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Risk management presentation April 29 2013 Risk management presentation April 29 2013 Document Transcript

  • P a g e | 1International Association of Risk and ComplianceProfessionals (IARCP)1200 G Street NW Suite 800 Washington, DC 20005-6705 USATel: 202-449-9750 www.risk-compliance-association.comTop 10 risk and compliance management related news storiesand world events that (for better or for worse) shaped theweeks agenda, and what is nextDear Member,I thought that I had seen everything, but I waswrong.Whospokeabout thefounderoftheEmirates, SheikhZayedbinSultanAlNahyan at El Paso,Texas?Richard W. Fisher, President and CEO of the Federal Reserve Bank ofDallas. Of course, heexplained theword―Emirates‖Richard said:Thefounder of theEmirates—acollectionof former ―Trucial States‖alongthelowercoast oftheArabian Sea—wasSheikhZayedbin SultanAlNahyan, a wiseman whohadno formal education but knew of itsenormousvalue. He said, ―Education is a lanternwhich lightsthe darkalleys of ignorance.‖Doyou want toknow whichthe titleof the speech is?Oil and Gas,BlondesandOver-Accessorized Brunettes, andRuthless, Hard-DrinkingCowboys(WithReference to SheikhZayed, DianaNatalicio, My Nephew Charlesand President PeñaNieto)International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 2Richard wantstoset the record straight. He said:―I find that when I speak about my district in foreign lands—say, in NewYorkorWashington, D.C.—thereisastereotypicalreactionnot unliketheimageprojected by the TV showDallas.―Of course you are doingwell,‖theysay.―You are rich in oil and gas, blondesand over-accessorizedbrunettes,and ruthless, hard-drinkingcowboys.‖Today, I want to set the recordstraight.‖Richard, theyareright tobelievethat!Ok, I admit that your presentation is superb, and that you convinced mein some ways, but I still believe that you are rich in blondesandover-accessorizedbrunettesin Texas.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 3Note: The aboveslideis about ―employment‖, not ―employment ofblondesand over-accessorizedbrunettes‖Read moreat Number 2below.Welcometo the Top 10list.BestRegards,GeorgeLekatisPresident of the IARCPGeneral Manager, ComplianceLLC1200G Street NW Suite800,Washington DC20005,USATel: (202) 449-9750Email: lekatis@risk-compliance-association.comWeb: www.risk-compliance-association.comHQ:1220N. Market Street Suite804,Wilmington DE 19801,USATel: (302) 342-8828International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 4Report to G20 Finance Ministers and CentralBank Governorson monitoringimplementation of Basel III regulatory reformFull, timely and consistent implementationof BaselIII remainsfundamental tobuilding a resilientfinancial system, maintainingpublicconfidence in regulatory ratiosandprovidinga level playing field for internationallyactivebanks.This report updatesG20 FinanceMinistersand Central Bank GovernorsonprogressinadoptionoftheBaselIII regulatoryreformssincetheBaselCommitteeon BankingSupervision issueditsOctober 2012report‗Oil and Gas, Blondesand Over-AccessorizedBrunettes, and Ruthless, Hard-DrinkingCowboys‘(WithReferencetoSheikh Zayed, DianaNatalicio, MyNephew Charlesand President Peña Nieto)Remarksat theUniversityof Texasat El PasoCentennial LectureRichard W. Fisher, President and CEOFederal Reserve Bank of Dallas, El Paso, TexasInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 5Quantitative and qualitative monetaryeasingSpeechby Mr Haruhiko Kuroda, Governor of theBank of Japan, at a meetingheld by theYomiuri International EconomicSociety, TokyoRichardM. Ashton, DeputyGeneralCounselIndependent ConsultantsBefore the Subcommitteeon Financial Institutionsand ConsumerProtection, Committeeon Banking, Housing, and UrbanAffairs, U.S.Senate, Washington, D.C.Joint CommitteeReport onRisksand Vulnerabilities in the EU Financial SystemTheEuropean financial system continuesto face a dauntingrangeofinterrelated risks, necessitatinga concerted responseby policymakersboth at the political level and from theEuropean System of FinancialSupervision, includingthe European SupervisoryAuthorities(ESAs), inorder to restorethe confidenceand trust that hasbeen erodedduringrecent years‘financial crisis.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 6EU Bank Capital RequirementsRegulation and DirectiveTheEU Capital RequirementsRegulation (CRR) and Directive (CRD)aim tostabilize and strengthenthebanking system bymakingbanks setaside more and higher qualitycapital asa cushion against crises.Thenew rules should alsofoster a convergence of supervisory practicesacrosstheEU.Banks that are better ableto withstandfuture crisesshould be morecapableof financinginvestment and growth.EIOPA Guidelinesonpreparing for Solvency IIOn 27 March2013the European Insuranceand Occupational PensionsAuthority (EIOPA) publisheditsConsultationson Guidelinesonpreparingfor SolvencyII along witha cover note tobe read inconjunction withtheconsultations.Monetary policy – many targets, manyinstruments. Where do we stand?Remarksby Mr Mervyn King, Governor of the Bank of England, at theIM F Conferenceon ―Rethinkingmacro policy II: first stepsand earlylessons‖,Washington DCInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 7SME financing, market innovation and regulationSpeechby Mr Benoît Coeuré, Member of the ExecutiveBoard of theEuropean Central Bank, at the plenarySession 11―Challengesand feasibilityof diversifying thefinancingof EU corporatesand SMEs‖, at the EurofiHighLevel Seminar,organisedin associationwiththeIrishPresidencyoftheCouncil of the EU, DublinFinancial inclusionOpeningaddressby Mr DentonRarawa,Governor of Central Bankof Solomon Islands,atthe10th Meetingof the PacificIslandsWorking Group (PIWG) on ―Financial inclusion‖, HoniaraInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 8Report to G20 Finance Ministers andCentral Bank Governorson monitoringimplementation of Basel III regulatoryreformApril 2013SummaryFull, timely and consistent implementationofBasel III remainsfundamental to building aresilient financial system, maintainingpublic confidencein regulatoryratios and providinga level playing field for internationallyactivebanks.This report updatesG20 FinanceMinistersand Central Bank GovernorsonprogressinadoptionoftheBaselIII regulatoryreformssincetheBaselCommitteeon BankingSupervision issueditsOctober 2012report.Thescope of this update is broader than previousprogressreportsto theG20.In additiontoreportingon the stepstaken by Basel CommitteememberjurisdictionstowardsimplementingtheBaselIII capitalstandards,whichwasthe focusof thelast report, this updatealsocoversdevelopmentsinother Basel III regulatory standards, and banks‘progressin bolsteringtheir capital bases.Thereport alsohighlightsspecific implementation-relatedshortcomingsthat are surfacing, whichrequire continued policy and operationalattention.BaselCommitteemembersagreedtobegin implementationof BaselIII‘scapital standardsfrom 1January 2013, requiring that theytranslatetheBasel III standardsintonational lawsand regulationsbeforethisdate.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 9Sincethe Basel Committee‘sOctober 2012report, eight more memberjurisdictionshave issued final Basel III-basedcapitalregulations,bringing the total to14.Eleven Basel Committee member jurisdictions now have final Basel IIIcapital rules in force: Australia, Canada, China, Hong KongSAR, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa andSwitzerland.Three BaselCommittee member jurisdictions–Argentina, Brazil andRussia–haveissuedfinal rulesandwill bring themintoforcebyend2013.Theother 13member countriesthat missed the1January 2013deadlinefor issuing final regulationshave published their draft regulations:ninecountriesthat are alsomembersof the EuropeanUnion, Indonesia, Korea, Turkey and theUnitedStates.The Basel Committee is urging those jurisdictions to issue final versionsof their regulations as soon as possible and to align their implementationwiththe internationallyagreedtransitionperioddeadlines.It is particularlyimportant for member jurisdictionsthat are home toglobalsystemicallyimportant banks(G-SIBs) tocompletetheissuanceoffinal Basel III regulations.Despitesome delays in implementingBaselIII regulations,nationalsupervisorsare ensuring that internationallyactivebanks are, wherenecessary, makingsteady progressin strengtheningtheir capital basetomeet the new Basel III standards.Thelatest data collected by theBasel Committeeindicatethat, for the 12monthsending June2012,largeinternationallyactivebankson averageraised their capital ratios.For example, the averageCommon EquityTier 1(CET1) capital ratiosrosefrom 7.1%to8.5% of risk-weightedassets.For thosebanksthat do not yet meet thefully-phased inrequirements,CET1capital shortfallsfell from roughly €450billion to€200billion.