Principles hasincreased from 25 to 29.There are a total of 39 new assessment criteria, comprising 34 newessential criteria and 5 new additional criteria.In addition, 34 additional criteria from the existing assessmentmethodology have been upgraded to essential criteria that representminimum baseline requirements for all countries.A consultative version of the revised Core Principles was issued for publicconsultation in December 2011.The Committee appreciates the constructive comments received andthanks those who have taken the time and effort to express their views onthe consultative document. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Core Principles for Effective Banking Supervision (The BaselCore Principles)Executive summary1. The Core Principles for Effective Banking Supervision (CorePrinciples) are the de facto minimum standard for sound prudentialregulation and supervision of banks and banking systems.Originally issued by the Basel Committee on Banking Supervision (theCommittee) in 1997, they are used by countries as a benchmark forassessing the quality of their supervisory systems and for identifyingfuture work to achieve a baseline level of sound supervisory practices.The Core Principles are also used by the International Monetary Fund(IMF) and the World Bank, in the context of the Financial SectorAssessment Programme (FSAP), to assess the effectiveness of countries’banking supervisory systems and practices.2. The Core Principles were last revised by the Committee in October2006 in cooperation with supervisors around the world.In its October 2010 Report to the G20 on response to the financial crisis,the Committee announced its plan to review the Core Principles as part ofits ongoing work to strengthen supervisory practices worldwide.3. In March 2011, the Core Principles Group was mandated by theCommittee to review and update the Core Principles.The Committee’s mandate was to conduct the review taking into accountsignificant developments in the global financial markets and regulatorylandscape since October 2006, including post-crisis lessons for promotingsound supervisory systems.The intent was to ensure the continued relevance of the Core Principlesfor promoting effective banking supervision in all countries over time andchanging environments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 4. In conducting the review, the Committee has sought to achieve theright balance in raising the bar for sound supervision while retaining theCore Principles as a flexible, globally applicable standard.By reinforcing the proportionality concept, the revised Core Principlesand their assessment criteria accommodate a diverse range of bankingsystems.The proportionate approach also allows assessments of compliance withthe Core Principles that are commensurate with the risk profile andsystemic importance of a broad spectrum of banks (from largeinternationally active banks to small, non-complex deposit-takinginstitutions).5. Both the existing Core Principles and the associated Core PrinciplesMethodology (assessment methodology) have served their purpose wellin terms of helping countries to assess their supervisory systems andidentify areas for improvement.While conscious efforts were made to maintain continuity andcomparability as far as possible, the Committee has merged the CorePrinciples and the assessment methodology into a single comprehensivedocument.The revised set of twenty-nine Core Principles have also been reorganisedto foster their implementation through a more logical structure startingwith supervisory powers, responsibilities and functions, and followed bysupervisory expectations of banks, emphasising the importance of goodcorporate governance and risk management, as well as compliance withsupervisory standards.6. Important enhancements have been introduced into the individualCore Principles, particularly in those areas that are necessary tostrengthen supervisory practices and risk management.Various additional criteria have been upgraded to essential criteria as aresult, while new assessment criteria were warranted in other instances. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Close attention was given to addressing many of the significant riskmanagement weaknesses and other vulnerabilities highlighted in the lastcrisis.In addition, the review has taken account of several key trends anddevelopments that emerged during the last few years of market turmoil: - the need for greater intensity and resources to deal effectively with systemically important banks; - the importance of applying a system-wide, macro perspective to the microprudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to address systemic risk; - and the increasing focus on effective crisis management, recovery and resolution measures in reducing both the probability and impact of a bank failure.The Committee has sought to give appropriate emphasis to theseemerging issues by embedding them into the Core Principles, asappropriate, and including specific references under each relevantPrinciple.7. In addition, sound corporate governance underpins effective riskmanagement and public confidence in individual banks and the bankingsystem.Given fundamental deficiencies in banks’ corporate governance that wereexposed in the last crisis, a new Core Principle on corporate governancehas been added in this review by bringing together existing corporategovernance criteria in the assessment methodology and giving greateremphasis to sound corporate governance practices.Similarly, the Committee reiterated the key role of robust marketdiscipline in fostering a safe and sound banking system by expanding anexisting Core Principle into two new ones dedicated respectively togreater public disclosure and transparency, and enhanced financialreporting and external audit. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 8. At present, the grading of compliance with the Core Principles is basedsolely on the essential criteria.To provide incentives to jurisdictions, particularly those that areimportant financial centres, to lead the way in the adoption of the highestsupervisory standards, the revised Core Principles will allow countries theadditional option of voluntarily choosing to be assessed and gradedagainst the essential and additional criteria.In the same spirit of promoting full and robust implementation, theCommittee has retained the existing four-grade scale of assessingcompliance with the Core Principles.This includes the current “materially non-compliant” grading that helpsprovide a strong signalling effect to relevant authorities on remedialmeasures needed for addressing supervisory and regulatory shortcomingsin their countries.9. As a result of this review, the number of Core Principles has increasedfrom 25 to 29.There are a total of 39 new assessment criteria, comprising 34 newessential criteria and 5 new additional criteria.In addition, 34 additional criteria from the existing assessmentmethodology have been upgraded to essential criteria that representminimum baseline requirements for all countries.10. The revised Core Principles will continue to provide a comprehensivestandard for establishing a sound foundation for the regulation,supervision, governance and risk management of the banking sector.Given the importance of consistent and effective standardsimplementation, the Committee stands ready to encourage work at thenational level to implement the revised Core Principles in conjunctionwith other supervisory bodies and interested parties. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • I. Foreword to the review11. The Basel Committee on Banking Supervision (the Committee) hasrevised the Core Principles for Effective Banking Supervision (CorePrinciples).In conducting its review, the Committee has sought to balance theobjectives of raising the bar for banking supervision (incorporating thelessons learned from the crisis and other significant regulatorydevelopments since the Core Principles were last revised in 2006) againstthe need to maintain the universal applicability of the Core Principles andthe need for continuity and comparability.By raising the bar, the practical application of the Core Principles shouldimprove banking supervision worldwide.12. The revised Core Principles strengthen the requirements forsupervisors, the approaches to supervision and supervisors’ expectationsof banks.This is achieved through a greater focus on effective risk-basedsupervision and the need for early intervention and timely supervisoryactions.Supervisors should assess the risk profile of banks, in terms of the risksthey run, the efficacy of their risk management and the risks they pose tothe banking and financial systems.This risk-based process targets supervisory resources where they can beutilised to the best effect, focusing on outcomes as well as processes,moving beyond passive assessment of compliance with rules.13. The Core Principles set out the powers that supervisors should have inorder to address safety and soundness concerns. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • It is equally crucial that supervisors use these powers once weaknesses ordeficiencies are identified.Adopting a forward-looking approach to supervision through earlyintervention can prevent an identified weakness from developing into athreat to safety and soundness.This is particularly true for highly complex and bank-specific issues (egliquidity risk) where effective supervisory actions must be tailored to abank’s individual circumstances.14. In its efforts to strengthen, reinforce and refocus the Core Principles,the Committee has nonetheless remained mindful of their underlyingpurpose and use.The Committee’s intention is to ensure the continued relevance of theCore Principles in providing a benchmark for supervisory practices thatwill withstand the test of time and changing environments.For this reason, this revision of the Core Principles builds upon thepreceding versions to ensure continuity and comparability as far aspossible.15. In recognition of the universal applicability of the Core Principles, theCommittee conducted its review in close cooperation with members ofthe Basel Consultative Group which comprises representatives from bothCommittee and non-Committee member countries and regional groupsof banking supervisors, as well as the IMF, the World Bank and theIslamic Financial Services Board.The Committee consulted the industry and public before finalising thetext. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • General approach16. The first Core Principle sets out the promotion of safety andsoundness of banks and the banking system as the primary objective forbanking supervision.Jurisdictions may assign other responsibilities to the banking supervisorprovided they do not conflict with this primary objective.6 It should not be an objective of banking supervision to prevent bankfailures.However, supervision should aim to reduce the probability and impact ofa bank failure, including by working with resolution authorities, so thatwhen failure occurs, it is in an orderly manner.17. To fulfil their purpose, the Core Principles must be capable ofapplication to a wide range of jurisdictions whose banking sectors willinevitably include a broad spectrum of banks (from large internationallyactive banks to small, non-complex deposit-taking institutions).Banking systems may also offer a wide range of products or services andthe Core Principles are aligned with the general aim of catering todifferent financial needs.To accommodate this breadth of application, a proportionate approach isadopted, both in terms of the expectations on supervisors for thedischarge of their own functions and in terms of the standards thatsupervisors impose on banks.Consequently, the Core Principles acknowledge that supervisors typicallyuse a risk-based approach in which more time and resources are devotedto larger, more complex or riskier banks.In the context of the standards imposed by supervisors on banks, theproportionality concept is reflected in those Principles focused on _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • supervisors’ assessment of banks’ risk management, where the Principlesprescribe a level of supervisory expectation commensurate with a bank’srisk profile and systemic importance.18. Successive revisions to existing Committee standards and guidance,and any new standards and guidance will be designed to strengthen theregulatory regime.Supervisors are encouraged to move towards the adoption of updated andnew international supervisory standards as they are issued.Approach toward emerging trends and developments(i) Systemically important banks (SIBs)19. In the aftermath of the crisis, much attention has been focused onSIBs, and the regulations and supervisory powers needed to deal withthem effectively.Consideration was given by the Committee to including a new CorePrinciple to cover SIBs.However, it was concluded that SIBs, which require greater intensity ofsupervision and hence resources, represent one end of the supervisoryspectrum of banks.Each Core Principle applies to the supervision of all banks.The expectations on, and of, supervisors will need to be of a higher orderfor SIBs, commensurate with the risk profile and systemic importance ofthese banks.Therefore, it is unnecessary to include a specific stand-alone CorePrinciple for SIBs. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (ii) Macroprudential issues and systemic risks20. The recent crisis highlighted the interface between, and thecomplementary nature of, the macroprudential and microprudentialelements of effective supervision.In their application of a risk-based supervisory approach, supervisors andother authorities need to assess risk in a broader context than that of thebalance sheet of individual banks.For example, the prevailing macroeconomic environment, businesstrends, and the build-up and concentration of risk across the bankingsector and, indeed, outside of it, inevitably impact the risk exposure ofindividual banks.Bank-specific supervision should therefore consider this macroperspective.Individual bank data, where appropriate, data at sector level andaggregate trend data collected by supervisors should be incorporated intothe deliberations of authorities relevant for financial stability purposes(whether part of, or separate from, the supervisor) to assist inidentification and analysis of systemic risk.The relevant authorities should have the ability to take pre-emptive actionto address systemic risks.Supervisors should have access to relevant financial stability analyses orassessments conducted by other authorities that affect the bankingsystem.21. This broad financial system perspective is integral to many of the CorePrinciples. For this reason, the Committee has not included a specificstand-alone Core Principle on macroprudential issues. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 22. In supervising an individual bank which is part of a corporate group, itis essential that supervisors consider the bank and its risk profile from anumber of perspectives: on a solo basis (but with both a micro and macrofocus as discussed above); on a consolidated basis (in the sense ofsupervising the bank as a unit together with the other entities within the“banking group”) and on a group-wide basis (taking into account thepotential risks to the bank posed by other group entities outside of thebanking group).Group entities (whether within or outside the banking group) may be asource of strength but they may also be a source of weakness capable ofadversely affecting the financial condition, reputation and overall safetyand soundness of the bank.The Core Principles include a specific Core Principle on the consolidatedsupervision of banking groups, but they also note the importance ofparent companies and other non-banking group entities in anyassessment of the risks run by a bank or banking group.This supervisory “risk perimeter” extends beyond accountingconsolidation concepts.In the discharge of their functions, supervisors must observe a broadcanvas of risk, whether arising from within an individual bank, from itsassociated entities or from the prevailing macro financial environment.23. Supervisors should also remain alert to the movement, or build-up, offinancial activities outside the regulated banking sector (the developmentof “shadow banking” structures) and the potential risks this may create.Data or information on this should also be shared with any otherauthorities relevant for financial stability purposes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (iii) Crisis management, recovery and resolution24. Although it is not a supervisor’s role to prevent bank failures,supervisory oversight is designed to reduce both the probability andimpact of such failures.Banks will, from time to time, run into difficulties, and to minimise theadverse impact both on the troubled bank and on the banking andfinancial sectors as a whole, effective crisis preparation and management,and orderly resolution frameworks and measures are required.25. Such measures may be viewed from two perspectives:(i) The measures to be adopted by supervisory and other authorities(including developing resolution plans and in terms of informationsharing and cooperation with other authorities, both domestic andcross-border, to coordinate an orderly restructuring or resolution of atroubled bank); and(ii) Those to be adopted by banks (including contingency funding plansand recovery plans) which should be subject to critical assessment bysupervisors as part of their ongoing supervision.26. To reflect, and to emphasise, the importance of crisis management,recovery and resolution measures, certain Core Principles include specificreference to the maintenance and assessment of contingencyarrangements.The existing Core Principle on home-host relationships has also beenstrengthened to require cooperation and coordination between home andhost supervisors on crisis management and resolution for cross-borderbanks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • (iv) Corporate governance, disclosure and transparency27. Corporate governance shortcomings in banks, examples of whichwere observed during the crisis, can have potentially seriousconsequences both for the bank concerned and, in some cases, for thefinancial system as a whole.A new Core Principle, focused on effective corporate governance as anessential element in the safe and sound functioning of banks, hastherefore been included in this revision.The new Principle brings together existing corporate governance criteriain the assessment methodology and gives greater emphasis to soundcorporate governance practices.28. Similarly, the crisis served to underline the importance of disclosureand transparency in maintaining confidence in banks by allowing marketparticipants to understand better a bank’s risk profile and thereby reducemarket uncertainties about the bank’s financial strength.In recognition of this, a new Core Principle has been added to providemore direction on supervisory practices in this area.Structure and assessment of Core PrinciplesStructure29. The preceding versions of the Core Principles were accompanied by aseparate assessment methodology that set out the criteria to be used togauge compliance with the Core Principles.In this revision, the assessment methodology has been merged into asingle document with the Core Principles reflecting the essentialinterdependence of Core Principles and Assessment Criteria and theircommon usage. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Core Principles have also been reorganised: Principles 1-13 addresssupervisory powers, responsibilities and functions, and Principles 14-29cover supervisory expectations of banks, emphasising the importance ofgood corporate governance and risk management, as well as compliancewith supervisory standards.This re-ordering highlights the difference between what supervisors dothemselves and what they expect banks to do. For comparability with thepreceding version, a mapping table is provided in Annex 1.Assessment30. The Core Principles establish a level of sound supervisory practicethat can be used as a benchmark by supervisors to assess the quality oftheir supervisory systems.They are also used by the IMF and the World Bank, in the context of theFinancial Sector Assessment Programme (FSAP), to assess theeffectiveness of countries’ banking supervisory systems and practices.31. This revision of the Core Principles retains the previous practice ofincluding both essential criteria and additional criteria as part of theassessment methodology.Essential criteria set out minimum baseline requirements for soundsupervisory practices and are of universal applicability to all countries.An assessment of a country against the essential criteria must, however,recognise that its supervisory practices should be commensurate with therisk profile and systemic importance of the banks being supervised.In other words, the assessment must consider the context in which thesupervisory practices are applied.The concept of proportionality underpins all assessment criteria even if itis not always directly referenced. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 32. Effective banking supervisory practices are not static.They evolve over time as lessons are learned and banking businesscontinues to develop and expand.Supervisors are often swift to encourage banks to adopt “best practice”and supervisors should demonstrably “practice what they preach” interms of seeking to move continually towards the highest supervisorystandards.To reinforce this aspiration, the additional criteria in the Core Principlesset out supervisory practices that exceed current baseline expectationsbut which will contribute to the robustness of individual supervisoryframeworks.As supervisory practices evolve, it is expected that upon each revision ofthe Core Principles, a number of additional criteria will migrate tobecome essential criteria as expectations on baseline standards change.The use of essential criteria and additional criteria will, in this sense,contribute to the continuing relevance of the Core Principles over time.33. In the past, countries were graded only against the essential criteria,although they could volunteer to be assessed against the additionalcriteria too and benefit from assessors’ commentary on how supervisorypractices could be enhanced.In future, countries undergoing assessments by the IMF and/or theWorld Bank can elect to be graded against the essential and additionalcriteria.It is anticipated that this will provide incentives to jurisdictions,particularly those that are important financial centres, to lead the way inthe adoption of the highest supervisory standards.As with the essential criteria, any assessment against additional criteriashould recognise the concept of proportionality as discussed above. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 34. Moreover, it is important to bear in mind that some tasks, such as acorrect assessment of the macroeconomic environment and the detectionof the build-up of dangerous trends, do not lend themselves to a rigidcompliant/non-compliant structure.Although these tasks may be difficult to assess, supervisors should makeassessments that are as accurate as possible given the informationavailable at the time and take reasonable actions to address and mitigatesuch risks.35. While the publication of the assessments of jurisdictions affordstransparency, an assessment of one jurisdiction will not be directlycomparable to that of another.First, assessments will have to reflect proportionality.Thus, a jurisdiction that is home to many SIBs will naturally have a higherhurdle to obtain a “Compliant” grading10 versus a jurisdiction which onlyhas small, non-complex deposit-taking institutions.Second, with this version of the Core Principles, jurisdictions can elect tobe graded against essential criteria only or against both essential criteriaand additional criteria.Third, assessments will inevitably be country-specific and time -dependent to varying degrees.Therefore, the description provided for each Core Principle and thequalitative commentary accompanying the grading for each CorePrinciple should be reviewed in order to gain an understanding of ajurisdiction’s approach to the specific aspect under consideration and theneed for any improvements. Seeking to compare countries by a simplereference to the number of “Compliant” versus “Non-Compliant” gradesthey receive is unlikely to be informative. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 36. From a broader perspective, effective banking supervision isdependent on a number of external elements, or preconditions, whichmay not be within the direct jurisdiction of supervisors.Thus, in respect of grading, the assessment of preconditions will remainqualitative and distinct from the assessment (and grading) of compliancewith the Core Principles.37. Core Principle 29 dealing with the Abuse of Financial Servicesincludes, among other things, supervision of banks’ anti-moneylaundering/combating the financing of terrorism (AML/CFT) controls.The Committee recognises that assessments against this Core Principlewill inevitably, for some countries, involve a degree of duplication withthe mutual evaluation process of the Financial Action Task Force(FATF).To address this, where an evaluation has recently been conducted by theFATF on a given country, FSAP assessors may rely on that evaluation andfocus their own review on the actions taken by supervisors to address anyshortcomings identified by the FATF.In the absence of any recent FATF evaluation, FSAP assessors willcontinue to assess countries’ supervision of banks’ AML/CFT controls.Consistency and implementation38. The banking sector is only a part, albeit an important part, of afinancial system and in conducting this review of its Core Principles, theCommittee has sought to maintain consistency, where possible, with thecorresponding standards for securities and insurance (which havethemselves been the subject of recent reviews), as well as those foranti-money laundering and transparency.Differences will, however, inevitably remain as key risk areas andsupervisory priorities differ from sector to sector. In implementing the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Core Principles, supervisors should take into account the role of thebanking sector in supporting and facilitating productive activities for thereal economy.II. The Core Principles39. The Core Principles are a framework of minimum standards for soundsupervisory practices and are considered universally applicable.The Committee issued the Core Principles as its contribution tostrengthening the global financial system.Weaknesses in the banking system of a country, whether developing ordeveloped, can threaten financial stability both within that country andinternationally.The Committee believes that implementation of the Core Principles by allcountries would be a significant step towards improving financialstability domestically and internationally, and provide a good basis forfurther development of effective supervisory systems.The vast majority of countries have endorsed the Core Principles andhave implemented them.40. The revised Core Principles define 29 principles that are needed for asupervisory system to be effective.Those principles are broadly categorised into two groups: the first group(Principles 1 to 13) focus on powers, responsibilities and functions ofsupervisors, while the second group (Principles 14 to 29) focus onprudential regulations and requirements for banks.The original Principle 1 has been divided into three separate Principles,while new Principles related to corporate governance, and disclosure andtransparency, have been added.This accounts for the increase from 25 to 29 Principles. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 41. The 29 Core Principles are:Supervisory powers, responsibilities and functions• Principle 1 – Responsibilities, objectives and powers:An effective system of banking supervision has clear responsibilities andobjectives for each authority involved in the supervision of banks andbanking groups.A suitable legal framework for banking supervision is in place to provideeach responsible authority with the necessary legal powers to authorisebanks, conduct ongoing supervision, address compliance with laws andundertake timely corrective actions to address safety and soundnessconcerns.• Principle 2 – Independence, accountability, resourcing andlegal protection for supervisors:The supervisor possesses operational independence, transparentprocesses, sound governance, budgetary processes that do not undermineautonomy and adequate resources, and is accountable for the dischargeof its duties and use of its resources.The legal framework for banking supervision includes legal protection forthe supervisor.• Principle 3 – Cooperation and collaboration:Laws, regulations or other arrangements provide a framework forcooperation and collaboration with relevant domestic authorities andforeign supervisors.These arrangements reflect the need to protect confidential information.• Principle 4 – Permissible activities: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The permissible activities of institutions that are licensed and subject tosupervision as banks are clearly defined and the use of the word “bank” innames is controlled.• Principle 5 – Licensing criteria:The licensing authority has the power to set criteria and rejectapplications for establishments that do not meet the criteria.At a minimum, the licensing process consists of an assessment of theownership structure and governance (including the fitness and proprietyof Board members and senior management) of the bank and its widergroup, and its strategic and operating plan, internal controls, riskmanagement and projected financial condition (including capital base).Where the proposed owner or parent organisation is a foreign bank, theprior consent of its home supervisor is obtained.• Principle 6 – Transfer of significant ownership:The supervisor has the power to review, reject and impose prudentialconditions on any proposals to transfer significant ownership orcontrolling interests held directly or indirectly in existing banks to otherparties.• Principle 7 – Major acquisitions:The supervisor has the power to approve or reject (or recommend to theresponsible authority the approval or rejection of), and impose prudentialconditions on, major acquisitions or investments by a bank, againstprescribed criteria, including the establishment of cross-borderoperations, and to determine that corporate affiliations or structures donot expose the bank to undue risks or hinder effective supervision. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • • Principle 8 – Supervisory approach:An effective system of banking supervision requires the supervisor todevelop and maintain a forward-looking assessment of the risk profile ofindividual banks and banking groups, proportionate to their systemicimportance; identify, assess and address risks emanating from banks andthe banking system as a whole; have a framework in place for earlyintervention; and have plans in place, in partnership with other relevantauthorities, to take action to resolve banks in an orderly manner if theybecome non-viable.• Principle 9 – Supervisory techniques and tools:The supervisor uses an appropriate range of techniques and tools toimplement the supervisory approach and deploys supervisory resourceson a proportionate basis, taking into account the risk profile and systemicimportance of banks.• Principle 10 – Supervisory reporting: The supervisor collects, reviews and analyses prudential reports andstatistical returns from banks on both a solo and a consolidated basis, andindependently verifies these reports through either on-site examinationsor use of external experts.• Principle 11 – Corrective and sanctioning powers ofsupervisors:The supervisor acts at an early stage to address unsafe and unsoundpractices or activities that could pose risks to banks or to the bankingsystem.The supervisor has at its disposal an adequate range of supervisory toolsto bring about timely corrective actions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This includes the ability to revoke the banking licence or to recommendits revocation.• Principle 12 – Consolidated supervision:An essential element of banking supervision is that the supervisorsupervises the banking group on a consolidated basis, adequatelymonitoring and, as appropriate, applying prudential standards to allaspects of the business conducted by the banking group worldwide.• Principle 13 – Home-host relationships:Home and host supervisors of cross-border banking groups shareinformation and cooperate for effective supervision of the group andgroup entities, and effective handling of crisis situations. Supervisorsrequire the local operations of foreign banks to be conducted to the samestandards as those required of domestic banks.Prudential regulations and requirements• Principle 14 – Corporate governance:The supervisor determines that banks and banking groups have robustcorporate governance policies and processes covering, for example,strategic direction, group and organisational structure, controlenvironment, responsibilities of the banks’ Boards and seniormanagement, and compensation.These policies and processes are commensurate with the risk profile andsystemic importance of the bank.• Principle 15 – Risk management process: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The supervisor determines that banks have a comprehensive riskmanagement process (including effective Board and senior managementoversight) to identify, measure, evaluate, monitor, report and control ormitigate all material risks on a timely basis and to assess the adequacy oftheir capital and liquidity in relation to their risk profile and market andmacroeconomic conditions.This extends to development and review of contingency arrangements(incuding robust and credible recovery plans where warranted) that takeinto account the specific circumstances of the bank.The risk management process is commensurate with the risk profile andsystemic importance of the bank.• Principle 16 – Capital adequacy:The supervisor sets prudent and appropriate capital adequacyrequirements for banks that reflect the risks undertaken by, and presentedby, a bank in the context of the markets and macroeconomic conditionsin which it operates.The supervisor defines the components of capital, bearing in mind theirability to absorb losses.At least for internationally active banks, capital requirements are not lessthan the applicable Basel standards.• Principle 17 – Credit risk:The supervisor determines that banks have an adequate credit riskmanagement process that takes into account their risk appetite, riskprofile and market and macroeconomic conditions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This includes prudent policies and processes to identify, measure,evaluate, monitor, report and control or mitigate credit risk (includingcounterparty credit risk) on a timely basis.The full credit lifecycle is covered including credit underwriting, creditevaluation, and the ongoing management of the bank’s loan andinvestment portfolios.• Principle 18 – Problem assets, provisions and reserves:The supervisor determines that banks have adequate policies andprocesses for the early identification and management of problem assets,and the maintenance of adequate provisions and reserves.• Principle 19 – Concentration risk and large exposure limits:The supervisor determines that banks have adequate policies andprocesses to identify, measure, evaluate, monitor, report and control ormitigate concentrations of risk on a timely basis.Supervisors set prudential limits to restrict bank exposures to singlecounterparties or groups of connected counterparties.• Principle 20 – Transactions with related parties:In order to prevent abuses arising in transactions with related parties andto address the risk of conflict of interest, the supervisor requires banks toenter into any transactions with related parties on an arm’s length basis;to monitor these transactions; to take appropriate steps to control ormitigate the risks; and to write off exposures to related parties inaccordance with standard policies and processes.• Principle 21 – Country and transfer risks: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The supervisor determines that banks have adequate policies andprocesses to identify, measure, evaluate, monitor, report and control ormitigate country risk and transfer risk in their international lending andinvestment activities on a timely basis.• Principle 22 – Market risks:The supervisor determines that banks have an adequate market riskmanagement process that takes into account their risk appetite, riskprofile, and market and macroeconomic conditions and the risk of asignificant deterioration in market liquidity.This includes prudent policies and processes to identify, measure,evaluate, monitor, report and control or mitigate market risks on a timelybasis.• Principle 23 – Interest rate risk in the banking book:The supervisor determines that banks have adequate systems to identify,measure, evaluate, monitor, report and control or mitigate interest raterisk in the banking book on a timely basis.These systems take into account the bank’s risk appetite, risk profile andmarket and macroeconomic conditions.• Principle 24 – Liquidity risk:The supervisor sets prudent and appropriate liquidity requirements(which can include either quantitative or qualitative requirements orboth) for banks that reflect the liquidity needs of the bank.The supervisor determines that banks have a strategy that enablesprudent management of liquidity risk and compliance with liquidityrequirements. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The strategy takes into account the bank’s risk profile as well as marketand macroeconomic conditions and includes prudent policies andprocesses, consistent with the bank’s risk appetite, to identify, measure,evaluate, monitor, report and control or mitigate liquidity risk over anappropriate set of time horizons.At least for internationally active banks, liquidity requirements are notlower than the applicable Basel standards.• Principle 25 – Operational risk:The supervisor determines that banks have an adequate operational riskmanagement framework that takes into account their risk appetite, riskprofile and market and macroeconomic conditions.This includes prudent policies and processes to identify, assess, evaluate,monitor, report and control or mitigate operational risk on a timely basis.• Principle 26 – Internal control and audit:The supervisor determines that banks have adequate internal controlframeworks to establish and maintain a properly controlled operatingenvironment for the conduct of their business taking into account theirrisk profile.These include clear arrangements for delegating authority andresponsibility; separation of the functions that involve committing thebank, paying away its funds, and accounting for its assets and liabilities;reconciliation of these processes; safeguarding the bank’s assets; andappropriate independent internal audit and compliance functions to testadherence to these controls as well as applicable laws and regulations.• Principle 27: Financial reporting and external audit: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The supervisor determines that banks and banking groups maintainadequate and reliable records, prepare financial statements in accordancewith accounting policies and practices that are widely acceptedinternationally and annually publish information that fairly reflects theirfinancial condition and performance and bears an independent externalauditor’s opinion.The supervisor also determines that banks and parent companies ofbanking groups have adequate governance and oversight of the externalaudit function.