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 10TheBaselCommittee‘sRegulatory ConsistencyAssessment Programme(RCAP) introducedin 2012is helpingadvanceand deepen theBasel IIIreform efforts.TheRCAP is monitoring progressin introducingregulations, assessingtheir consistencywiththe agreed international standards, and analysingoutcomesacrossbanksandregulatoryregimes, therebyhelpingtoensureconfidencein the regulatoryframework.TheRCAP is alsohelpingemphasisethat issuingdomestic BaselIII-basedrulesalone doesnot guaranteeeffectiveimplementation.Sound supervisory and industry practicesalong withrigorousenforcement and analysisof intendedprudential outcomesare alsorequiredfor effectiveimplementation of theBasel III framework.Acentral element of theRCAP is the assessment of the content andsubstanceof different jurisdictions‘regulations.TheBasel Committeehaslaunched a series of theseassessmentstogaugethe consistencyof domestic regulationswiththe requirementsoftheBasel framework.Thefirst three assessmentscovered final capital regulationsin Japan anddraft capital regulationsin the European Union and the UnitedStates.Subsequently, theBasel Committeeassessedregulationsin Singaporeand isnow evaluatingBasel III capital regulationsin China andSwitzerland.Evaluationsof regulationsinAustralia, Brazil and Canada will beginduringthe second half of 2013.There will alsobenew assessmentsof EU and US regulationsimmediatelyafter theyare finalisedand issued.TheCommitteeaimsto completea firstassessment of BaselIII capitalregulationsin every member jurisdictionby the end of 2015.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 11TheRCAP alsostudies theconsistencyof regulations‘effectson banks.This work, whichtheCommitteestartedin 2012,is analysingthe sourcesof variation acrossbanksin their estimatesof risk weightedassets(RWAs).The first set of findings, which was published in January 2013, identifiedconsiderable variation in the risk weighting of assets held in the tradingbook dueto factorsother than risk exposures.Preliminaryresultsfor the assetsheld in thebankingbook point in asimilar direction.While some variationin RWAs is natural and desirable, excessivevariationdiminishesthe comparability of thereportedcapital ratios.Further analysisisthereforeunder way, and areaswhere Basel Committeestandardsmight bemodifiedtoreduceexcessivevariationare becomingapparent.TheCommitteehasbegun to consider what form some of thesemodificationsmight take.Three typesof policyoptionsare emerging:(i)Improving public disclosure and regulatorydata collectiontoaid theunderstandingof banks‘calculationsof RWAs;(ii) Narrowingthemodellingchoicesfor banks;and(iii)Further harmonisingsupervisorypracticeswithregard to modelapprovals(toreducethe level of variationin RWAs).In this context, the Committee‘s fundamental review of the market riskframework will address some of the key findingswith regard to the riskmeasurement of tradingbook assets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 12TheCommitteecontinuesitsworktofinalisethedevelopment of itspost-crisisreforms, includingtheremainingoutstanding componentsoftheBasel III framework.With respect to Basel III‘sliquidityreforms, the final form of theLiquidityCoverageRatiowaspublishedin January 2013.TheCommitteeintendsto finaliseitswork on the leverageratio in2013,and most if not all work on theNet StableFunding Ratio, thetradingbook, securitisationand largeexposuresshould be finishedin2014.It remainsessential, however, that theBasel frameworkbe adopted andfullyimplementedin a timelymanner.While the BaselCommitteecontinuestostrengthenitsimplementationmonitoring effortsand theRCAP, it urgesG20 FinanceMinistersandCentral Bank Governors torenew their commitment to completion of theBasel III regulatory reforms consistently, expeditiouslyand completely.Progressreport on Basel III implementationFull, timely and consistent implementationof Basel III is fundamental tobuildinga resilient financial system, maintainingpublic confidenceinregulatoryratios and to providing a level playing field for internationallyactivebanks.Toaid in the implementationprocess, the Basel Committeehas put inplacetheRegulatoryConsistencyAssessment Programme (RCAP) tomonitor, review and report on Basel III implementation.It coversthree areas:(i)Thetiming of Basel standardsadoption;(ii)Theconsistencyof domestic regulationswiththeBasel standardsandidentificationof material gaps;and(iii)Theconsistencyof theregulations‘effects.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 13This report providesan overview of the statusof Basel III (includingBasel II and 2.5).It providesanupdateon policy development workand on the progressbankshave madein adjustingto thenew Basel standards.Thereport alsooutlinesprogresson:(i)Completing thedevelopment and issuanceof standardsunder theBasel framework;(ii)Adoption of rulesand assessment of consistencybyBasel Committeemembers;and(iii)analyzing outcomes(eg impact studiesand international studiesofconsistencyin bank risk measurement practices).(i) Completing the Basel III frameworkThecore componentsof the Basel III capital frameworkwerefinalised in2011. Since then, theBasel Committeehassubstantiallycompletedtheremainingcomponents(seeTable1).Thecapital frameworksfor global and domestic systemicallyimportantbanks(G-SIBs and D-SIBs) werepublishedin 2011and 2012respectively.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 14TheCommitteeissuedthefinal standardfortheLiquidityCoverageRatioin January2013,withimplementationscheduledtocommence in 2015.It isactivelyworkingtofinalisethespecificationoftheotherkeyelementsof the Basel III package:in particular, theleverageratioand the NetStableFunding Ratio.Agreement on the Liquidity Coverage RatioOn 6 January2013,the Group of Central Bank Governorsand HeadsofSupervision(GHOS) – the governingbody of the Basel Committee–endorsedthe revisedLCR.TheLCR is one of theBasel Committees key reformsto strengthenglobal liquidityregulationswiththe goal of promotinga more resilientbankingsector.TheLCR promotesthe short-term resilienceof a banksliquidityriskprofile.It doesthis byensuringthat a bank hasan adequatestock ofunencumberedhigh-qualityliquid assetsthat can be converted intocasheasilyand immediatelyin privatemarketstomeet itsliquidityneedsfor a30calendar day liquiditystressscenario.It will improve the banking sectors ability to absorb shocks arising fromfinancial and economic stress, whatever the source, thusreducing the riskof spilloversfrom thefinancial sector tothe real economy.TheLCR will be introducedon 1January2015with theminimumrequirement at 60%, risingin equal annual stepsof 10percentagepointstoreach 100% on 1January2019.This graduated approach is designed to ensure that the LCR can beintroduced without disrupting the orderly strengthening of bankingsystemsor the ongoing financingof economic activity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 15(ii) Adoption of Basel III-based regulationsand assessment ofconsistencyTable2summarisestheoverall progressBasel Committeemembershavemadein implementingthe Basel risk-basedcapital framework asofend-March2013.Membershavemade considerableprogresssincethe last report waspublishedin October 2012.Moredetail regardingtheimplementationstatusof each memberjurisdictioncan be found in the tablesinAnnex 1, which includesummaryinformation about the next stepsand theimplementation plansbeingconsidered.Basel IIOf the27Basel Committeemember countries, 24have nowimplementedBasel II fully.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 16TheUnited States,whichisone of the three jurisdictionsyet to fullyimplement Basel II, hasissuedfinal regulationson BaselII; however, itslargest banks arestill on parallel run for implementingthe advancedapproaches.Theremainingtwojurisdictions(Argentina and Russia) havealsoinitiatedtheprocessfor the implementation of Basel II and planto issuethefinal regulationsin 2013.Basel 2.5Thenumber of members whohave implemented Basel2.5 fullyhas risento22. Of theremainingfive members,threehave initiatedstepstoimplement theregulations.Basel IIIEleven members havenow issued final Basel III rules, whichare legallyin force in these jurisdictions.Threemembershaveissuedfinal rulesbut havenot yet brought themintoforce.All remainingmembers have issueddraft rules.Going forward, the monitoring of the adoption of the Basel standardswillbe broadened to include other components of the framework, such as theLCR and the requirementsfor G-SIBs and D-SIBs.Thebroadened monitoringwill alsobecome part of the periodic updatespublishedbythe Basel Committee, thenext of whichis expected inOctober 2013.Regardingnon-Basel Committeemember jurisdictions,in 2012theFinancial Stability Instituteof the Bank for International Settlementspublishedtheresultsof itsbiennial surveyon the adoption of the Baselstandards.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 17Seventy non-member jurisdictionsparticipatedin the survey, and morethan half indicatedtheywerein the processof implementingBasel III.Consistency of domestic regulationswith Basel standardsIn 2012,the Committeeconducted the first detailed assessmentsof thecontent and substanceof thefinal regulationsimplementingtheBaselIIIpackagein Japan, and the draft regulationsin the European Union andtheUnited States.TheCommitteecontinued theprogramme withthe assessment ofSingapore, whichwaspublished in March2012,and is currentlyin theprocessof assessingSwitzerlandand China.AssessmentsofAustralia, Brazil and Canada will commence later thisyear.Also, new assessmentsof theEU and USassessmentswill be conductedoncetheir final Basel III regulationshave been published.TheBasel Committeeurgesjurisdictionsto addressmaterialinconsistenciesbetweendomesticregulationsand the globallyagreedBasel frameworkidentifiedby the final assessments.It will monitor progressin future reviewsaswell asfuture analysisofprudential outcomes.Theseassessmentscontributeto greater consistencyin thenationaladoption of BaselIII standards.For example, in thecaseof Singapore, the MonetaryAuthority ofSingaporepromptly resolved a number of initial assessment findingsbyamending thedomestic regulationsthat implement Basel III.Theseamendmentscontributedtoa more consistent domesticimplementationoftheBaselframework,and thusset apositiveprecedentfor future assessments.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 18(iii) Regulatory outcomesBank progressin adjusting to Basel III capital standardsSince2010the BaselCommittee hasperiodicallymonitored theprogressof a sampleof banksin itsmember jurisdictionsin adjustingtotheminimum BaselIII requirementsfor capital and liquidity.Atotal of 210banksparticipatedin themost recent study, including101largeinternationallyactive(Group 1) banks and 109other (Group 2)banks.Overall, banks aremakingsubstantial progresstowardsmeeting theBasel III minimum standards.Graph 1showsbanks‘capital shortfallsassumingfull implementationoftheBasel III requirementsasof 30June2012,includingchangestothedefinitionof capital and risk-weightedassets,and ignoring phase-inarrangements.Group 1banksthat could not currentlymeet theminimum requirementswouldhave had an overall shortfall of €3.7billion for the CET1minimumcapitalrequirement of 4.5%, risingto€208.2billionforaCET1target levelof 7.0% (ie includingthe capital conservation buffer); thelatter shortfallalsoincludesthe capital surchargesfor G-SIBs accordingto theupdatepublishedbythe Financial Stability Board in November 2012whereapplicable.As a point of reference,the sum of profitsafter tax prior todistributionsacrossthesame sampleof Group 1banksbetween1July2011and 30June2012was€379.6billion.Compared toDecember 2011, theaggregate CET1 shortfall withrespect tothe4.5% minimum for Group 1banksimproved – theshortfall was€8.2billion (68.7%) lower.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 19At the CET1target level of 7.0% (plusthesurchargeson G-SIBsasapplicable), the aggregate CET1 shortfall for Group 1banks alsoimproved – it was€175.9billion(45.8%) lowerthan in December 2011.Therevised G-SIB surchargesdid not significantlychange the amount oftheshortfalls.Graph 2 showstheweightedaveragecapital ratios for the banksin thesample.TheweightedaverageCET1ratio for Group 1banksassumingfullimplementationof theBasel III requirementsimproved from 7.1% inJune2011to 8.5% in June 2012,while their total capital ratioincreasedfrom 8.6% to9.9%.As of end-June2012,average capital ratiosunder the Basel III frameworkfor a consistent sample of Group 2 bankswerehigher than thoseforGroup 1banks, but had improved onlyslightly.CET1ratios increasedfrom 8.8% in June 2011to 9.0% in June 2012,andtotal capital ratiosimproved from 11.1%to 11.3% over the same period.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 20Studiesof risk-weighted assetsand consistency of regulatoryoutcomesAs part of its implementationprogramme, the Basel Committeeinitiatedstudiesintotheconsistencyof thecalculation of the risk-basedcapitalratio (theratioof capital toRWAs) acrossbanks.Inconsistenciesin the measurement of risk-weightedcapital ratiosmaystem from either calculationsof capital or risk weightedassets,ie thenumerator or the denominator of the ratio(Table3).Thestudies initiallyfocused on the consistencyof measuring RWAs, thedenominator of theratio.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 21With regard tothemeasurement of RWAs, the Baselstandardsdeliberatelyallowbanks and supervisorssome flexibility in measuringrisksin order toaccommodatedifferencesin riskappetiteand localpractices,but alsowiththe goal of accommodatinggreater precision.Somevariation in RWAsshould thereforebe expected.In addition, from a financial stabilityperspective,some diversityin riskmanagement practicesis desirableto avoid a situation in whichall banksact in a similar way, whichpotentiallycould createadditional instability.However,excessivevariation – that is, that doesnot reflect materialdifferencesin theunderlying riskstakenby banks – is undesirable andcould be harmful tothe international level playing field.As a first step, the Committeeexaminedin more detail thedrivers ofpossibleinconsistenciesin themeasurement of RWAsfor thebankingbook and tradingbook of banks.Importantly, theobjectiveof thisworkwasnot tojudgethecorrectnessofbanks‘modelling choicesor toassessthecompliance of supervisoryapproachestakenin different jurisdictions.Rather, theobjectivewastoobtain a preliminaryestimate of thepotentialfor variationin RWAsacrossbanks and tohighlight aspectsof the Baselstandardsthat contribute to this variation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 22Thefindingsprovideadirectionfor policy optionsthat canbeconsideredif theCommitteewishestonarrowthepotential forvariationinthefuture.In January 2013, the preliminaryfindingsregardingthe RWAsin thetradingbook werepublished.Theanalysis investigatingRWAsin the bankingbook is under way, anditsresultsare expectedto bepublishedin the comingmonths.Analysisof risk-weighted assets in the trading bookIn the tradingbook study, the Committeeundertook(i)An analysis of publicly available data of largegloballyactivebankswith significant tradingoperationsand(ii)Ahypothetical test portfolio exerciseto examinewhat methodologychoicesarethe greatestpotential driversbehind the variabilityof internalmarket riskmodel outcomes.Thereview of publicdisclosuresfocusedon a sampleof 16 global bankswith significant tradingactivity.Theobservationperiodincludedthemost recent changesrelatedtoBasel2.5, whichhad