• Principle 28 – Disclosure and transparency: The supervisor determines that banks and banking groups regularlypublish information on a consolidated and, where appropriate, solo basisthat is easily accessible and fairly reflects their financial condition,performance, risk exposures, risk management strategies and corporategovernance policies and processes.• Principle 29 – Abuse of financial services:The supervisor determines that banks have adequate policies andprocesses, including strict customer due diligence rules to promote highethical and professional standards in the financial sector and prevent thebank from being used, intentionally or unintentionally, for criminalactivities.42. The Core Principles are neutral with regard to different approaches tosupervision, so long as the overriding goals are achieved.They are not designed to cover all the needs and circumstances of everybanking system. Instead, specific country circumstances should be moreappropriately considered in the context of the assessments and in thedialogue between assessors and country authorities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 43. National authorities should apply the Core Principles in thesupervision of all banking organisations within their jurisdictions.Individual countries, in particular those with advanced markets andbanks, may expand upon the Core Principles in order to achieve bestsupervisory practice.44. A high degree of compliance with the Core Principles should fosteroverall financial system stability; however, this will not guarantee it, norwill it prevent the failure of banks. Banking supervision cannot, andshould not, provide an assurance that banks will not fail. In a marketeconomy, failures are part of risk-taking.45. The Committee stands ready to encourage work at the national levelto implement the Core Principles in conjunction with other supervisorybodies and interested parties.The Committee invites the international financial institutions and donoragencies to use the Core Principles in assisting individual countries tostrengthen their supervisory arrangements.The Committee will continue to collaborate closely with the IMF and theWorld Bank in their monitoring of the implementation of theCommittee’s prudential standards.The Committee also remains committed to further enhancing itsinteraction with supervisors from non-member countries. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Is part of your job to predict the future?Do you live in the new forward looking perspective in risk management?In 1964, Arthur C. Clarke, science fiction writer, inventor and futuristobserved:“Trying to predict the future is a discouraging and hazardous occupation,because the prophet invariably falls between two chairs.If his predictions sound at all reasonable, you can be quite sure that in 20,or at most 50 years, the progress of science and technology has made himseem ridiculously conservative.On the other hand, if by some miracle, a prophet could describe the futureexactly as it was going to take place, his predictions would sound soabsurd, so far-fetched, that everybody would laugh him to scorn.”Statement by Dr. Kaigham J. GabrielDeputy Director, Defense AdvancedResearch Projects AgencySubmitted to the Subcommittee on EmergingThreats and CapabilitiesUnited States House of RepresentativesInteresting partsAt DARPA, we are often asked to predict the future.After all, since it was created in 1958, DARPA’s singular mission has beento create and prevent strategic surprise.Simple. Clear. Direct.It may appear that the best way to create strategic surprise is to predictwhat’s next. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Predict with great accuracy and as far as out as possible.We hunger to know what’s next.To predict the future. But our hunger to predict is not matched by ourability to do so.In 1964, Arthur C. Clarke, science fiction writer, inventor and futuristobserved:“Trying to predict the future is a discouraging and hazardous occupation,because the prophet invariably falls between two chairs.If his predictions sound at all reasonable, you can be quite sure that in 20,or at most 50 years, the progress of science and technology has made himseem ridiculously conservative. On the other hand, if by some miracle, aprophet could describe the future exactly as it was going to take place, hispredictions would sound so absurd, so far-fetched, that everybody wouldlaugh him to scorn.”At DARPA, we believe it is not about predicting the future... it is aboutbuilding it. Indeed, the technical visionaries at DARPA are notoracles—they are builders.Chairman Thornberry, Ranking Member Langevin, Members of theSubcommittee, my name is Ken Gabriel.I am the Deputy Director of the Defense Advanced Research ProjectsAgency.I would like to highlight some of the accomplishments of the Agency overthe last 12 months and, outline the challenges we see and our intentionsfor the coming year.The impact from some of our work will be felt years from now. Otherwork is contributing sooner and is in the fight today. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Regardless of where in that spectrum we are, DARPA’s work isunderscored by a focus on building.Building capabilities and demonstrations at convincing scale that drivethe advance of the underlying technologies and science.We innovate by building. We achieve our best, by building.Building the futureSome of the Agency’s greatest contributions— things we now take forgranted and as having been inevitable were, at their inception, oftenconsidered impossible.The Internet, stealth, UAVs for example, when first proposed weredescribed by some as impractical, far-fetched, and risky.But these seemingly impossible things were turned to the improbable andthen to the inevitable by people with vision and determination to maketheir vision real.A determination to build. DARPA program managers have a hunger tosucceed, a sense of urgency, and a commitment to the Nation’s Security.For more than 50 years, the Agency has sought the Nation’s best, giventhem the resources they need, and cleared the obstacles in their way.The lifeblood of DARPA is the cadre of program managers and leadershipexecutives that represent some of the best technical minds in the country.Professionals who put their careers in suspended animation in service tocountry.Accountable to the Agency, to the Department, and to our Warfighters,DARPA’s program managers are drawn from academia, industry,non-profits, the Services, and laboratories and serve for a tour of 3 to 5years. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Program managers, office directors, the Director, and the DeputyDirector; all change on a regular cadence.This practice results in roughly 25 percent annual starts and exits andensures the Agency is current with existing and emerging technologicaltrends, encourages a continual challenging of conventional approaches,and imparts an ethic of urgency.One key continuing challenge for the Agency and, by extension, for thewell-being of the Department of Defense is recruiting this talent toservice. DARPA’s ability to do so demands rapid, agile and efficienthiring.In the last 2.5 years the Agency has recruited more than 75 new programmanagers – this has been essential to many of our efforts includingDARPA’s significantly expanded cyber program and our big data effortsin support of operations in Afghanistan, among others.DARPA has demonstrated successful and responsible use of its hiringauthorities.Indeed, the Agency has been at essentially present-day personnel levelssince 1992 and has never exceeded the allocated top-line number ofauthorized full-time equivalents.Timelines for hiring within the Agency are short and match the cadenceand tempo of tours reflected above.Simply put, we cannot undertake a 6-month or even a year-long hiringactivity, as is common in government, for a technical subject matterexpert critically needed to undertake efforts in response to a technologicalshift and with other competing career opportunities.Rather, we need to sustain an efficient and expedient engagement that isnaturally always within the construct of fiscal, ethical, and legalresponsibilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This is not something we can afford to risk. Together we must protect itvigorously.Our business practices are a vital part of building.Execution is what allows the people at DARPA to build.To turn ideas into reality, the Agency must operate effectively with agility,speed, and technical and administrative integrity.DARPA executes a budget of nearly $3 billion as appropriated byCongress.It does so with approximately 120 program managers and a roughly equalnumber of Government support staff.Financial resources and lean business practices allow the Agency topursue ideas that most dare not touch.And to do so quickly. There are no entitlements to programs or people, nocaptive laboratories, no immutable tenets.The Agency applies a “thoughtful ruthlessness” in its dogged pursuit ofthe best people, ideas, and output.The breadth, urgency, and technical demands of DARPA programs arereal.The innovative ideas the Agency pursues are fragile and fleeting, and theorganization’s business practices must be aligned with the speed andflexibility required to pursue those ideas.The authenticity of Defense applications demands an organizationdedicated to excellence in execution through all levels of management,policies, and personnel. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Indeed, in the face of such pressures, creativity requires heroicintellectual leaps not just from the technical side of the organization, butequally from the support side of the organization.DARPA has support offices dedicated to essential functions that enablethe mission through innovative practices that mirror the technicalinnovations of the Agency.In past years, Congressional oversight committees expressed concernthat DARPA’s financial execution was inadequate; specifically, thatDARPA was not obligating a significant fraction of the money it hadrequested.These concerns resulted in budget cuts and rescissions, but, as well,obligation delays meant fewer resources at work for the Department.In our 2010 written testimony, we reported on the steps the Agency hadtaken to improve business process and the resulting, significantimprovements in financial execution.In 2011, we maintained our emphasis on responsible and efficientfinancial execution.At the end of September 2011, the Agency’s obligation rate was 21 pointshigher (85 percent) than the 5-year average (64 percent) despite thedelayed 2011 Appropriations signing.At the end of fiscal year 2011, the improved execution translated into morethan $600 million in the performer community, working for theDepartment and Nation.Speed is part of the vibrancy of innovation and building. Better businesspractices are just better Government.It affects not only the performers, but the Agency too. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • People come to DARPA not for careers in Government, but to serve. Overthe decades, this cadre has consistently delivered.The list of historical achievements is well known, long, and includesstealth, the Internet, and UAVs.Today we are working on the production of vaccines from tobacco plantsmeasured in days rather than months; prosthetics controlled directly bythoughts; and clean-slate, convergent approaches to defensive andoffensive cyber security capabilities among many other innovations.Discouraging the fear of failureDoing things that have never been done before, building the future,comes with risk.Risk of failure.As a Department, as a Nation, we must not forget that greataccomplishments often had failure along the path.We cannot fear it.The history of the Corona program and imaging satellites tells us that ittook 13 launches over several years before the first images were collected.Thirteen.Each of the other 12 launches failed to collect a single image.No doubt, some at the time called them failures.But each of those 12 launches informed the next build and successivelycreated the capability of imaging satellites from what seemed impossible,to just improbable and, eventually, inevitable. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The first successful flight in 1960 covered 1.65 million square miles ofSoviet territory—more than all earlier U-2 missions combined.A more recent example is HTV-2, a DARPA program that is part of theDepartment’s prompt global strike activities.HTV-2 seeks to travel at Mach 20 in an unmanned, boost-glide,maneuvering vehicle.The fastest high lift-to-drag ratio aircraft ever built. Mach 20. Twentytimes the speed of sound.That means anywhere in the world in 60 minutes or less.Or New York to Los Angeles in 11 minutes and 20 seconds, with thesurface of the vehicle at blast furnace temperatures: 3500 degrees F—thetemperature of molten steel.We are essentially burning the airfoil as we fly it.It might seem impossible. It’s not.It’s just hard.There have been two test flights to date.The first revealed an underestimation and simulation of aerodynamiceffects in one of four variables needed for controlled hypersonic flight.The second flight demonstrated that we had fixed the aerodynamiccontrol from the first flight, but precisely because we reached a differentstage of the flight, we had 3 minutes of fully aerodynamically controlledflight at Mach 20.Although neither of the flights completed all elements of the tests, the twoflights combined fielded the largest collection of flight-test assetsassembled and yielded more aerodynamic and test measurement data at _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • these hypersonic regimes than what has been collected in ground testsover the last 40 years.There’s no way to learn to fly at Mach 20 unless you build… and fly.From hypersonic flight to detecting overpressure during blasts, buildingremains important.A persistent, acute DoD need has been for a reliable, accurate andaffordable method to detect and characterize traumatic brain injury or(TBI).We undertook basic and fundamental work in neuroscience and the effectof blasts on the fine structure that revealed the role of over pressure inTBI.Overpressure waves distinguish blast exposure from other types of causesof TBI (for example, sports injuries where acceleration and kineticimpact, but no overpressures are contributors).Informed by this neuroscience work, DARPA launched a program tobuild, demonstrate, and evaluate a blast gauge that incorporated apressure sensor, acceleration sensor, and recording electronics.Four versions of the gauge were built over the course of a year and for atotal development cost of approximately $1 million.Each version building in the learnings—learnings from both the use andmanufacturing of the earlier versions.In partnership with the Army, the final version was fielded to an entirebrigade of 841 warfighters, the 2nd Brigade, 4th Infantry Division in RCSouth over the course of six months— from August 2011 to February 2012.The initial units used to outfit the first brigade cost $85 per unit, 3 perwarfighter per month of deployment for a total cost of $1.6M. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • But over time, informed by the building and shipping of over 16,000 unitsand incorporating improved manufacturing processes, the cost is nowapproximately $45 per unit, and the next brigade will be outfitted for$540,000.At DARPA we plan for success, not failure.We don’t seek, embrace, or celebrate failure.We learn from our failure, and we build future capabilities throughpersistence, focus, and informed trial. We don’t encourage failure; wediscourage the fear of failure.The price of not buildingIn the best of times, failure is difficult to endure.There is a hunger and need to be efficient.To husband our resources. In times of fiscal pressure that hunger issharper.The conventional wisdom and response for relief is to roadmap,coordinate and plan to better predict and better prepare.To slow our efforts so as to retire more risks, to build less often and thuslower costs.If we can improve our predictions, we can better plan for and build thesystems needed.The argument being, “We can’t afford to fail.”The trouble with this approach is that, out of balance, it fails to weigh therisks of not building. Because it is equally important not to losesight of the companion worry: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • “What’s the price of not building often and along shorter timelines?”At DARPA we examined this fundamental argument through the lens oftwo parameters: per-system cost and total number of systems to bepurchased.Across many different types of representative defense systems— air, land,and sea— over the last 2 to 3 decades, the analysis reveals a consistentand disturbing pattern.Programs of record begin with a target per-system cost and total numberof systems to be purchased.Over the course of a program, due to a variety of factors includingfinancial constraints, technical risks and changing priorities, there is asteady increase in the per-system cost and a corresponding decrease inthe total number of systems to be purchased.For the systems we analyzed, with associated development and fieldingtimes ranging from 14 to 30 years, the final number of systems purchasedwere typically one-fourth the original number of systems envisioned atthe start of the programs.The judgment of whether fielding one-fourth of the original number ofsystems is enough is not DARPA’s.This pattern of increasing timelines to initial operational capability,increasing cost per unit delivered, and companion decrease in thenumber of units, is divergent with an increasingly dynamic threatenvironment.Our next step was to attempt to reveal what is causing the divergence.Many people are familiar with Norm Augustine’s chart that shows theextrapolated cost of a fighter aircraft intersecting with the Defense _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • budget, such that sometime in 2054 the entire Defense budget will berequired to buy one aircraft.Further, given the pace of global technological development and access,we can no longer afford the time it takes us to build Defense systems.In DARPA’s 2010 and 2011 written testimony, we highlighted anddescribed the Agency’s advanced manufacturing initiative, with the focuson reducing and controlling for time.But it is not simply the argument that time is money.As a Department, we are at a juncture where not only the increasing costbut the increasing time it takes us to develop defense systems is avulnerability in and of itself.In the past, defense technology could be relied on to be ahead of civil orcommercial technology.Defense technology drove commercial technology and the defenseindustry was often an early adopter and customer of new technologies.And in a few unique areas, defense will remain ahead of commercialcapabilities.But the number of these areas is decreasing.In the last 2 decades, this long-standing precedent has begun to reverse,and commercial technology has begun to outstrip defense technology.This is perhaps felt most acutely in cybersecurity and the consumerelectronics products and services that have fundamentally changed theway we connect and interact with the world and each other.Vulnerabilities created by commercial technologies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Unintentionally, and without malice, commercial consumer electronicshas created vulnerabilities by enabling sensors, computing, imaging, andcommunications capabilities that as recently as 15 years ago, were theexclusive domain of military systems.These capabilities now are in the hands of hundreds of millions of peoplearound the world and in use every day.The effect of these commercial capabilities on Defense and NationalSecurity may be seen in the impact of these trends on electronic warfare(EW) systems and anti-access and area denial (A2AD). EW: an area ofhistoric advantage to the US military; and A2AD: an area of increasingconcern in several strategic regions of the globe.This is not an abstract vulnerability.We have not enjoyed spectrum dominance since about 1997. Up untilthen, our EW systems could both detect and respond effectively to EWthreats directed at us.In the last 15 or so years, however, that has ceased to be true.In both waveform complexity and carrier frequency, adversaries havemoved to operating regimes currently beyond the capabilities of oursystems.What we find are three principal reasons why it has been possible to applycommercially available electronic capabilities to produce military-gradeEW systems.First, as microelectronic devices continue to shrink in size, they are,perhaps counter intuitively, also improving in performance.For example, smaller microelectronic devices are able to switch fasterand, thus, operate at higher frequencies.This means that specialized microelectronic devices produced for DoDare now matched or nearly matched in performance to standard _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • silicon-based microelectronics commercially available from multiple,global sources.Second, custom signal processing chips that took 2 to 3 years to developand required chip designers, sophisticated design, and simulation toolsalong with chip fabrication facilities are increasingly being replaced byprogrammable chips or field-programmable gate arrays (FPGAs).Unlike custom signal processing chips that have their specific functionfixed at the time of fabrication, FPGAs can be programmed, andreprogrammed, like software, after fabrication.This means that developers can cut as much as 18 months offdevelopment schedules, from 3 to 4 years to as little as 1.5 years.Finally, the demand created by the global, mobile communicationsindustry has led to a global manufacturing capacity and economicefficiencies that deliver the above capabilities at ever decreasing prices.EW was once the province of a few peer-adversaries.It is now possible to purchase commercial off-the-shelf (COTS)components for more than 90 percent of the electronics needed in an EWsystem.This has reduced the barriers to developing, producing, and fielding suchsystems to within the capabilities of many nation states and non-stateactors.And because of the improved performance of commercially available,programmable microelectronics, nearly a dozen countries are nowproducing EW system variants and new versions at a much faster cadencethan we have; from a pace of a new system every 5 to 10 years 2 decadesago, to one every 1.5 years today.This means that our conventional approaches no longer afford us a timeor capability advantage. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Increasingly, our conventional approaches are divergent with the threat.These insights led us to new investments that leverage COTS technologywhere it makes sense to, counter COTS where we need to, and transcendCOTS where practical.Leveraging COTS.If a commercial computer chip is fast enough to accomplish a task in aUS military system, there is no point to designing an alternative; just usewhat is available.This does not imply equivalent capability at the system level.Namely, we are not doomed to an even playing field just because we areusing the same processor chip as an adversary.We can make a network of such chips to overcome the adversary’s system.Better algorithms tightly integrated with the hardware, and improvedcooling to wring more performance from each chip, are two exampleswhere technological advances would allow us to prevail even when we areall using the same basic technology.Countering COTS; alternatives to GPS as an example.We use global positioning system (GPS) because it is cheap and easy.It is COTS for us – most of our precision-guided munitions capability, aswell as timing for our command and control systems, have becomedependent on GPS.The adversary knows this and has aggressively sought means to counterour dependency on GPS. Jammers and commercially driven spectrumcompression may threaten our ability to use GPS in areas denied.Attempts to make GPS receivers that can survive that jamming isimpractical and not convergent with the threat. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • GPS signals are inherently weak.The ease with which GPS signals are jammed or spoofed motivatedevelopments of development of alternative position, navigation, andtiming approaches that are not dependent on GPS alone.An example of how we might counter COTS is to recognize that GPS isjust one way of providing positioning, navigation, and timing data.But it is not the only way. We might carry our own navigation system.The same trends in COTS advances, used to build alternative navigationguidance systems such as highly integrated, inexpensive, low poweraccelerometers and gyros, may enable the DoD to accomplish its missioneven when GPS is denied.Our analysis revealed that extending the performance of today’s inertialguidance systems by a factor of 20—from roughly 1 minute to 18 minutes,will permit 98 percent of our GPS-dependent weapons to operate at GPSaccuracy during their mission duration without a GPS signal.Transcending COTS.COTS electronics is a formidable source of new, high performancetechnology, but it has inherent limitations.The main one is economics– industry is motivated by the profit incentive,and modern electronics is extremely expensive to design and produce insmall volumes.This highly nonlinear effect of high volume manufacturing is why theextremely complex technology inside cell phones appears to be so cheap.This opens a window of opportunity for the US military anywhere thatproduct unit volumes will be low, COTS electronics will be unavailable.Very high power transmit/receive modules for radars and radios, for _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • example, are simply unnecessary in the COTS space, so the Military mustdesign and produce its own.Although this performance advantage will come with a cost greater thancommercial products, this means the United States will enjoy a technicallead over any potential adversary who cannot invest and do likewise.Operational vice intelligence capabilities in cybersecurityIn cybersecurity, we have the area that most highlights the danger oftaking too long to build.The shelflife of cybersecurity systems and capabilities is sometimesmeasured in days.Thus, to a greater degree than in other areas of defense, cybersecuritysolutions require that we develop the ability to build quickly, at scale, andover a broad range of capabilities.This is true for both offensive and defensive capabilities.DARPA’s role in the creation of the Internet means we were party to theintense opportunities it created and share in the intense responsibility ofprotecting it.We should emphasize that national policymakers, not DARPA, willdetermine how cyber capabilities will be employed to protect and defendNational Security interests.But the Agency has a special responsibility to explore the outerboundaries of such capabilities that the United States is well prepared forfuture challenges.To date, there has been much focus on increasing our defensivecapabilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • To be sure, the list of needed capabilities is long.Our networks may be safer than they were, but systems are often easilypenetrated, accounts are routinely hacked, intellectual property andsensitive information are compromised, and the supply chain is notsecure.And because computers are embedded in nearly all our systems—cyberattack cannot be regarded as a threat only to our networks andinformation—but rather to all our physical systems as well.Protecting cyberspace and the Nation requires both significantlyenhanced defensive and offensive cyber capabilities; capabilities acrossthe full spectrum of the conflict.Of note, our Intelligence Community has significant cyber capabilities,but the are geared predominantly to intelligence tasks.The tasks required for Defense purposes are sufficiently different that wecannot simply scale our intelligence cyber capabilities and adequatelyserve the needs of the Department of Defense.Rather we need cyber options that can be executed at the speed, scale,and pace of our military kinetic options with comparable predictedoutcomes.Modern warfare demands the effective use of cyber, kinetic, andcombined cyber and kinetic means.That will happen only if cyber capabilities are at scales and speedsmatched to our kinetic options.Informed by these insights and with a willingness to accept ourresponsibility to contribute, we assessed that DARPA has a significantrole to play. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • We recruited an expert cyber team of individuals from diverse experiencesincluding the “white hat” hacker community, academia, labs andnonprofits, major commercial companies, in addition to the Defense andIntelligence Communities.We launched several programs, increased the level of activities in others,and closed some out.Our cyber efforts are designed to create the capabilities needed formilitary missions.We need more options.We need more speed and scale.We need approaches that match the diversity, dynamic range, andoperational tempo of DoD activities.This cannot be achieved by simply doing more of what we’ve been doingor by increasing our intelligence-oriented cyber capabilities.Examples include programs such as Clean-Slate design of Resilient,Adaptive, Secure Hosts or CRASH, which takes its inspiration from thedefensive mechanisms of biological systems and seeks to developcybersecurity technologies by radically rethinking basic hardware andsystems designs.And PROgramming Computation on EncryptEd DATA or PROCEED,which is a big reach program motivated by recent breakthroughs in whatis called fully homomorphic encryption, which could fundamentallychange the nature of assured computations on untrusted hardware.If successful, PROCEED puts cybersecurity into an encryption realm, arealm that requires state-level computational resources.The Cyber Fast Track program recognizes an untapped pool of expertsand innovators who could contribute, if we provide a path. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • That path matches both their execution and the shelflife of cybersecurityproducts. In the last 7 months, more than 100 proposals were received byCyber Fast Track, and 32 awards were made.Just as important, the average time from receipt of proposal to award is 7days.We note that the process and contracting mechanism rigorously meetsDoD regulations for competition and awards; we need not be slow to befair, ethical, or prudent.Eighty-four percent of these small companies and performers have neverdone business with the Government before, expanding the number anddiversity of talent contributing to the Nation’s cybersecurity.Since 2009, DARPA has steadily increased its cyber research. Our cyberresearch funding is increasing from $228 million in FY2012 to $246 millionin FY2013.And over the next five years, our proposed investment in cyber researchwill grow steadily from 8 percent to 12 percent of topline.We are also shifting our investments to activities that promise moreconvergence with the threat that recognize the unique needs of theDepartment of Defense.To this end, in the coming years, DARPA will focus an increasing portionof our cyber research on the investigation of offensive capabilities toaddress military-specific needs.We began these efforts on our own. But part of the growth in our resourcecommitment beginning in 2012 and extending through 2017, is at thehand of senior leaders in the Department, who added $500 million over 5years for clean-slate, convergent cyber research at DARPA.DARPA’s engagement in cyber is not new. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This expanded effort builds on an existing foundation and continuingcontributions to cyber.Indeed, past DARPA-developed technologies are widely prevalent inmilitary, intelligence, and commercial use today. But there is still much todo.DARPA activities are part of a larger whole within National Security atthe National Security Agency , the newly formed CYBERCOMMAND,the Services, the private sector, universities, nonprofits and, asappropriate, the Department of Homeland Security.Clearly, the challenges of cyberspace require the concerted efforts ofmany. Indeed, we all must be protectors of and operate withincyberspace.And these challenges also demand the involvement of technical experts atunprecedented levels.We expect that part of our responsibility will be in advisory roles duringthe formation of policy and legal frameworks, because new policies andlaws—domestic and international—must be executable, enforceable, andsustainable.To be of use, such policies and laws will demand evaluation andadjustment on timescales that correspond to the dynamic nature andcompressed evolutionary timescales of advances in cyberspace.We’ll have to move faster than we are accustomed to.We’ll need the tools and guidance to do so.Discomfort and strategic surpriseSome of these observations feel uncomfortable. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Even to us. Our responsibility, however, is to the uncomfortable.It is the Agency’s singular mission to identify divergences and the threatsand opportunities they represent.These are the seeds of strategic surprise.We need approaches that are convergent with the challenges and deliversystems and solutions on timescales and with agilities that matchoperational needs.In this time of fiscal constraint, we are committed to doing our part.But this does not mean that we lose our nerve for building.Thank you. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Basel ii / iii in RussiaThe Bank of Russiaconsiders it necessary to create legislative fundamentals in Russia for in-troducing all the standards of banking regulation and bankingsupervision established by the Basel Committee on Banking Supervision(BCBS).These include legislation empowering the Bank of Russia to setrequirements for credit institutions’ corporate governance, risk andcapital management systems, to exercise consolidated supervision, to useprofessional judgment in supervisory practices, and also to definedisciplinary action against members of executive bodies and boards ofdirectors (supervisory boards) for faults in the activity of their creditinstitutions.In order to implement the provisions of Basel II, the Bank of Russia willcarry out work in 2012-2014 to draft banking regulation and supervisoryrules envisaging approaches to credit risk assessment based on internalratings.The Bank of Russia will also cooperate with credit institutions in draftingand introducing internal capital adequacy assessment procedures.In order to introduce new international requirements for capital qualityand adequacy and maintain the required level of liquidity as stipulated bythe BCBS documents adopted in 2010 (Basel III) and supported by theG20 leaders at their summit in Seoul in November 2010, the Bank ofRussia intends to take the following measures:– make amendments to the regulations to review the structure ofregulatory capital and introduce requirements for the adequacy of capitalcomponents; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • –set requirements for building capital buffers, introducing the leverageindicator defined as the ratio between capital and the total value of assetsand off-balance sheet items that are not weighted by risk;– introduce two liquidity ratios: the short-term liquidity coveragestandard defined as the ratio of liquid assets to net cash outflow over thenext 30 calendar days in a market stress scenario, and the net stablefunding standard determined as the ratio of available reliable sources offunding with a maturity of at least one year to the required amount ofstable funding in a stress scenario.In 2013-2014, the Bank of Russia will define approaches for banks tocreate the counter-cyclical capital buffers as an instrument to limitsystemic risks.In order to implement these approaches, additional indicators of riskgrowth in the Russian financial system are intended to be developed.Measures are planned in 2012-2014 to work out criteria for classifyingbanks as systemically important, and also define regulatory requirementsfor their activity, taking into account the proposals developed by theBCBS jointly with the Financial Stability Board (FSB) for global sys-temically important financial institutions.While developing corresponding criteria for Russian banks, the Bank ofRussia will take into account the specifics of the domestic market forbanking services, and also the work being carried out by the BCBS andthe FSB to adapt the proposed approaches to the regulation of nationalsystemically important banks.With regard to international recommendations on compliance with FSBprinciples and standards relating to compensation (remuneration), theBank of Russia will implement them taking into account the specificrequirements of national legislation.In order to reduce the administrative burden on banks, measures areplanned to unify supervisory requirements for the sustainability of credit _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • institutions and the requirements for their participation in the depositinsurance system by making corresponding amendments to legislation.In order to increase the transparency of Russian credit institutions, theywill be required to disclose information to the public on the qualificationsand work experience of their top managers.Measures will be required to statutorily establish the duty of shareholdersand persons exerting indirectly (through third parties) material influenceon decisions taken by the credit institutions’ management bodies,including third parties, to provide information to credit institutions forthe disclosure of the ownership structure.These would include cases where the shares of credit institutions are keptby nominal holders.Measures are planned to further develop the legislative framework ofcredit institutions’ affiliated parties to increase the transparency of theownership structure of credit institutions.In particular, it will be necessary to stipulate the duty of all affiliatedparties of credit institutions to provide information on them and be heldresponsible for their failure to comply with this requirement.Work will be continued to legislatively improve merger and acquisitionprocesses.Amendments will be made to the legislation to stipulate a possibility forlegal entities (including credit institutions) with different forms of incor-poration to participate in the reorganisation of credit institutions, whichwill give an additional stimulus to raise their capitalisation through re-structuring.The policy towards integration into the world financial market should beconducted taking into account national interests, the real level ofdevelopment and the competitiveness of the Russian banking sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The ban on opening foreign bank branches will remain as a necessarymeasure for maintaining the competitiveness of Russian banks in thedomestic market for banking services and the Bank of Russia willcontinue its participation in drafting the corresponding federal law.The Bank of Russia will participate in work to draft laws aimed atproviding additional protection for creditors and consumers of financialservices, including the improvement of the law on pledge and thedevelopment of legislation on consumer credit.At the same time, work will continue to implement measures forimproving the financial literacy of the population with respect to banking.Measures to increase the transparency of credit institutions as a result ofthe use of International Financial Reporting Standards (IFRS) in theiractivities are an important step towards raising the efficiency of thebanking sector and boosting clients’ confidence in banks.With this in mind, these tasks should be resolved through theimplementation of Federal Law No. 208-FZ, dated 27 July 2010, ‘OnConsolidated Financial Statements’, under which credit institutions arerequired to draw up, submit and publish consolidated financialstatements.For its part, the Bank of Russia considers it necessary to encourage creditinstitutions to be conservative enough in making fair value measurementsunder the IFRS standards and, if necessary, will use banking regulationand supervisory powers to adjust the measurements, proceeding fromprudential approaches.The Bank of Russia will further study approaches and measures formaintaining the systemic stability of the banking sector.The Bank of Russia will continue to upgrade its macroprudential analysistools by calculating banking sector financial soundness indicators,among other things, and posting them on the IMF website, and to assesssystemic risk by conducting stress tests. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In order to better protect the banking system and credit institutions’creditors, including bank depositors, and reduce the risks of abuses bycredit institutions’ managers and owners, work will continue to improvethe mechanisms of liquidation procedures at banks.These measures will include the assignment of criminal responsibility tothe heads of credit institutions, and also persons responsible foraccounting and other records, for deliberately entering false data intodocuments regulating civil rights and duties, accounting and otherrecords and reports on the economic activities of a credit institution, andalso for making corrections that distort the substance of these documents,if these actions are taken in pursuit of personal gain or in one’s personalinterest and inflict damage on citizens, organisations or the state. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Central Bank of the Russian FederationBanking LegislationIntroductionThe Central Bank of the Russian Federation(Bank of Russia) was founded on July 13,1990, on the basis of the Russian RepublicBank of the State Bank of the USSR.Accountable to the Supreme Soviet of theRSFSR, it was originally called the StateBank of the RSFSR.On December 2, 1990, the Supreme Soviet of the RSFSR passed the Lawon the Central Bank of the RSFSR (Bank of Russia), which declared theBank of Russia a legal entity and the main bank of the RSFSR,accountable to the Supreme Soviet of the RSFSR.The law specified the functions of the bank in organising moneycirculation, monetary regulation, foreign economic activity andregulation of the activities of joint-stock and co-operative banks.In June 1991, the Statute of the Central Bank of the RSFSR (Bank ofRussia), accountable to the Supreme Soviet of the RSFSR, was approved.In November 1991, when theCommonwealth of IndependentStates was founded and Unionstructures dissolved, theSupreme Soviet of the RSFSRdeclared the Central Bank of theRSFSR to be the only body of state monetary and foreign exchangeregulation in the RSFSR. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The functions of the State Bank of the USSR in issuing money and settingthe ruble exchange rate were transferred to it.The Central Bank of the RSFSR was instructed to assume before January1, 1992, full control of the assets, technical facilities and other resources ofthe State Bank of the USSR and all its institutions, enterprises andorganisations.On December 20, 1991, the State Bank of the USSR was disbanded and allits assets, liabilities and property in the RSFSR were transferred to theCentral Bank of the RSFSR (Bank of Russia), which several months laterwas renamed the Central Bank of the Russian Federation (Bank ofRussia).In 1991-1992 an extensive network of commercial banks was created in theRussian Federation under Bank of Russia guidance throughcommercialisation of the specialised banks’ branches.The disbandment of the State Bank of the USSR was followed by changesin the chart of accounts, the establishment of a network of Central Bankcash settlement centres and their provision with computer technology.The Central Bank began to buy and sell foreign exchange in the currencymarket it established and to set and publish the official exchange rates offoreign currencies against the ruble.In December 1992, as a result of the establishment of a single centralisedfederal treasury system, the Bank of Russia was no longer required toprovide cash services for the federal budget.The Bank of Russia carries out its functions, which were established bythe Constitution of the Russian Federation (Article 75) and the Law "Onthe Central Bank of the Russian Federation (Bank of Russia)" (Article 22),independently from the federal, regional and local government structures.In 1992-1995, to maintain stability of the banking system, the Bank ofRussia set up a system of supervision and inspection of commercial _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • banks and a system of foreign exchange regulation and foreign exchangecontrol.As the agent of the Ministry of Finance, it organised the governmentsecurities market, known as the GKO market, and began to participate inits operations.In 1995, the Bank of Russia stopped extending loans to finance the federalbudget deficit and centralised loans to individual sectors of the economy.To override the consequences of the 1998 financial crisis, the Bank ofRussia took steps towards restructuring the banking system in order toimprove the performance of commercial banks and increase theirliquidity.Insolvent banks were removed from the banking services market, usingthe procedures established by the applicable law.Of great importance for the post-crisis recovery of the banking sector wasthe creation of the Agency for Restructuring Credit Institutions (ARCO)and the Inter-Agency Co-ordinating Committee for Banking SectorDevelopment in Russia (ICC).Thanks to the effective measures implemented by the Bank of Russia,ARCO and ICC, by the middle of 2001 Russia’s banking sector had on thewhole overcome the aftermath of the crisis.The Bank of Russia monetary policy was designed to maintain financialstability and create conditions conducive to sustainable economicgrowth.The Bank of Russia promptly reacted to any change in the real demandfor money and took steps to stimulate positive economic dynamics, cutinterest rates, damp down inflationary expectations and slow the inflationrate. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • As a result, the ruble gained somewhat in real terms and financial marketstability increased.Due to the balanced monetary and exchange rate policies pursued by theBank of Russia, the country’s international reserves have grown and therehave been no sharp fluctuations in the exchange rate.The efforts made by the Bank of Russia with regard to the paymentsystem were designed to increase its reliability and efficiency for financialand economic stability.To make the Russian payment system more transparent, the Bank ofRussia introduced reports on payments by credit institutions and its ownregional branches, which took into account international experience,methodology and practice of surveillance over payment systems.In 2003, the Bank of Russia launched a project designed to improvebanking supervision and prudential reporting by introducinginternational financial reporting standards (IFRS).The project provides for the implementation of a set of measures,including measures to ensure credit institutions’ credible accounting andreporting, raise requirements for the content, amount and periodicity ofinformation to be published, and introduce accounting and reportingstandards matching international good practice.In addition, measures are to be taken to disclose information on the realowners of credit institutions, exercise control over their financial positionand raise requirements for credit institutions’ executives and theirbusiness reputation.There are some problems to which the Bank of Russia pays specialattention.One of them is that specific risks connected with the dynamics of theprices of some financial assets and the price situation on the real estatemarket have begun to play an increasingly important role recently. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The practice of lending to related parties led to high risk concentrationsin some banks, compelling the Bank of Russia to upgrade the methods ofbanking regulation and supervision by making greater emphasis onsubstantive (risk-oriented) supervision.Fictitious capitalisation of banks is another matter of serious concern forthe Bank of Russia.To prevent banks from using all sorts of schemes designed to artificiallyovervalue or undervalue the required ratios, the Bank of Russia in 2004issued a number of regulations, including the Regulation "On theProcedure for Creating Loan Loss Reserves by Credit Institutions" andthe Instruction "On Banks’ Required Ratios."As the number of credit institutions extending mortgage loans to thepublic increased, in 2003 the Bank of Russia issued the Ordinance "OnConducting a One-off Survey of Mortgage Lending," which set theprocedure for compiling and presenting data on housing mortgage loansextended by credit institutions.With the adoption of the Federal Law "On Mortgage Securities," creditinstitutions which ensured the observance of the requirements for theprotection of investors’ interests received the lawful opportunity torefinance their claims on mortgage loans by issuing mortgage securities.In pursuance of the Federal Law "On the Central Bank of the RussianFederation (Bank of Russia)" and Federal Law "On MortgageSecurities," the Bank of Russia issued the Instruction "On the RequiredRatios for Credit Institutions Issuing Mortgage-Backed Bonds," whichspecified the calculation and established the values of the required ratiosand the values and methodology of calculating additional required ratiosfor credit institutions issuing mortgage-backed bonds.In December 2003, the Federal Law "On Insurance of Personal BankDeposits in the Russian Federation" was adopted. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The law stipulated the legal, financial and organisational framework forthe mandatory personal bank deposits insurance system, and also thepowers, procedure for the establishment and operation of an institutionimplementing mandatory deposit insurance functions and set theprocedure for paying deposit compensation.At present, an overwhelming majority of banks participate in the depositinsurance system. They account for almost 100% of total personaldeposits placed in Russian banks.In April 2005, the Russian Government and Bank of Russia adopted theBanking Sector Development Strategy for the Period up to 2008, adocument which set as the main objective of banking sector developmentin the medium term (2005-2008) the enhancement of the banking sector’sstability and efficiency.The principal goals of banking sector development are as follows: - increasing the protection of interests of depositors and othercreditors of banks; - enhancing the effectiveness of the banking sector’s activity inaccumulating household and enterprise sector funds and transformingthem into loans and investments; - making Russian credit institutions more competitive; - preventing the use of credit institutions in dishonest commercialpractices and illegal activities, especially the financing of terrorism andmoney laundering; - promoting the development of the competitive environment andensuring the transparency of credit institutions; - building up investor, creditor and depositor confidence in thebanking sector. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The banking sector reform will help implement Russia’smedium-term social and economic development programme (2005-2008),especially its objective to end the raw materials bias of the Russianeconomy by rapidly diversifying it and utilising its competitiveadvantages. At the next stage (2009-2015), the Russian Government and Bank ofRussia will attach priority to effectively positioning the Russian bankingsector on international financial markets.Banking LegislationBanking legislation is a branch of law representing a system of statutoryacts regulating banking activities.The legal regulation of banking activities is exercised by the Constitutionof the Russian Federation, Civil Code of the Russian Federation, FederalLaw No. 86-FZ, dated July 10, 2002, ‘On the Central Bank of the RussianFederation (Bank of Russia)’ (hereinafter referred to as the Bank ofRussia Law), Federal Law No. 395-1, dated December 2, 1990, ‘On Banksand Banking Activities,’ and other federal laws and Bank of Russiaregulations.Point g of Article 71 of the Constitution of the Russian Federationstipulates that the Russian Federation has the jurisdiction over thefinancial, currency, credit and customs regulation, the issue of money andthe fundamentals of the price policy.This provision signifies that the legal regulation of banking activities mayonly be conducted at the federal level.Part 2 of Article 75 of the Constitution of the Russian Federation laysdown the principle of the Bank of Russia being independent from otherstate bodies when performing its basic function to protect the rouble andensure its stability. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Bank of Russia Law spells out the principle of the Bank of Russiaindependence, stipulating that the Bank of Russia performs the functionsand exercises the powers established by the Constitution of the RussianFederation and the Bank of Russia Law independently from other federalbodies of state power, regional authorities and local governments.The Bank of Russia Law establishes the legal status of the Bank of Russia,the size of its authorised capital, the procedure for creating the NationalBanking Board and management bodies and their principal functions;settles the relations between the Bank of Russia and the bodies of statepower and local governments and the relations between the Bank ofRussia and credit institutions; spells out the principles of organisingnon-cash settlements and cash circulation; sets out the principles ofimplementing the monetary policy and designated its instruments; listsBank of Russia operations and transactions; establishes the powers inregard of banking regulation and supervision, and formulates theprinciples of organising the Bank of Russia and its accountability andaudit.Article 4 of the Bank of Russia Law lists the functions performed by theBank of Russia.Article 7 of the Bank of Russia Law stipulates that in regard of the mattersrelated to its competence by this Federal Law and other federal laws theBank of Russia issues in the form of ordinances, regulations andinstructions statutory acts binding upon the federal bodies of state power,regional authorities, local governments and all legal entities and naturalpersons.With few exceptions, Bank of Russia statutory acts should be registeredaccording to the procedure established for the state registration ofstatutory legal acts of the federal bodies of executive power.In addition to issuing its own regulations, the Bank of Russia takes anactive part in other forms of the legislative process, because under the lawthe drafts of federal laws and statutory legal acts of the federal bodies ofexecutive power concerning the performance by the Bank of Russia of its _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • functions should be submitted to the Bank of Russia for considerationand approval.Another basic federal law regulating banking activities is the Federal Law‘On Banks and Banking Activities’, which defines major terms used in thelegal regulation of banking, such as ‘credit institution,’ ‘bank,’ ‘non-bankcredit institution,’ ‘banking group,’ etc.This Federal Law determines the components of the Russian bankingsystem, lists banking operations and other transactions, describes thespecifics of credit institution operations on the securities market and setsthe procedure for registering credit institutions and licensing bankingactivities and the procedure for opening credit institution branches andrepresentative offices.It formulates the principles of the relationships between creditinstitutions and their customers and between credit institutions and thestate, lists the grounds for the revocation of a banking licence, lays downthe principles of ensuring the soundness of credit institutions, establishesthe banking secrecy regime and anti-monopoly restrictions for creditinstitutions and sets out the principles of organising the savings businessin the Russian Federation.The passage of Federal Law No. 40-FZ, dated February 25, 1999, ‘OnInsolvency (Bankruptcy) of Credit Institutions’ (hereinafter referred to asthe Insolvency Law) was a major step forward in building in Russia acivilised credit institution insolvency (bankruptcy) system meeting thegenerally accepted international standards.The Insolvency Law sets the procedure for carrying out credit institutioninsolvency (bankruptcy) prevention measures, declaring creditinstitutions insolvent (bankrupt) and subsequently liquidating them.The relations connected with credit institution insolvency (bankruptcy)prevention that are not regulated by the Insolvency Law are regulated byother federal laws and Bank of Russia statutory acts issued in pursuanceof these laws. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The relations connected with credit institution insolvency (bankruptcy)that are not regulated by the Insolvency Law are regulated by FederalLaw No. 127-FZ, dated October 26, 2002, ‘On Insolvency (Bankruptcy),’and Bank of Russia regulations in cases stipulated by the Insolvency Law.Under the Insolvency Law, a credit institution is considered incapable ofmeeting creditors’ pecuniary claims and (or) making compulsorypayments if it has failed to exercise these duties for 14 days after they aredue and (or) the value of the credit institution’s property (assets) is notenough to allow it to meet its obligations to creditors and (or) makecompulsory payments.The Insolvency Law pays special attention to the bankruptcy preventionmeasures conducted before the revocation of a banking licence. Thesemeasures are as follows: — the financial rehabilitation of the credit institution; — the appointment of the provisional administration to the creditinstitution; — the reorganisation of the credit institution. The legal regulation of the system of measures aimed at anti-moneylaundering and counter-terrorism financing is implemented pursuant toFederal Law No. 115-FZ, dated August 7, 2001, ‘On Countering theLegalisation (Laundering) of Criminally Obtained Incomes and TerroristFinancing’ (hereinafter referred to as the Anti-money Laundering Law).The Anti-money Laundering Law contains criteria for the volume ofoperations subject to mandatory control, lists these operations anddetermines the organisations conducting operations with money or otherproperty that should inform an authorised agency about these operations,which include credit institutions, among other.Taking into consideration that capital may be laundered in manydifferent ways, these organisations are required to conduct internal _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • control for detecting operations subject to mandatory control and otheroperations with money or other property, in regard of which theseorganisations have the suspicion that these operations are conducted withthe objective of money laundering or financing terrorism.The Anti-money Laundering Law also stipulates that the provision to theauthorised agency of information and documents by organisationsconducting operations with money or other property according to theprocedure established by this Federal Law does not constitute a breach ofofficial, banking, tax or commercial secrets.The Anti-money Laundering Law was passed in compliance with theConvention on Laundering, Search, Seizure and Confiscation of theProceeds from Crime, signed in Strasbourg, France, and ratified byFederal Law No. 62-FZ, dated May 28, 2001.To boost public trust in the banking system, stimulate growth inorganised savings and reduce the risks taken by banks when building along-term resource base, Russia passed Federal Law No. 177-FZ, datedDecember 23, 2003, ‘On Insurance of Household Deposits with RussianBanks’.This Federal Law lays down the legal, financial and organisationalprinciples of operating the compulsory household bank deposit insurancesystem (hereinafter referred to as the deposit insurance system),establishes the competence of and the procedure for creating anorganisation performing compulsory deposit insurance functions(hereinafter referred to as the Deposit Insurance Agency), sets theprocedure for paying deposit compensation and regulates relationsamong banks, the Deposit Insurance Agency, the Bank of Russia and thefederal executive power bodies within the deposit insurance system.This Federal Law specifies the following basic principles of building andoperating the deposit insurance system: — the participation in the deposit insurance system is compulsory forbanks; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • — the deposit insurance system serves to mitigate the risk of adverseconsequences for depositors in the event of the banks’ failure to meettheir obligations; — the deposit insurance system is transparent; — the deposit insurance fund accumulates regular insurancecontributions made by the banks participating in the deposit insurancesystem. There are two insured events when an individual is entitled to depositcompensation from the Deposit Insurance Agency: — the revocation (cancellation) of the Bank of Russia banking licencefrom a bank in compliance with the Federal Law on Banks and BankingActivities; — the imposition by the Bank of Russia, pursuant to applicablefederal legislation, of a ban on the satisfaction of bank creditors’ claims. Federal Law No. 96-FZ, dated July 29, 2004, ‘On Bank of RussiaPayments on Household Deposits with Bankrupt Banks Uncovered bythe Compulsory Deposit Insurance System’, was a logical addition to thedeposit insurance system built in Russia. As the establishment of the deposit insurance system created the riskof financial instability for the banks that have not joined this system as aresult of the loss of customer and investor confidence and the eventualoutflow of deposits to the participating banks, this Federal Law extendedto the depositors of the non-member banks guarantees similar to thoseenjoyed by the depositors of the member banks. Under the law,compensation to depositors of the non-member banks is paid from Bankof Russia funds. Thus, the passing of this Federal Law became a major step forward inboosting confidence in the banking system as a whole. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • To ensure the implementation of the single state foreign exchangepolicy and stability of the Russian currency and domestic foreignexchange market, which are the factors of the country’s economicprogress and successful international economic cooperation, Russiapassed Federal Law No. 173-FZ, dated December 10, 2003, ‘On ForeignExchange Regulation and Control’ (hereinafter referred to as the ForeignExchange Regulation Law).The Foreign Exchange Regulation Law defines foreign exchangeoperations. In addition, it separates the powers of the federal governmentand the Bank of Russia relating to the regulation of foreign exchangeoperations.On January 1, 2007, the restrictions on foreign exchange operationsbetween residents and non-residents (the requirements that suchoperations are routed through special accounts and that a certain amountof money is deposited when foreign exchange operations are conducted,the prohibition to buy domestic securities for foreign currency, thepreliminary registration of a resident account (deposit) opened with abank outside Russia and the compulsory sale of a part of foreign currencyearnings) were lifted.Residents and non-residents may now make settlements on operationswith domestic and foreign securities in rubles or foreign currency.At the same time, the Foreign Exchange Regulation Law (Article 11)retains the requirement that foreign exchange and cheques, includingtraveller’s cheques, denominated in foreign currency are bought throughauthorised banks only.To boost the domestic foreign exchange market and prevent capital flightfrom Russia, the Foreign Exchange Regulation Law retains therequirement for residents to repatriate foreign and domestic currency(Article 19).Federal Law No. 218-FZ, dated December 30, 2004, ‘On Credit Histories’,has an important role to play in arranging credit relations and building amodern economy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The purpose of this Federal Law is to create and legalise conditions forthe compiling, processing, storage and disclosure by credit bureaus ofinformation about how borrowers meet their obligations under loan(credit) agreements, give creditors and borrowers more protection byreducing overall credit risk and enhance the efficiency of creditinstitutions.The Federal Law on Credit Histories is designed to allow banks to cutcosts when assessing their borrowers’ creditworthiness and, consequently,reduce the price of loans they extend.A major role in implementing this Federal Law is played by the Bank ofRussia, whose division, the Central Catalogue of Credit Histories,performs the function of a single information centre informing users freeof charge in what credit bureau they can find information about anindividual credit history maker.In addition to the borrowers, creditors and the Central Catalogue ofCredit Histories, the credit bureaus participate in the exchange ofinformation about how borrowers meet their obligations to creditors.The principal objective of the credit bureaus is to accumulate informationcharacterising the borrower’s payment discipline in regard of thefulfilment of the loan (credit) agreements and eventually this informationforms the credit histories of legal entities and natural persons, which maybe subsequently passed to the persons who have received permission toget a credit report for the conclusion of a loan (credit) agreement.Measures to be implemented by the Bank of Russia to upgradethe banking system and banking supervision in 2012 and in 2013and 2014In order to upgrade the banking system and banking supervision in2012-2014, the Bank of Russia will focus on implementing measuresstipulated by the Strategy of Russian Banking Sector Development until _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • 2015 that are intended to increase the quality of banks’ activity andmaintaining the stability of the Russian banking sector.The banking sector will face increased competition (both intrasectoraland intersectoral) in the most lucrative segments of the banking servicesmarket.This will lead credit institutions to raise their capitalisation.The consolidation of the banking sector is also expected to intensify, andnew, larger banking structures will emerge.At the same time, the diversification of the banking business and bankingincome will develop further, including as a result of the introduction ofnew technologies and the improvement of bank risk management andbanking regulation.Measures will be taken to reduce risk concentration, including riskconcentration per borrower (or group of related borrowers), investment,area of activity, and industry. Banks are expected to develop bankingproducts that generate an income from fee in order to keep their incomesstable.Credit institutions will pay close attention to the development of theirlong-term resource base, in which household deposits will play anincreasingly important role.These trends are expected to improve the accessibility of bankingservices both for individuals and organisations.Tougher competition and measures to develop banking regulation andbanking supervision will increase transparency and market discipline inthe banking sector.As a result, credit institutions will increasingly focus on their long-termperformance, make more rational decisions and build effectivemanagement systems, including risk management systems. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • As part of its efforts to improve banking regulation and bankingsupervision, the Bank of Russia will continue in 2012-2014 its work to raisethe quality of bank capital and assets, limit the level of risks, including thelevel of their concentration, and increase the reliability of creditinstitutions’ accounting and reporting.The development of substantive risk-based approaches that take thedomestic and international experience into account will be a keyinstrument in the sphere of banking regulation and banking supervision.Measures to improve banking supervision and increase its qualityenvisage: - identifying bank risks, taking into account the prospects of the economy and the financial sector, and developing an early response system; - using differentiated approaches to supervision, taking into account the systemic importance, profile and level of risks, and also the level of credit institutions’ transparency; - carrying out supervisory measures to reduce risk concentration, including exposure to affiliated parties; - developing supervision on a consolidated basis; - developing cooperation with government regulatory and control agencies, including foreign supervisors, in order to exchange information.Measures are envisaged to develop a system of control to be exercised bythe Bank of Russia’s head office over the situation in the banking sector,especially at systemically important credit institutions.The Bank of Russia considers it necessary to create legislativefundamentals in Russia for introducing all the standards of bankingregulation and banking supervision established by the Basel Committeeon Banking Supervision (BCBS).These include legislation empowering the Bank of Russia to setrequirements for credit institutions’ corporate governance, risk and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • capital management systems, to exercise consolidated supervision, to useprofessional judgment in supervisory practices, and also to definedisciplinary action against members of executive bodies and boards ofdirectors (supervisory boards) for faults in the activity of their creditinstitutions.In order to implement the provisions of Basel II, the Bank of Russia willcarry out work in 2012-2014 to draft banking regulation and supervisoryrules envisaging approaches to credit risk assessment based on internalratings.The Bank of Russia will also cooperate with credit institutions in draftingand introducing internal capital adequacy assessment procedures.In order to introduce new international requirements for capital qualityand adequacy and maintain the required level of liquidity as stipulated bythe BCBS documents adopted in 2010 (Basel III) and supported by theG20 leaders at their summit in Seoul in November 2010, the Bank ofRussia intends to take the following measures: - make amendments to the regulations to review the structure of regulatory capital and introduce requirements for the adequacy of capital components; - set requirements for building capital buffers, introducing the leverage indicator defined as the ratio between capital and the total value of assets and off-balance sheet items that are not weighted by risk; - introduce two liquidity ratios: the short-term liquidity coverage standard defined as the ratio of liquid assets to net cash outflow over the next 30 calendar days in a market stress scenario, and the net stable funding standard determined as the ratio of available reliable sources of funding with a maturity of at least one year to the required amount of stable funding in a stress scenario.In 2013-2014, the Bank of Russia will define approaches for banks tocreate the counter-cyclical capital buffers as an instrument to limitsystemic risks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In order to implement these approaches, additional indicators of riskgrowth in the Russian financial system are intended to be developed.Measures are planned in 2012-2014 to work out criteria for classifyingbanks as systemically important, and also define regulatory requirementsfor their activity, taking into account the proposals developed by theBCBS jointly with the Financial Stability Board (FSB) for global sys-temically important financial institutions.While developing corresponding criteria for Russian banks, the Bank ofRussia will take into account the specifics of the domestic market forbanking services, and also the work being carried out by the BCBS andthe FSB to adapt the proposed approaches to the regulation of nationalsystemically important banks.With regard to international recommendations on compliance with FSBprinciples and standards relating to compensation (remuneration), theBank of Russia will implement them taking into account the specificrequirements of national legislation.In order to reduce the administrative burden on banks, measures areplanned to unify supervisory requirements for the sustainability of creditinstitutions and the requirements for their participation in the depositinsurance system by making corresponding amendments to legislation.In order to increase the transparency of Russian credit institutions, theywill be required to disclose information to the public on the qualificationsand work experience of their top managers.Measures will be required to statutorily establish the duty of shareholdersand persons exerting indirectly (through third parties) material influenceon decisions taken by the credit institutions’ management bodies,including third parties, to provide information to credit institutions forthe disclosure of the ownership structure. These would include caseswhere the shares of credit institutions are kept by nominal holders. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Measures are planned to further develop the legislative framework ofcredit institutions’ affiliated parties to increase the transparency of theownership structure of credit institutions.In particular, it will be necessary to stipulate the duty of all affiliatedparties of credit institutions to provide information on them and be heldresponsible for their failure to comply with this requirement.Work will be continued to legislatively improve merger and acquisitionprocesses.Amendments will be made to the legislation to stipulate a possibility forlegal entities (including credit institutions) with different forms of incor-poration to participate in the reorganisation of credit institutions, whichwill give an additional stimulus to raise their capitalisation through re-structuring.The policy towards integration into the world financial market should beconducted taking into account national interests, the real level ofdevelopment and the competitiveness of the Russian banking sector.The ban on opening foreign bank branches will remain as a necessarymeasure for maintaining the competitiveness of Russian banks in thedomestic market for banking services and the Bank of Russia willcontinue its participation in drafting the corresponding federal law.The Bank of Russia will participate in work to draft laws aimed atproviding additional protection for creditors and consumers of financialservices, including the improvement of the law on pledge and thedevelopment of legislation on consumer credit.At the same time, work will continue to implement measures forimproving the financial literacy of the population with respect to banking.Measures to increase the transparency of credit institutions as a result ofthe use of International Financial Reporting Standards (IFRS) in their _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • activities are an important step towards raising the efficiency of thebanking sector and boosting clients’ confidence in banks.With this in mind, these tasks should be resolved through theimplementation of Federal Law No. 208-FZ, dated 27 July 2010, ‘OnConsolidated Financial Statements’, under which credit institutions arerequired to draw up, submit and publish consolidated financialstatements.For its part, the Bank of Russia considers it necessary to encourage creditinstitutions to be conservative enough in making fair value measurementsunder the IFRS standards and, if necessary, will use banking regulationand supervisory powers to adjust the measurements, proceeding fromprudential approaches.The Bank of Russia will further study approaches and measures formaintaining the systemic stability of the banking sector.The Bank of Russia will continue to upgrade its macroprudential analysistools by calculating banking sector financial soundness indicators,among other things, and posting them on the IMF website, and to assesssystemic risk by conducting stress tests.In order to better protect the banking system and credit institutions’creditors, including bank depositors, and reduce the risks of abuses bycredit institutions’ managers and owners, work will continue to improvethe mechanisms of liquidation procedures at banks.These measures will include the assignment of criminal responsibility tothe heads of credit institutions, and also persons responsible foraccounting and other records, for deliberately entering false data intodocuments regulating civil rights and duties, accounting and otherrecords and reports on the economic activities of a credit institution, andalso for making corrections that distort the substance of these documents,if these actions are taken in pursuit of personal gain or in one’s personalinterest and inflict damage on citizens, organisations or the state. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In the course of inspections, which the Bank of Russia will conduct in2012-2014, special at tention will be paid to the inspection of credit in-stitutions of systemic importance to the banking sector of the RussianFederation and its regions, along with the inspection of credit institutionsthat conduct highly risky operations and credit institutions that are nottransparent enough.The inspections will focus on assessing bank risks (credit and marketrisks, liquidity and concentration risks, including risk concentration onthe owners’ business), the systems of their management, and theidentification of doubtful transactions.In order to achieve the best results in the inspection of credit institutions(their branches), the Bank of Russia will continue the on-goingmonitoring of the process of arranging and holding inspections and thecoordination of work for conducting these inspections. Special attentionwill be paid to formulating risk-based assignments for the inspections ofcredit institutions.The improvement of the inspection organisation’s structure, whichenvisages measures to centralise the Bank of Russia’s inspecting activityby 2014, will help make inspections more effective.Regulatory support for inspections will be improved, taking into accountinternationally-accepted approaches, and the Bank of Russia’s measuresto implement the Strategy of Russian Banking Sector Development until2015.The Bank of Russia is legislatively empowered to set requirements forcredit institutions to develop internal control procedures to prevent thelegalisation (laundering) of criminally obtained incomes and thefinancing of terrorism.In light of this, special attention will be paid to risk-based approachesused by credit institutions to identify customers, their representatives,beneficiaries, and also to monitor operations for the provision of servicesto customers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • –participate in carrying out a plan to create an international financialcentre in Moscow; –participate, jointly with the Federal Financial Markets Service, inimproving approaches towards regulating the activity of clearing or-ganisations and central counterparties; – participate in upgrading the legislation regulating depositoryactivities, and recognise the concept of a foreign nominal holder; – participate in upgrading the legislation regulating the organisationof exchange trade; – make arrangements for the inclusion of the Russian rouble insettlement currencies of the Continuous Linked Settlement (CLS) system; – participate, jointly with the Ministry of Finance, in efforts to furtherliberalise the government securities market by making amendments toBank of Russia’s regulations and other instructions allowing theplacement and circulation of government securities on stock exchangesin accordance with their rules; – participate in upgrading the legislation to define the status of theprecious metal account; – participate in upgrading the legislation regulating the terms andconditions of the issue and circulation of the certificates of deposit andsavings certificates. – improve the legislative and contractual base regulating repotransactions in the Russian market. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Measures to be implemented by the Bank of Russia to improvethe Russian payment system in 2012 and in 2013 and 2014In 2012-2014, the Bank of Russia will carry out measures to develop andupgrade the Russian payment system for the purpose of ensuring thestable functioning of Russia’s financial system.The Bank of Russia will take measures to implement Federal Law No.161-FZ, dated 27 June 2011, ‘On the National Payment System’.In particular, work will be carried out to draft a Strategy for theDevelopment of the National Payment System stipulating measures toensure the stable functioning of the national payment system, increase itseffectiveness and competitiveness, improve the Bank of Russia paymentsystem, develop infrastructural and intersystem interaction betweenparticipants in the national payment system, and also enhanceaccessibility and the security of payment services, including with the useof innovative payment instruments.In order to follow up with this federal law, the Bank of Russia will developregulations in 2012 to cover the following areas: –the regulation of the Bank of Russia payment system; – the regulation of payment systems, as well as supervision andoversight in the national payment system; –measures to ensure the smooth operation of payment systems andinformation protection (security) in money remittances.In order to ensure the development of the national payment system, theBank of Russia will participate in the work of the Technical Committeeon Financial Operations Standards to continue creating a nationalstandard of cashless settlements based on the ISO 20022 methodologyand introducing it into the national payment system. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Basic measures to develop the Bank of Russia payment system will focuson improving the Bank of Russia system of real-time gross settlements(BESP).It will especially focus on expanding settlement services provided tocredit institutions, as well as financial market participants, the FederalTreasury and Bank of Russia divisions, including a broader format of theBESP system operation.It will also increase the operational efficiency and automation of intradayliquidity management procedures.The implementation of these measures will create conditions for loweringthe risks and costs incurred by payment system participants. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Importance of StrongRisk Management: InsightsFrom The ExaminationWorldBy Jason C. Schemmel, Community and Regional supervisory examinerwith the Federal Reserve Bank of RichmondIntroductionIn 1995, the Board of Governors of the Federal Reserve System issued SR95-51, which instructed examiners to begin assigning a formal supervisoryrating to the adequacy of an institution’s risk management processes.Examiners had always emphasized the importance of sound riskmanagement processes, but this guidance heralded an era of heightenedawareness in light of new technologies, product innovation and rapidlychanging banking markets.Examiners continue to assess and consider factors such as profitability,asset quality and capital adequacy when assigning supervisory ratings,but these indicators, to a large degree, tell a story about the past.At the heart of risk management is the concept of looking toward thefuture, as being able to identify, measure, monitor and control risksbefore they spread is critical to the conduct of safe and sound banking,regardless of the size and complexity of the institution.Analysis of banking performance during the recession of 2007–2009indicates that banks with strong forward-looking risk mitigationstrategies weathered the recession more successfully than other banks,even those taking identical risks (see “Weathering the Storm: A CaseStudy of Healthy Fifth District State Member Banks Over the RecentDownturn” in the summer 2012 edition of S&R Perspectives).These successful institutions all possessed the key elements of a riskmanagement framework, including: - An active board of directors and senior management team _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • - Policies, procedures and risk limits governing all activities that are clearly communicated throughout the organization - Timely and accurate management information systems (MIS) - Strong internal controlsTo understand the risk management challenges currently facing our statemember banks, we asked key members of the Federal Reserve Bank ofRichmond’s Community and Regional (C&R) management team toidentify areas that are(1) Consistently cited in reports of examination as risk managementweaknesses or(2) Expected to receive heightened attention in the near future. Thisarticle reinforces existing supervisory guidance and expectations anddiscusses the most commonly cited examination issues related to themanagement of credit, liquidity, market, operational, and legal andreputational risks.Properly addressing these matters will improve the prospects of early riskdetection and help to prevent losses.Credit RiskC&R relationship managers and subject matter experts alike expressedconcern over three areas: new product lines, home equity lines of credit(HELOC) and appraisal review.New Product LinesInterviews with bankers during examinations over the previous 12–24months revealed that many management teams and boards of directorsintend to reduce future reliance on real estate lending by expanding intocommercial lending.The number of bankers that stated this intention is striking and indicatesthe potential for fierce competition for commercial business. In fact, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • several banks have reported recent solicitations from third partiesattempting to negotiate participation in syndicated commercial loans.Prior to expanding into commercial lending, or any new product line, itwill be critical for banks to properly research the product and ensure italigns with the bank’s strategic plan and the risk appetite of the board ofdirectors.Banks that venture into commercial lending are expected to have theappropriate expertise on staff to underwrite and monitor the credits.Moreover, the lending staff must be guided by robust policies, proceduresand risk limits.As was the case in the late 1990s, intense competition for commercial loancustomers often leads to significant easing of both loan terms andfront-end financial analysis.Discipline was — and will be — a key success factor.Existing supervisory guidance stresses: - The importance of using formal forward-looking analysis in the loan approval process - The value of assessing alternative or “downside” scenarios - The dangers of unduly weighting the short-term benefit of attracting or retaining customers through price concessions while giving insufficient consideration to potential longer-term consequences1Additionally, exceptions to approved underwriting and pricing policiesshould be rare, properly approved, aggregated and actively monitored bysenior management.HELOCsThere is considerable concern among C&R credit risk specialists that,unlike many other real estate loans, the losses in HELOC portfolios haveyet to fully materialize. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Many of the loans originated from 2003 to 2007 are approaching the end oftheir draw periods and will soon convert from interest-only to amortizingloans or have principal due as a balloon payment.Observations from recent examinations indicate that banks withsignificant concentrations of HELOCs have not fully identified andmeasured the potential impact of these events.Institutions with significant exposure to HELOCs should ensure thatthey are adhering to effective account management practices.These include: - Periodically refreshing credit scores on customers - Periodically assessing utilization rates - Periodically assessing payment patterns, including borrowers who make only minimum payments or those who rely on the line to keep payments current - Using reasonably available tools to determine the payment status of senior liens associated with junior liens - Obtaining updated information on the collateral’s value when market factors indicate a deterioration in value since origination or when the borrower’s payment performance deterioratesMeasurement of this data will allow bankers to identify customers whomay default when loan terms change and facilitate the creation ofeffective workout solutions.Data procured from this analysis should also be incorporated into theinstitution’s allowance for loan and lease losses (ALLL) methodology.Appraisal ReviewExaminers continue to observe appraisal review practices that areinconsistent with supervisory guidance. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Too often, appraisal reviews only consist of checklists used by thereviewer to determine compliance with federal regulations.While determining compliance with regulations is surely critical, it ismerely one aspect of the appraisal review process.Just as important is an evaluation of whether the methods, assumptionsand data sources in the appraisal (or evaluation) are appropriate andwell-supported.An institution’s policies and procedures for reviewing appraisals andevaluations should address, at a minimum, the following:Staff members who review appraisals and evaluations should beindependent of both the property being valued and the loan productionstaff.Reviewers should also possess the requisite expertise to perform a reviewcommensurate with the level of risk and complexity in the transaction.The depth of review should be appropriate for the risk and complexity ofthe transaction and property, but always be sufficient to ensure themethods, assumptions and conclusions within the appraisal andevaluation are reasonable and well-supported.Staff within the institution should have clear written guidance on how toresolve deficiencies uncovered during a review.All reviews should be thoroughly documented and placed withinappropriate credit files.Liquidity RiskAll financial institutions, regardless of size and complexity, should have aformal contingency funding plan (CFP) that clearly sets out the strategiesfor addressing liquidity shortfalls in emergency situations.C&R relationship managers indicated that most banks have institutedsome form of CFP; however, many banks continue to struggle with thedetails. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • In general, the CFPs reviewed during examinations do not adequatelyaddress a sufficient range of liquidity stress events.The narrative section of the CFP should contain a thorough description ofany liquidity event — or combination of events — that could adverselyimpact the bank’s liquidity.The events may be institution-specific or arise from external factors.Examples include, but are not limited to, the inability to fund assetgrowth; the inability to renew or replace a maturing funding source;unexpected deposit runoff; or financial market dislocations.Additionally, CFPs frequently are not robust enough with regard to thevarious stages and levels of stress severity that can occur during acontingent liquidity event.The narrative section should fully describe the stages of each event, itsseverity and its expected duration.Stress events should be modeled with sufficient severity to providemanagement and the board of directors with enough information toascertain the durability of the bank’s liquidity position.Moreover, the duration of the event is a critical factor in accuratelymeasuring potential funding gaps and available funding sources.Some events may be temporary while others may be longer-term.In either case, the event should ultimately be modeled through itsconclusion.Designing the CFP in this fashion affords the opportunity to identifyearly-warning indicators for each stage, assess potential funding needs atvarious points in a developing crisis and specify action plans.Market RiskProper measurement of market risk requires regularly assessing thereasonableness of assumptions that underlie an institution’s exposureestimates. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • C&R subject matter experts have observed repeated weaknesses in threeareas related to model assumptions: documentation, sensitivity testingand corporate governance.Key model assumptions such as asset prepayments, nonmaturity depositprice sensitivity and deposit decay rates are often unsupported andundocumented.Inputs for these assumptions typically have a material impact on themodel’s output; therefore, it is critical to ensure they are accurate.Assumptions should be specific to the bank and based on an appropriatelevel of empirical evidence.The decisions made and the rationale behind them should then bethoroughly documented.To aid in determining which assumptions exert the greatest impact onmeasurement results, banks should periodically perform sensitivitytesting.Doing so will provide valuable insight into how to allocate scarceresources, i.e., the most critical assumptions should be given the mostattention. When actual experience differs significantly from pastassumptions and expectations, institutions should use a range ofassumptions to appropriately reflect this uncertainty.Finally, banks should develop a comprehensive governance system foractively monitoring and regularly updating key underlying assumptions.This system should include oversight by representatives from any majorbusiness line that can directly or indirectly influence the bank’s marketrisk exposure.Deliberations from these meetings and the rationale behind changes tokey assumptions should be thoroughly documented in meeting minutes. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Operational RiskC&R operational risk specialists have identified two areas of concern astechnology is increasingly integrated into the business of banking:information security and vendor management.Information SecurityOne of the most common operational risk deficiencies cited duringexaminations over the last 18 months relates to information security.It remains a challenge for all banks, regardless of size, because of thecomplex interconnectivity between the bank, its customers and itsvendors.The proliferation of mobile devices and electronic payment channels hasincreased the opportunities for hackers to compromise bank systems andsteal critical data.Therefore, strong internal controls surrounding access management areessential, including a robust risk assessment process; effectiveprocedures for administering, logging and monitoring critical systems;and independent validation of controls through audits or penetrationtesting.Vendor ManagementNot surprisingly, the increase in technological banking solutions has ledto an increase in outsourcing.The scope of activities outsourced, however, has not been limited totraditional activities such as core processing and now may includeinterest rate risk modeling, stress testing or loan loss mitigationstrategies.Recent examinations indicate that vendor management practices areoften not keeping pace with the growing volume and scope ofoutsourcing activities, particularly in the areas of due diligence andservice provider oversight. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Due diligence prior to engagement should fully consider the provider’sability to meet the institution’s needs.Institutions should consider the provider’s technical and industryexpertise, operations and controls, and financial condition.Once a contract has been signed, the institution must implement anoversight program to monitor each service provider’s controls, conditionsand performance.The oversight program should be commensurate with the risk of theoutsourced relationship and be thoroughly documented for use in futurecontract negotiations, termination issues and contingency planning.Legal and Reputational RiskFinally, C&R operational risk specialists expressed concern with theproliferation of social networking platforms and their potential effect onbanks’ legal and reputational risks.A social networking service is an online service, platform or site thatfacilitates the building of social relations among people who sharecommon interests, activities or relationships.Their use has exploded as companies attempt to reach customers withadvertising and to generate business intelligence for future sales orcustomer service.Social networks pose several risks to banking organizations, including thepotential disclosure of nonpublic personal information (NPI),disinformation or derogatory information, and security threats such asviruses or social engineering.Any of these or similar events could result in significant lawsuits ordamage to the institution’s reputation.Banks are encouraged to develop sound social connectivity policies thatgovern the use of social media by employees and to provide adequatetraining to employees on those policies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The use of social media should also be considered in the institution’sinformation technology risk assessment.ConclusionThe current recession has been longer and deeper than any since theGreat Depression, and institutions facing severe earnings pressures maybe tempted to reduce resources dedicated to risk management.But evidence suggests that strong risk management, not historicalfinancial performance, is the common denominator of successfulcommunity banks.Institutions should remain vigilant in order to identify risks that couldnegatively affect the bank and take appropriate action to measure,monitor and control them. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Regulatory reform: getting it doneRemarks by Mr Stefan Ingves, Governor of SverigesRiksbank and Chairman of the Basel Committee onBanking Supervision, at the 17th InternationalConference of Banking Supervisors, IstanbulIntroductionGood morning and welcome to the 17th International Conference ofBanking Supervisors.Let me start by thanking our hosts - the Central Bank of the Republic ofTurkey and the Turkish Banking Regulation and Supervision Agency.I would like to thank in particular Governor Erdem Başçi, ChairmanMukim Öztekin and of course the staff of both organisations for doingsuch an outstanding job of hosting this ICBS.We have benefited tremendously from your presence on the Committeesince 2009 and we look forward to returning to this historic city for futuremeetings and conferences.Finally, let me thank Deputy Prime Minister Ali Babacan for hisinsightful remarks.This ICBS will focus on the challenges we are facing to improvesupervisory practices, building on what we have learned in the recentpast.The starting point for such improvements and the foundation of all banksupervisory frameworks is the Core Principles for Effective BankingSupervision, which will be the topic of discussion on this first day of theICBS.We have also organised several panel and workshop discussions toexamine and debate the most recent policy responses to the financialcrisis and other supervisory and market developments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • A critical aspect of these policies is their full and timely implementationand we will have the opportunity to discuss the challenges that arise inthis regard.The conferences themesLet me say a few words about these two main topics. In conducting its review of the Core Principles, the Committee hassought to raise the bar for banking supervision by incorporating thelessons learned from the crisis and other significant regulatorydevelopments.At the same time, we have remained mindful of the fact that the CorePrinciples are applied on a global basis and that we need to maintaincontinuity and comparability.Given the worldwide application of the Core Principles, it is of utmostimportance that the revisions we have made are well understood andimplemented with, at a minimum, the same rigour as the previous set ofprinciples.The two co-chairs of the Basel Committee group that was responsible forthe revisions - Sabine Lautenschläger of the Deutsche Bundesbank andTeo Swee Lian of the Monetary Authority of Singapore - will co-chair apanel discussion on the revised Core Principles.This is a topic of great relevance for all of us, so I know this discussionwill be of great interest to everyone here.Regarding policy responses to the financial crisis - the second theme ofthe ICBS - there is always a danger of believing we have learned "all thereis to learn" or that "this couldnt happen to me".On the one hand, the root causes of financial crises are always very similaralthough they can differ in their manifestation.For example, in my own country - Sweden - and in many other countriesaround the globe, I have seen different crises evolve and one common _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • element has been excessive credit extended by banks that did not fullyappreciate the risks.On the other hand - and I can tell you this from first-hand experiencehaving been through too many financial crises for my liking -overconfidence and supervisory complacency are extremely dangerousand we must continually be alert to guard against these risks.Tomorrows workshops and panel discussion on what the crisis hastaught us are indeed timely.While a single day is not sufficient to address all of our challenges, thereflections of an impressive cast of speakers will offer a wide range ofdifferent perspectives on topical issues.These issues include: 1. The implications of non-financial sector leverage for banks and bank supervision; 2. Basel III implementation; 3. Liquidity standards and risk management; 4. Corporate governance, disclosure and transparency; and 5. Systemically important banks.The common thread here is the universal applicability of the lessons wehave drawn.The relevance of these topics is not limited to only certain jurisdictions ortypes of banks.Some will call this "back to basics" and rightly so.The label we choose to apply is not important; what is important is thatwe get the regulation right and that we are diligentin implementing ourstandards. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Committees work on implementation Having learned this lesson, the Committee now devotes considerableresources to monitoring implementation of the rules and standardsagreed by its members.Our work no longer stops once we issue a press release announcing newregulatory standards.From the Basel Committees perspective, one of the most enduringlessons we as supervisors have learnt is that full, timely and consistentimplementation is not a bonus - it is an imperative. So what have we done to put this commitment into practice? Almost oneyear ago, the Committee agreed on a process and framework to reviewmembers implementation of Basel III.The review framework is intended to provide additional incentives formember jurisdictions to fully implement the standards within thetimelines agreed.Let me briefly review its key elements.There are three levels of review:The first level is the timely adoption of Basel III. We have been regularlyreporting on member countries progress in implementing rules in theirlocal jurisdictions in accordance with agreed timetables.The second level is to ensure consistency of domestic regulations with theinternational minimum requirements. This is a line-by-line review of localrules with the Committees standards, conducted by teams of peersupervisors.The third level of review consists of an analysis of the outcomes of theBasel III implementation.It extends the first two levels of analyses to supervisory implementation atthe bank level. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • One cannot overstate what a significant step this is, as we for the first timehave teams of global supervisors travelling to individual banks andcomparing notes at a very detailed level across borders.This, more than anything, is symbolic of the big step the Committee istaking to get implementation right.Perhaps most importantly, the results of this work will be public, so therewill be complete transparency for all about how our rules are beingapplied in practice.In the past year, the Committee has published two standalone reportsdetailing its members progress in adopting the Basel III rules and wehave also prepared a report to the G20 Leaders that provided an update onimplementation.In a couple of weeks, we will issue Level 2 assessment reports for the firstthree jurisdictions under review: the European Union, Japan and theUnited States.Our next assessment will soon begin and this will review SingaporesBasel III rules; this will be followed by reviews of Switzerland and China.We are currently conducting Level 3 assessments on the calculation ofrisk-weighted assets and expect to publish our findings around the end of2012.The revised Core Principles and the Basel III rules were designed toachieve safer and sounder financial systems, whether big or small,complex or not.After considerable consultation with supervisors, bankers and otherinterested parties from around the world, the rules and standards havebeen developed and now need to be put into practice.Financial stability issues know no borders.We are keenly aware that the roots of the recent financial crisis arereplicable anywhere in the world and we know that risk will flow towherever it is underpriced. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • We know - and I have seen first-hand from my days at the IMF - that therisk of cross-border contagion rises exponentially with an increase incross-border banking activity and increasingly international financialmarkets.Our global banking foundation is therefore much firmer when we acttogether in implementing sound prudential standards.In that regard, I would like to spend a few minutes updating you on theCommittees current and future work agenda for developing regulatorystandards.Current and future agenda I will start with the global liquidity rules, which are a much debatedtopic.The Basel III liquidity framework, which was published in December2010, forms an essential part of the Basel III package and continues to beone of the most important items on the Committees agenda.When we published the rules, the Committee said it would carefullyassess whether there would be any unintended consequences.Some banks told us this careful approach has given rise to unnecessaryuncertainty and has hindered their efforts to work toward managing to thenew standards.The Committees governing body of Central Bank Governors and Headsof Supervision therefore directed the Committee to finalise any revisionsaround the end of this year and we are on track to deliver.The Basel III liquidity rules represent the first ever global framework toensure a bank maintains an adequate stock of liquidity and operates witha prudent funding structure.The Committee is therefore taking a careful and deliberate approach toreviewing the rules.But let me remind you that our goal is to raise the bar. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • It is designed to have an impact on banks and markets: that is notunintended.The rules are already having the desired effect as we have seen animprovement in risk management and in liquidity at many banks.In Sweden, for example, the four major banks all had liquidity coverageratios below 100% when they started reporting their LCR.They have since improved their liquidity management and positions andcurrently all four meet the new standards.OTC derivativesI would also like to say a few words about another of the Committeeshigh priorities and this relates to the broader global reform forover-the-counter derivatives markets.The financial crisis exposed major weaknesses of OTC derivativesmarkets, namely counterparty credit risk and a lack of transparency andthe attendant effects of contagion risk and spillover.A package of reforms agreed by the G20 Leaders aims to address thesedeficiencies, for example, by moving OTC trades towards centralclearing.The Basel Committee plays a key role in ensuring that banks adequatelycapitalise counterparty credit risk exposures, whether those exposuresrelate to other banks or to central counterparties (CCPs).For example, in December 2010 we published enhanced capital rules forbank exposures to counterparty credit risk arising from non-centrallycleared derivatives.More recently, we issued interim capital rules for bank exposures toCCPs.These rules will both take effect at the start of next year although workwill continue over the course of 2013 to ensure that the capitalisation rulesfor bank exposures to CCPs reflect risks in an appropriate manner and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • provide incentives for banks to move derivatives trades towards centralclearing.Another OTC derivatives market reform in which the Committee isinvolved is the development of global standards on margin requirementswhich are intended to mitigate contagion and spillover effects.A consultative paper on this topic was published in July and we hope thiswork, which is being conducted in collaboration with other standardsetters, will lead to updated proposals that we can consider by the end ofthis year.SecuritisationAllow me to say a few words about the Committees ongoing work relatedto the regulatory treatment of securitisations, on which we will soonpublish a consultative proposal.The performance of securitisation exposures and the central role theyplayed during the recent financial crisis were a key motivation for theCommittee to perform a broader review of its securitisation framework forregulatory capital requirements.Our objectives are to make capital requirements more prudent andrisk-sensitive; to mitigate mechanistic reliance on external credit ratings;and to reduce cliff effects.The Committee is well aware of the trade-off between the risk posed bysecuritisation and its function as an important tool for bank funding andliquidity.Now that there are signs of revival of the securitisation markets, it isimportant to finalise prudent and risk-sensitive solvency rules forsecuritisations as soon as possible.Fundamental review of the trading bookThe Committees proposals to revamp the securitisation framework are assweeping as our fundamental review of the trading book rules. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The Basel 2.5 modifications adopted in 2009 resulted in a substantialincrease in capital requirements for certain securitisations and structuredcredit products.But these modifications were largely built on the existing regulatorydefinitions and framework.At around the same time, the Committee commenced a fundamentalreview of trading book capital requirements.That review resulted in the publication of a conceptual paper this pastMay.That paper set out a revised market risk framework and proposed anumber of specific measures to improve trading book capitalrequirements.These proposals reflect the Committees increased focus on achieving aregulatory framework that can be implemented consistently bysupervisors and which achieves comparable levels of capital acrossjurisdictions.The consultation period ended last week.Once the Committee has reviewed the responses it has received, itintends to release for comment a more detailed set of proposals to amendthe Basel III framework.We also plan on conducting a quantitative impact study based on thoseproposals.Global and Domestic Systemically Important Banks In the time remaining, I would like to say a few words about theCommittees work with respect to global and domestic systemicallyimportant banks.Last year, the Basel Committee issued final rules for global systemicallyimportant banks (G-SIBs), which were endorsed by the G20 Leaders attheir November 2011 meeting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • The G20 Leaders also asked the Committee and the Financial StabilityBoard to work on extending the G-SIFI framework to domesticsystemically important banks (D-SIBs). G-SIBs will be subject to an additional loss absorbency requirement overand above the Basel III requirements that are being introduced for allinternationally active banks.This additional requirement is intended to limit the cross-border negativeexternalities on the global financial system and economy associated withthe most globally systemic banking institutions.But similar externalities can apply at a domestic level: indeed, from adomestic perspective, they can be even larger.While not all D-SIBs are significant from a global perspective, the failureof such a bank could have a much greater impact on its domesticfinancial system and economy than that of a non-systemic institution.Against this backdrop, the Basel Committee has developed a set ofprinciples on the assessment methodology and the higher lossabsorbency requirement for D-SIBs.The proposed framework takes a complementary perspective to theG-SIB framework by focusing on the impact that the distress or failure ofbanks will have on the domestic economy.However, the proposed D-SIB framework will take a principles-basedapproach, in contrast to the prescriptive approach of the G-SIBframework.This will allow an appropriate degree of national discretion in theassessment and application of policy tools in order to accommodate thestructural characteristics of individual jurisdictions.The D-SIB principles, which will be published in the coming weeks,require countries to adopt a framework for assessing the systemicimportance of their banks on a domestic basis by January 2016. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • This is consistent with the phase-in arrangements for the G-SIBframework and means that national authorities will establish a D-SIBframework in advance of that deadline.The Basel Committee will introduce a strong peer review process for theimplementation of the principles. This will help ensure that appropriateand effective frameworks for D-SIBs are in place across differentjurisdictions.Simplicity in our rulesI will finish my review of the Committees current work by saying a fewwords about a topic that pervades our current efforts - and that issimplicity.Basel III, with its straightforward, non-risk-based measure of capital toassets and the frameworks rules for a streamlined capital structure aretwo good examples.This mindset has become ingrained in other efforts, such as theCommittees current review of the securitisation framework and theoperational risk framework.More broadly, the Committee is also reviewing the broader Baselframework to determine whether the rules strike the appropriate balancebetween regulatory complexity and risk sensitivity.The aim of this work is identify areas where we could reduce the level ofcomplexity or where comparability could be improved.Special acknowledgmentBefore concluding, let me make a special acknowledgement of someonewho very well may be the most widely known person in the room today,and who is attending the ICBS for the last time.As many of you know, Jonathan Fiechter will be retiring from the IMF ina month or so, and I would be remiss if I did not acknowledge the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • significant contribution he has made to the work of the Basel Committee,its working groups, regional groups of banking supervisors and nationalsupervisors themselves.Even though he is currently not a supervisor himself, he has beenunfailing in his support of effective regulation and strong supervision. So,Jonathan, on behalf of everyone here, we thank you and wish you the verybest for the future.ConclusionLet me bring my remarks to a close as we have a stimulating programmeahead of us and, therefore, I will not keep you waiting.The Basel Committee is leading on two very important efforts: the first isto fine-tune the regulatory framework and develop policy responses thatfirstly respond to the lessons of the crisis, and then keep pace as marketsand institutions evolve.The second is ensure that the agreed-upon policy responses areimplemented fully, consistently and globally.That is the reality check.We believe, as do the G20 Leaders, that these reforms are the right onesfor making progress towards improved financial stability, growth andsustainable economic development.With this in mind let us make sure that the discussions today andtomorrow are fruitful and will help you and your organisations achievethese important goals.NotesStefan IngvesStefan Ingves is Chairman of the Executive Board and Governor of theRiksbank. Mr Ingves is a member of the ECB General Council and a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • member of the Board of Directors of the Bank for InternationalSettlements (BIS).He was appointed Chairman of the Basel Committee on BankingSupervision in 2011.He also chairs the Advisory Technical Committee of the EuropeanSystemic Risk Board.In addition, Mr Ingves is Sweden’s governor in the InternationalMonetary Fund.Mr Ingves has previously been Director of the Monetary and FinancialSystems Department at the International Monetary Fund, DeputyGovernor of the Riksbank and General Director of the Swedish BankSupport Authority.Prior to that he was Under-Secretary and Head of the Financial MarketsDepartment at the Ministry of Finance.Stefan Ingves holds a PhD in economics.Stefan Ingves term of office is six years from 1 January 2006.The General Council of the Riksbank has appointed Stefan Ingves asGovernor of the Riksbank for an additional term of office of six years,from and including 1 January 2012. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • Certified Risk and Compliance Management Professional(CRCMP) Distance learning and online certification programCompanies like IBM, Accenture etc.consider the CRCMP a preferredcertificate. You may find more if yousearch (CRCMP preferred certificate)using any search engine.The all-inclusive cost is $297.What is included in the price:A. The official presentations we use in our instructor-led classes(3285 slides)The 2309 slides are needed for the exam, as all the questions are based onthese slides. The remaining 976 slides are for reference.You can find the course synopsis at:www.risk-compliance-association.com/Certified_Risk_Compliance_Training.htmB. Up to 3 Online ExamsYou have to pass one exam.If you fail, you must study the official presentations and try again, but youdo not need to spend money. Up to 3 exams are included in the price.To learn more you may visit:www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdfwww.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • C. Personalized Certificate printed in full color.Processing, printing, packing and posting to your office or home.D. The Dodd Frank Act and the newRisk Management Standards (976slides, included in the 3285 slides)The US Dodd-Frank Wall Street Reformand Consumer Protection Act is the mostsignificant piece of legislation concerningthe financial services industry in about 80years.What does it mean for risk andcompliance management professionals? Itmeans new challenges, new jobs, newcareers, and new opportunities.The bill establishes new risk management and corporate governanceprinciples, sets up an early warning system to protect the economy fromfuture threats, and brings more transparency and accountability.It also amends important sections of the Sarbanes Oxley Act. Forexample, it significantly expands whistleblower protections under theSarbanes Oxley Act and creates additional anti-retaliation requirements.You will find more information at:www.risk-compliance-association.com/Distance_Learning_and_Certification.htm _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
    • _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com