takeneffect in some jurisdictionsbut not all.Despitethe asynchronousadoption of Basel 2.5, value wasfound incomparing market riskRWAs acrosspre- and post-Basel 2.5 jurisdictionsbecausemany of theissuescarryover tothenew regime, for exampleregardingthe contribution to RWAs from internal models andstandardisedapproaches.For some banks, thedisclosuresrequired under Basel II (Pillar 3)factored intothe analysisand provided a chancetoevaluatethe utilityofsuch disclosures.Basedon public disclosures,the analysisshowedconsiderablevariationin averagepublishedRWAsfor tradingassetsand provided someInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 23indicationthat differencesin the composition and size of tradingpositionsare correlatedwith banks‘averagemarket riskRWAs.However,thequalityof disclosureswasgenerallyfound tobeinsufficienttoallowinvestorsand other interestedpartiesto assesshow much of thevariationreflectsdifferinglevelsof actual risk andhowmuchisaresult ofother factors.Thefocusof the hypothetical test portfolioexercisewasto discover thedesignelementsof internalmodelsthat havethegreatest potentialimpacton thelevel of variability in market risk RWAs.Hypothetical test portfoliosovercome thelimitationsencountered whenattemptingto usepublic and supervisorydata on real portfolios toinvestigatepotential sourcesof variationbecausetheycontrol fordifferencesin portfolio composition.However,they showonly potential and not realised variation in outcome.Moreover,inthiscase, theexercisefocusedon aseriesofsimplelongandshort positions,designedtoreveal theimpact of model designfeatures.Toshed light on theeffect of different sources of variation on morerealisticportfolios, theCommitteeplanstoconduct afurtherhypotheticaltest portfolio exerciselater in 2013.This will includeother, more complex, hypothetical test portfolios, withtheaim ofhelpingtheCommitteetodeepenitsanalysisofthevariationinrisk measurement of trading booksacrossbanks.Thehypothetical test portfolioexerciseindicatedthat there can be asubstantial differencebetweenthebank reporting the lowestRWAsandthebank reportingthe highest.This outcome isattributedto a rangeof factors:- Asizeableportionof thevariation isduetosupervisorydecisionsapplied either toall banksin a jurisdiction, or to individual banks.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 24An exampleof the former wouldbe policy decisionstorestrictmodellingoptions(eg to disallowanydiversification benefit betweentypesof risk).An exampleof the latter would be the application of supervisorymultipliers:around onequarter of thetotal variation in thehypothetical diversified portfolio could beattributed to thissinglefactor.Thesesupervisoryactionstypicallyresult in higher capitalrequirementsthan wouldotherwisebe the casebut can alsoincreasethevariation in RWAs betweenbanks, particularlyacrossjurisdictions.Thesesupervisoryactions,particularlyat anindividualbank level, areoftennot disclosed.- Another key sourceof variation ismodellingchoicesmade by banks.Theexercisefound that a small number of keymodellingchoicesarethemain driversof the remainingmodel-drivenvariability.Thestudydid not seek to identify the optimal level of variation, but thepreliminaryfindingshighlight potential policy optionsthat could reducefor variationwhereit is consideredexcessive.Thesepolicy optionscomplement important policyinitiativesthat arealready under way, such asthe fundamental review of thetradingbook, and policy work on disclosures.Thepolicyoptionsare further discussedbelow.Analysisof risk-weighted assets in the banking bookTheCommitteeisfinalisingits first studyon sourcesof materialdifferencesacrossbanksin RWAsin thebanking book.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 25Aswiththetradingbook, theCommitteehasbeenassessingtheextent towhichthesevariationsare driven by differencesin risk levelsor inpractices,by analysing data and studying banks‘risk assessment andquantification practices.TheCommitteerevieweda widerangeof existinganalysesof RWAsacrossbanksand countries toassessmethodologies and identify possibledriversof RWAvariation.Thestudieshighlightedmany potential drivers,most of whichsuggestedthat RWAdifferencesare due to both risk-basedand practice-basedfactors.Risk-based factors are those that stem from differences in underlying riskat the exposure or portfolio level and in business models, including assetclassmix.Practice-basedfactorsincludedifferencesin bank practices(egapproachestorisk management and measurement) and in the regulatoryenvironment (eg supervisorypractices,implementinglawsandregulationsincludingnational discretion, accounting standards).While the focusof the studiesvaried acrossthese factors, noexistingstudycould pinpoint thedefinitivecausesof RWAdifferencesbetweenbanks.Supervisory data analysisTheCommitteeanalysed supervisorydata it collectedaspart of itsongoing capital monitoring.Theanalysis covered 56large, internationallyactivebankingorganisationsand 44 non-internationallyactive banking organisationsin15jurisdictions.Theanalysis suggeststhat a major portionof the variation in RWAsisdrivenby asset classmix, a risk-baseddriver.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 26Theremainingdispersion is duetodifferent risk weightswithin assetclasses– either from differencesin actual risk (risk-based) or itsmeasurement (practice-based).Key practice-baseddrivers includethechoiceof modellingapproachforcredit risk, capital floor adjustment, the treatment of defaultedandsecuritisationexposures, aswell asthecalibrationof associatedprobabilitiesof default (PDs) and losses-given-default (LGDs).Many, although certainlynot all, of thesedriversreflect elementsof theflexibilityprovided tobanksand supervisorswithin the Baselframework.Portfolio benchmarking analysisA portfolio benchmarking exercise was used to explicitly investigate themagnitude of practice-based differences, by controlling for risk throughthe useof common obligorsacrossbanks.Thirty-twobanks from 13jurisdictionsparticipatedin theexercise,reporting PD and LGD estimatesfor a set ofsovereign, bank, and corporateexposures.The findings indicate that there is considerable consistency across bankswith regard to the relative riskinessof obligorsin the exercise (ie the rankorder in terms of risk), but that there are sizeable differencesin the levelsof the perceived risk.Theanalysis suggeststhat different estimatesof the PD and/ or LGD forthesameexposurescreatematerial differencesin risk-weightedassetsacrossbanks.Range of practicesand meetingswith banksTheCommitteealsoidentified and assessedthesignificanceof a list ofpractice-baseddriversof RWA variation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 27Many of thesedriversare provided for in theBasel standardsor inindividual countries‘implementation of theBasel framework.Further insightson practiceswerecollectedthrough meetingsin March2013with 12of the 32 banksthat participatedin theportfoliobenchmarkingexercise.Themeetingsfocused on the banks‘RWA modellingpracticesforbankingbookexposureswithaviewtodevelopingabetterunderstandingof the specific driversof observed variation.Potential policy optionsand directions for future workThepreliminaryresultsfor both thetradingbook and the bankingbookindicateconsiderablevariation in average risk-weightedassetsacrossbanks,of whichonlya part can be explainedbyvariation in actualrisk-taking.While some amount of variation isexpectedin any regime basedoninternalmodels, whereit is consideredexcessivethe findingssuggest apotential direction for future policy work that could narrow down thepotential variation.Generally, the analysis highlightsthree potential typesof policy optionsthat could be consideredin thefuture:(i)Improvement of public disclosureand regulatorydatacollectiontoaidin theunderstandingof risk-weightedassets;(ii)Narrowingdownthemodellingchoicesfor banks, includingthroughfurther use of floorsand/ or benchmarks;and(iii)Further harmonisation of supervisory practiceswith regard to modelapprovals.At this stage, the suggestionsfor policyoptionsshould not be seen ascomprehensive, nor aspre-emptingany specific policy measures,butInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 28rather aspotential directionsfor future work tobe consideredby theCommittee.Furthermore, the potential policymeasuresshould not be seenasmutuallyexclusive: some combination of the three could be appropriategoingforward.Morebroadly, the Committeehasbeen consideringthe appropriatebalancebetweenrisk sensitivity, comparabilityand simplicity.In thenear term, theCommitteeintendstopublisha paper settingout itsthinkingon the relevant policy trade-offsand identifying potential policyoptionsthat the Committeeintendsto explore tomakethe regulatoryframeworksimpler and more comparable.Annex 1TheBasel III frameworkbuilds upon and enhancesthe regulatoryframeworkset out under BaselII and Basel2.5.Thetablesherein thereforereviewmembers‘regulatoryadoptionof BaselII, Basel2.5 and Basel III.- BaselII, whichimprovedthemeasurement ofcredit riskandincludedcapture of operational risk, wasreleased in 2004and wasduetobeimplemented from year-end 2006.TheFramework consistsof threepillars:Pillar 1containstheminimum capital requirements;Pillar 2 setsout the supervisoryreview processand Pillar 3 correspondstomarket discipline.- Basel 2.5, agreed in July2009, enhanced themeasurementsof risksrelatedtosecuritisation and trading book exposures.Basel 2.5 wasduetobe implemented no later than 31December 2011.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 29- In December2010,theCommitteereleasedBaselIII, whichsethigherlevelsfor capital requirementsand introduceda new global liquidityframework.Committeemembersagreedtoimplement Basel III from 1January2013,subjecttotransitional and phase-inarrangements.In November 2011, G20 Leadersat theCannesSummit calledonjurisdictionstomeet their commitment toimplement fullyandconsistentlyBasel II and Basel 2.5 by end 2011, and Basel III, starting in2013and completingby 1January 2019.In June 2012,G20 Leadersat the LosCabosSummit reaffirmed their callfor jurisdictionstomeet their commitments.This messagewasreiteratedin Moscowin February 2013by theG20FinanceMinistersand Central Bank Governors.MethodologyThedata contained in this annex arebasedon responsesfrom BaselCommitteemember jurisdictions.Thefollowingclassificationis used for thestatusof adoption of Baselregulatoryrules:1.Draft regulation not published:no draft law,regulation or other officialdocument hasbeen made public todetail theplanned content of thedomesticregulatory rules.This statusincludescaseswherea jurisdictionhascommunicatedhigh-levelinformationabout itsimplementation plansbut not detailedrules.2.Draft regulation published: a draft law, regulation or other officialdocument is alreadypublicly available, for examplefor publicconsultation or legislativedeliberations.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 30Thecontent of the document hasto be specificenough to beimplemented whenadopted.3.Final rule published:the domesticlegal or regulatory framework hasbeen finalisedand approved but isstill not applicableto banks.4.Final rulein force: thedomesticlegal and regulatory frameworkisalready applied to banks.In order tosupport and supplement the statusreported, summaryinformation about thenext stepsand theimplementationplansbeingconsideredby membersare alsoprovided for each jurisdiction.In additiontothe statusclassification, a colour code is used toindicatetheimplementationstatusof each jurisdiction.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 31International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 32International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 33International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 34Annex 2Singapore reviewIn March2013, theBasel Committeecompleteditsassessment ofSingapore.Theassessment evaluated the localregulationsestablishedby theMonetaryAuthority of Singapore (MAS), whichimplementsBasel III inSingapore.Theregulationswerepublished in September 2012and further amendedin November 2012.Additional regulationsimplementingassociateddisclosurerequirementswerepublishedin December 2012and werealsoconsidered in theassessment.Theassessment found that Singapores overall capital regimeis in linewith therequirementsof theBasel framework.Singaporesregulationswerefound tobe ―compliant‖ in 12out of the 14componentsassessed.While twoother componentswereassessedas―largelycompliant‖, thedeviationswerenot consideredto be material by the assessment team.As a result, the overall framework wasgraded withan overall assessmentoutcome of ―compliant‖.Theassessment team alsonoted Singapores activeand continuingcommitment totheglobal regulatory reforms that form part of thepackageof reformsannounced by the Basel Committee.In this regard, it must be highlightedthat the MonetaryAuthority ofSingapore (MAS) wasable to promptly resolvea number of initialInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 35assessment findingsby issuing amendmentsto thedomestic rulesthatimplement Basel III.Theseamendmentscontributedto thefavourableassessment outcome.Annex 3Sample of banks included in the Basel Committee‘s monitoringexerciseIn 2010 the Committee started periodically monitoring the progress of asample of internationally active banks in adjusting to the new Basel IIIstandardsfor capital and liquidity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 36Thetablebelow showsthe distributionof participationby jurisdictioninthemost recent study.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 37‗Oil and Gas, Blondesand Over-AccessorizedBrunettes, and Ruthless, Hard-DrinkingCowboys‘(With Reference to Sheikh Zayed, Diana Natalicio, My NephewCharlesand President Peña Nieto)Remarksat theUniversityof Texasat El PasoCentennial LectureRichard W. Fisher, President and CEOFederal Reserve Bank of Dallas, El Paso, TexasI so appreciate being here at the University of Texas atEl Paso (UTEP), my first outing since returning from atrip totheUnitedArab Emirates.Thefounder of theEmirates—acollectionof former ―Trucial States‖alongthelowercoast oftheArabian Sea—wasSheikhZayedbin SultanAlNahyan, a wiseman whohadno formal education but knew of itsenormousvalue.He said, ―Educationis a lanternwhichlightsthedark alleysofignorance.‖I mention this becauseI cannot think of an educator whoembodies thispractical dictum better than Diana Natalicio.President Natalicioisa bright, shininglantern in the worldof education.Actually, that‘san understatement:Sheisa klieg light!We are blessedto have her lead UTEP and move Texasand thenationforwardon the frontiersof higher education.I am tremendouslyhonored tobe introduced by her. Thank you, Diana.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 38I am goingto depart from my usual format today and rely heavily onslides—slidesthat provide afactual basisfor what isgoingtobeadoseof―Texasbrag.‖With itsbranchesin El Paso, SanAntonio and Houston, the FederalReserveBank of Dallas—theFederal Reserve‘sEleventh District—coversabout 27millionpeople over 360,000squaremilesstretchingfromnorthern Louisiana tosouthern New Mexico.Over 96percent of theeconomic output of the district comesfrom Texas.I find that when I speak about my district in foreign lands—say, in NewYorkorWashington, D.C.—thereisastereotypicalreactionnot unliketheimageprojected by the TV showDallas.―Of course you are doingwell,‖theysay.―You are rich in oil and gas, blondesand over-accessorizedbrunettes,and ruthless, hard-drinkingcowboys.‖Today, I want to set the recordstraight.PricesAre Presently Stable; Employment IsFar From Optimal;the Efficacy of Quantitative Easing Is asYet UnclearTheroadtodignityisthroughwork:Jobsprovidethemeansforeconomicadvancement.As the nation‘scentral bank, the Federal Reserveistasked withmaintainingprice stability—a common monetary policy goal of allresponsiblecentral banks.But under the lawscreated by Congressthat govern our franchise andallowit to operateindependently, theFed worksunder a dual mandate—toconduct monetary policy that keepspricesfrom inflatingor deflatingand to achievefull employment.At the moment, and for the foreseeablefuture, neither inflationnordeflationappearson the forecasthorizon.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 39However, the longer-term inflationaryconsequencesof themassivequantitativeeasingprogramswehaveundertaken—programsI haveopposedin our Federal Open Market Committee(FOMC) meetingsbutthat have been approved by themajorityof the committee—are asyet unclear.Thoseaftereffectswill depend on how artful the committeewill be inunwindingthat accommodation on a timely basis.Indeed, one of the signal achievementsof Federal Reserve policy underBen Bernanke‘sleadershipis tohave formalizeda long-term inflationtarget of 2 percent, something theFOMC had never beforedistinctlydeclared.Presently, the 12-month inflation rateis 1.6percent, accordingto ourcalculationat the DallasFed, wherewedoa ―trimmedmean‖ analysisof178itemsconsumersuse,includinggunsand beer (hopefullynot enjoyedsimultaneously) and thecost of gasoline,food, getting your hair cut oryour shoesrepaired, or buying an electronic device.Given that thetrimmed mean analysis hasproven tobe an excellentrule-of-thumbpredictorofheadlineinflationoneyear forward,wecansaywith some degreeof confidencethat, at present, wearekeepinginflationat or below our 2percent target.Employment, however, is not at a comfortablelevel.Pick up anynewspaperor goto anynewswebsiteor broadcastmediumand you will read or hear of the still-too-high unemployment rate thatbedevils our economy.Monetarypolicyactswithalag, includingunorthodoxmonetarypolicy asit is nowbeingconducted.It wouldappear from some studies and from anecdotal evidencethatcompanies are startingto usethecopiouscheap money theyhave accesstofor investing in capital projectsand employing increasingamountsofworkers.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 40But it isnot yet clearthat wewillachieveajustifiablebangforthetrillionsof bucksthe Fed hasfloodedtheeconomy with.Onlytimewill tell if theefficacyof quantitativeeasingwehaveundertaken wasjustifiable in regard to job creation and deliveringon thesecond component of our dual mandate.Yet many things doemerge when you examine the entrailsofemployment data from acrossthe country.Onethingis that you learna lot about Texas, whichis thefocusof myremarks today.‗If You Pull TexasOut of the Puzzle, the Country FallsDown‘For thepast 22years, Texashasoutgrownthecountryby a factor of morethan 2-to-1.Here is a slidethat showsthe percentageincreasein jobscreatedbyseveral largestatesand for the U.S.asa wholesince1990:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 41And here is a look at therate of job creationfor thosesame statesand theU.S. asa wholesince2000:We wereone of thelast statesto gointothe recent recession and one ofthefirst tocomeout. In termsofjobs,asof now,10stateshavecomebacktoor have exceededemployment levelsthat prevailed beforethe crisis:Alaska, Louisiana, Massachusetts,NewYork, NorthDakota, Oklahoma, South Dakota, Texas,Utah and West Virginia.The Federal Reserve has no index that measures the number of blondesor ruthless cowboys in Texas, but we can account for the influence of oiland gason our state‘swelfare:Oil and gasextractionand mining support directlyaccountsfor 2.4percent of our workforce—two-point-four percent.And the energy sector‘stotal contribution toour state‘sgrossdomesticproduct (GDP) is roughly 10 percent.Soyes, the foreignersare correct: We have a strong energy sector inTexas.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 42We are theNo. 1producer of oil and gasin the nation.We producemore oil than Venezuelaand more natural gasthan Canada.On net, high energypricesdo, indeed, benefit Texans.But look at this slideof the number of jobscreated by sector in 2012:Oil andgasandminingandtheir supportservicesaccountedfor22,100,orlessthan 7percent, of the 335,500jobscreated in Texaslast year.Professional and businessservicesaccounted for 74,200;trade, transportationand utilities62,000;leisureand hospitality52,400;educational and health services41,000;and construction 27,000.Each ofthesesectorscreatedmore jobsthan theenergy sector.Of course,the oil and gassector haslargemultipliers,sotheoveralleconomicimpact is greater than justthese22,100jobs.TheUniversity of Texasat SanAntonio—your sister organization—estimatesthat the EagleFord Shale generated over $61billion in economicimpact in 2012.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 43As this chart shows, however,oursis a diversifiedeconomy, creatingjobsacrossthespectrum.―But thesejobsareall lowpaying,‖ our uninformed friendssay.And tothat I respond:―You are right.We createmore low-paying jobsin Texasthan anybody else.Yet look at this breakdownof job creationby income quartile for TexasversustheUnited StatesminusTexasfor the past 10-plusyears‖:We created a lot of low-payingjobs. But wealsocreated far morehigh-paying jobs.Most importantly, while the UnitedStateshasseen job destructionin thetwomiddle-incomequartiles, Texashascreated jobsfor thosevitalmiddle-incomeworkers,too.Thebottom line—wehave experiencedgrowthacrossall sectorsand inall income categories.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 44And it continues:In February, job growthin Texaswasan annualized6.9percent.Year todate, construction, tradeand transportation, and professional andbusinessserviceshave ledthepack in what webelievewill be another yearofemployment growththat, knock onwood, willapproach3percent.Here aresomeotherfactsthat helproundout theeconomicpictureof ourstate.Our banksare more profitablethan thosein the rest of thenation …In the housing sector, wehave fewerunderwatermortgages…International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 45Robust new-homeconstruction …International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 46And an export sector that hascome out of the recession like gee-whiz.In, fact, you can seefrom this graph that without Texas,thetopblueline,exportsfrom the rest of theUnited States, indicatedby the red line, arehoveringaround thepeak level of 2008:My littlenephew,Charles, wasplaying witha three-dimensional woodenpuzzle map of the United Statesin hispreschool classtheother day.He camehome withthepiece that wasTexasand a smirk on hisface:―Mom,‖ he said, ―guesswhat?If you pull Texasout of thepuzzle of theUnitedStates,the rest of thecountry fallsdown!‖Although littleCharleslivesin Massachusetts,he getsthepicture.It came asno surprisewhena recent study by the highlyrespectedBrookingsInstitution, asreported in the Wall Street Journal lastweek, revealed that only14of thenation‘s100biggest metropolitanareashavemore peopleemployed than theydid before the 2007–09recessionandInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 47that six of them arein Texas:Austin, SanAntonio, McAllen, Dallas,Houston and … El Paso.―Robust employment in the oil and gasindustrieshelped the Texascities,‖the article read, ―although data from the TexasWorkforceCommission suggeststhe job recovery hascome from a varietyofindustries.‖Amen to that.El Paso at a CrossroadsYou‘ll notethat El Pasowasmentionedin theBrookingsstudy. Let‘s talka littleabout this uniquecity.It‘s nosmall wonderthat of the 23,000studentsenrolledat UTEP, 77percent areMexican–Americansand another 6percent commute fromCiudad Juárez, acrossthe border.El Pasois at the verynexusof the culturesand economiesof twocountries.As Roberto Coronado, our economist and assistant vice president inchargeat our El PasoBranch, likes topoint out, ―Given itsuniquegeographicposition, El Pasois very good at importing recessionsbothfrom the north and from the south of theRio Grande.‖I wouldadd that it‘s alsogood at drawingfrom thebest of both countriesin recoveries.TheEl Pasolabor market hasoutperformed that of theU.S.for severalyears.Here is a graph that showshow the El Pasoemployment picture haschangedrelativeto the U.S.sincethe onset of theGreat Recession:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 48Now, as the following chart demonstrates, it remains a fact that the localemployment picture is less bright in El Paso than in Texas‘s other majormetroareas.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 49Theunemployment rate here is hoveringaround 9 percent. El Paso‘sunemployment rate hashistoricallybeen 2 percentagepointshigher thantheU.S. rate and 3.2percentagepointsabove the Texasrate.In part, this isdue topopulation growth. El Pasohad more than 21millionborder crossingsin 2011alone.Most of thesevisitorscametoshop, but manystayed and looked for jobs.Thesevisitorsincreasethe number of job seekersin theunemploymentequation, drivingthe rate upward.Of additional concern is that El Pasoismore dependent on federalgovernment employment thananyotherTexascity, with5percent ofyourworkforcecoming from the public sector.And that isbeforeaccounting for the payroll of Fort Blissitself and theimpact it hason private-sectoremployment and consumption.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 50Clearly, El Pasoisquitevulnerabletoconstrictionin thegrowthoffederalspending. This will ultimatelypresent seriouschallengesasthe federalgovernment strugglesto right its fiscalimbalances.The Good NewsBut there isgood newsthat offsetsthat risk:ThankstotheNorthAmerican Free TradeAgreement, or NAFTA—anagreement that, asDianamentioned, I played a rolein implementingasdeputyU.S. trade representative—El Pasois nolonger at theedgeof theUnitedStatesbut, instead, at a strategic locationin thevast NorthAmerican market.In this context, the maquiladorasof Ciudad Juárez become an importantfactordeterminingEl Paso‘seconomicfate.Therelationshipexistsvia a ricochet effect that beginswithU.S.industrial activitypickingup, sayin automanufacturing, followedbynewproduction ordersbeingsent toCiudad Juárez maquiladoraplantsandthen economicbenefits flowingback toEl Paso.Theflowback toEl Pasocomesfrom firmson this sideof theborderprovidinglogisticalsupport, insuranceand other servicestothemaquiladoras—aswell asin the aforementioned form of maquiladoraemployeesshoppingand consumingmore on thisside of the border.And, asthis tableshows, it resultsin an increaseof high-value-addedsalesof El Paso-basedservicesintoCiudad Juárez, making up forreductionsin manufacturingjobson thissideof theborder:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 51Sigue México!As the maquiladoraexampleillustrates,Mexicohasa significant impacton thefate of theEl Pasoeconomy.ThisisfortunatebecausetheMexicaneconomyisbeingtransformedtoagreater degreethan most people here in El Norte understand.On Sunday, theDallasMorningNewskindlyran an op-ed pieceI wrotebased on the workof our DallasFed economists, titled ―MexicoOutdoestheU.S. on FiscalDiscipline.‖Thearticle outlinesthe great progressMexicohasmade in transformingitseconomy and thesignificant stepstaken by President EnriquePeñaNietoin the footstepsof his predecessors, from President Calderon backtoPresident Salinas.Here are thefacts:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 52MexicorecoveredmorequicklyfromtherecessionthantheUnitedStates.Mexico‘s3.3percent GDP growth in 2012compareswiththeU.S.‘s1.7percent.Mexico,home to 1980shyperinflation and a poster child of that decade‘sLatinAmerican debt crisis,hasrecorded a coreconsumer priceindexannual inflation ratebelow 3percent for the last three months. Infact, inflationin Mexicohastrended down for twodecadesfollowingtwoimportant reforms:central bank independencein 1994and adoption ofinflationtargetingin 2001.Meanwhile, the peso, floatingsincelate 1994, held itsownthrough theglobal financial crisis.And year todate, thepesohasgained 6.9percent against the dollar.Low and stableinflation, together witha steadypeso, hasprotected thepurchasingpowerof the Mexicanconsumer and allowed nest eggstogrow.Thosenest eggscan now be safelydepositedin banks.After a horrific banking crisisin 1994–95 and an ensuing decade ofstagnant lending, Mexico‘s banking industry is growing again andfinancial access, whilestill limited, is expandingquickly.Thenumber of Mexicanbanksincreased14.3percent in 2012;in theU.S., thenumber of institutionscontracted3.1percent.It maybesurprisingtoyou that Mexicanbanksarealsobettercapitalizedthan U.S.banks.Asof Dec. 31,2012,equity-to-asset ratioswere11.1percent at U.S.banksand 15.9 percent at Mexicanbanks.On the fiscalfront, Mexico‘s2012budget deficit wasa respectable2.6percent of GDP, whichcompareswith7 percent here.For all their differences, Mexicanlawmakersontheright andthelefthavea commitment tofiscal discipline.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 53Theyadopted a balanced-budget rule in 2006 and have chosen to abide byit rather than take the ―kick the can down the road‖ approach of the U.S.Congress.As a result, Mexico‘snational debt is stableat 28percent of GDP, whilehere it raced past $16 trillion in 2012,about 105percent of GDP.Mexicohasalsoremaineda staunch proponent of free trade.Exportsand importsnow make up 62percent of Mexicaneconomicoutput versus17.5 percent asrecentlyas1980.SinceMexico joined the GeneralAgreement on Tariffsand Trade (theforerunner of theWorld TradeOrganization) in 1986and ratifiedNAFTAin 1994, it hasforged 12 tradepactswith44 nations.With all theprogressin themacro economy, banking, financeand trade,structural reformsare what Mexiconow needstocatapult it toaleadershiprole among emerging-market economies.If President Peña Nieto‘sfirst 100days in office areany indication, thiscriticalnext step is underway.He hasengineeredthePactoporMéxico(Pact for Mexico)withtheotherpoliticalparties;arrested Elba Esther Gordillo, thecorrupt leaderof themassivenational teachers‘union; brought a class-action suit againstCarlosSlim‘s growth-retardingtelecommunicationsempire; and begun anational conversation about reformingthecountry‘swoefullyunderperforming, yet potentiallyrich energysector.If this effort at structural modernizationcontinues, Mexico‘sgrowthwillincreasesignificantly.All of this will begood for El Paso. Just asEl Pasosufferswhenrecessionafflictsboth sidesof theborder, it will prosper asexpansion takesholdhere in the U.S.and in Mexico.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 54TheGood, the Bad and the ComicalLet me giveyou a pictorial summary of this lecture:We are blessedby a force of nature named DianaNatalicio (aTexasblonde, bythe way!) …Courtesyof UTEP UniversityCommunicationsInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 55By UTEP asa symbol of El Paso‘scritical place at thecrossroadsofNorthAmerica…By having the good fortune to live in Texas…International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 56And by sharing a border withan increasinglysuccessful neighbor tooursouth.But wealsohave challenges.It wouldbeunbecomingof a central banker tobeentirely optimistic—weare a prettysober species.Sohereis thebad news.Here‘swhat is holding back the economic progressof ElPaso, Texas,MexicoandAmerica:Yup—Washington.TheFederal Reservehasprovided plentyof, if not toomuch, high-octanefuel in the form of cheap and abundant money to propel the economyforward.Our southern neighbor, Mexico,is responsiblymanaging itsfiscal affairsand structural reforms(asis our northern neighbor, Canada).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 57Texasisshowingthe nation the waytocreate jobsand encourageprosperitywitha highlydiversified economy.And yet Congressandexecutivebranchcannot agreeon abudget, or on apath forward for taxesand spending, or on a regulatorystructurethatincentivizesbusinessto put people back towork.Thisisthesubjectofanentireseparatelecture.But tosummarizetherootfiscalproblem of past Congressesand administrations,Democrat- orRepublican-led, my staff found a clip onYouTubethat sumsit up betterthan words:www.youtube.com/ watch?v=Df_6r_tZqGo.That sketch saysit all.We must all praythat our president and our congressionalrepresentativeswill find a wayto reversetheir spendthrift waysand do what isright byputtingusback on thepath of fiscal probity.El Pasoand Texashavedonewell despitethedisorderly behavior of ournation‘sfiscalauthorities.Imaginehow wellwewoulddo if theyactuallymanaged toget their acttogether!As weeagerlyawait that day, let usbe thankful for the exceptional natureof this great state, this great city and thiswonderful university.Ándale PuesGracias.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 58Quantitative and qualitativemonetary easingSpeechby Mr HaruhikoKuroda,Governor of theBank ofJapan, at a meetingheld by theYomiuriInternational Economic Society, TokyoIntroductionIt is a great honor tobe invitedto thismeetinghosted by theYomiuriInternational Economic Society today. This ismy first speech asGovernorof the Bank of Japan.Today, I wouldlike toexplain the ―Quantitativeand QualitativeMonetaryEasing‖ that wedecided toembark on last week.I. Basic thinkingWhenI wasappointedasthegovernor,I hadthefollowingbasicthinkingin mind.Thefirst isthatweshoulddowhateverisnecessarytoovercomedeflation, whichhasbeen causing a deteriorationin Japan‘seconomy fornearly15years.TheBank of Japan hasengaged in a widerangeof monetaryeasingefforts– includingthe implementation of the zero interest ratepolicy, thequantitativeeasingpolicy, and comprehensivemonetary easing.Despiteitscumulativeefforts, there havebeen noeasily derived concreteresults,and I have felt stronglythat weshould make all-out efforts toutilizeevery possibleresourcebestowedupon the Bank, rather than toadopt an incremental approach – or, put differently, toadopt gradualism.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 59Thesecond point is the importanceof committingstronglyand clearlythat the Bank is responsiblefor achievingthe pricestability target.At the MonetaryPolicy Meetingheld in January, the Bank – on itsownjudgment – set theprice stabilitytarget at 2 percent in termsof theyear-on-year rate of changein the consumer price index (CPI) and madea groundbreakingcommitment to achievethat target at theearliestpossibletime.Regardingthe time frame for achieving thetarget, lookingat othereconomies,many central bankshave been making effortstoachievethepricestabilityinthemedium term, withatimehorizonof about twoyearsfor the effectsof monetary policyto permeatethe economy.I have found it appropriate for Japan‘seconomy aswell to make acommitment witha time horizon of about twoyears.Thethird point isto conveythe Bank‘sstrong policystancetomarketsandeconomicentitieswith clarityand intelligibility, therebydramaticallychangingthe expectationsof market participantsaswell asfirms andhouseholds.During the course of 15 years of deflation, the public‘s behavior has beenbased on the assumption that priceswould either decline or be unlikely torise.It is necessaryto eliminatedeflationaryexpectationsthrough theBank‘sstrongcommitment and intelligible explanation.And lastly, weshouldentera new phaseof monetaryeasingboth in termsof quantityand qualityin order to underpin such a commitment.There is a reasontoemphasize the qualitativeaspect of monetary easingalongwith itsquantitativeaspect.While the Bank of Japan and other central banks in advancedeconomieshavealmost exhaustedfurther declinesin short-term interest rates,theyInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 60now engagein policies to increasethesize of their balancesheetsaspartof unconventional policy measures.There is nowa broad consensuswith regard totheeffectof balancesheetexpansion.That is, thecentral banks‘purchasesof government bondsand otherassetsfrom themarketshavetheeffect of encouragingfurther declinesinlong-term interest ratesand loweringrisk premia of asset pricesbyabsorbingrisks– such asthe one stemmingfrom interestratefluctuations.Consequently, it becomesimportant todeterminenot only how muchliquidityto supplybut alsohowto supplythat quantity.Even withthe same amount of liquidity, purchasingshort-term T-Billsproducesdifferent effectsthan in the casewherethe Bank purchasesother assetssuch aslong-term JGBsand risk assetslike exchange-tradedfunds(ETFs).Thus, it is important to workon two aspectsof monetary easing, both intermsof quantityand quality.II. Introduction of the ―Quantitative and Qualitative MonetaryEasing‖With thisbasicset of views,I assumed thegovernorshipand attendedtheMonetaryPolicyMeetingonApril 3 and 4.Followingdiscussion withother Policy Board members and taking intoaccount the staff view regardingpracticalities, wecame toa conclusion.Thename of the quantitativeand qualitativemonetary easingthat weintroduced this timespeaksfor itself.This is indeed a new phaseof monetary easingboth in termsof quantityandquality.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 61Strong and clear commitmentFirst, the Bank decided– asI mentioned earlier – toconveya strong andclear commitment.TheBank clearlyannounced in a statement that ―[it] will achievetheprice stability target of 2 percent in termsof the year-on-year rate ofchangein theconsumer price index (CPI) at the earliestpossibletime,with a time horizonof about twoyears.‖This is thedecisionof the Bank‘sPolicyBoard – namely, it expressesthewill of theBank asan institution.New phase of monetary easing both in termsof quantity andqualityNext, the Bank decidedtoembark on thequantitativeand qualitativemonetary easingasa meansto underpin thiscommitment.Concretely, witha view topursuing quantitativemonetary easing, theBank decidedtochangethemain operatingtarget for money marketoperationsfrom theuncollateralizedovernight call rate (i.e., interestrates) to themonetary base(i.e., quantity) and conduct moneymarketoperationssothat themonetary basewill increaseat an annual pace ofabout 60–70trillion yen.Themonetarybaseisthecurrencysuppliedtotheeconomy asawholebytheBank; more specifically, it is the sum of banknotesand coinsincirculation and financial institutions‘current account deposits at theBankof Japan.As of end-2012,its amount outstandingwas138trillionyen, and it isexpectedto reach about 200trillion yen at end-2013and 270trillion yen atend-2014.It will almostdoublein twoyears.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 62This accountsfor nearly60percent of nominal GDP, far abovethe levelsof anyother advanced economies.As a meanstoincreasethe monetary base, the Bank decidedtopurchaseJGBssothat itsholdingof their amount outstandingon theBank‘sbalancesheet will increaseat an annual pace of about 50trillion yen.Consequently, the Bank‘sholding of JGBswill be increasedfrom 89trillionyen at end-2012to190trillionyen at end-2014.In short, it willmorethan doublein twoyears.ThemonthlyflowofJGBpurchasesisexpectedtobecome7+ trillionyen, becausetheBank needstocompensate for JGBsredeemed.In termsof quality, in increasingthe purchasesof JGBs, thosewithallmaturitiesincluding40-year bondswill be made eligible forpurchase,and the averageremainingmaturityof the Bank‘s JGBpurchaseswill be extendedfrom slightlylessthan three years at presentto about sevenyears – equivalent to theaveragematurityof theamountoutstanding of JGBsissued.We intend tostrengthenthe workingof monetary easingon the economyandpricesbyencouraginga further decline not only in shorter-terminterest ratesbut alsoin those acrosstheyield curve.Furthermore, witha view toloweringrisk premia of asset prices, theBank will purchaseETFs and Japan real estateinvestment trusts(J-REITs) sothat their amountsoutstanding on the Bank‘sbalancesheetwill increaseat an annual paceof about 1trillion yen and about 30 billionyen, respectively.Intelligible monetary policyIn the implementationof the quantitativeand qualitativemonetaryeasing, asmentioned earlier, wehavetaken account of theneed topresent our policy stanceintelligibly to marketsaswellasfirms andhouseholds.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 63Until last week, theBank‘s purchasesof JGBshad been conductedaccordingto the followingtwotypesof operations:oneunder theAssetPurchaseProgram introduced in October 2010and the other forfacilitating money market operations,often referred to asRinbanoperations.ThisreflectstheBank‘svariouseffortstotacklechallengesin responsetochangesin economiccircumstances.In fact, thesetypes of operations, reflectingtheir objectives,had differedin termsof thepurchasingmethodsused.However,thisframeworkwassomewhat complicatedand entailed aproblem that the Bank‘sseriouseffortstocombat deflation bymonetaryeasingwererather difficult for the market and thepublicto understand.Basedon such recognition, the Bank hasterminatedtheAsset PurchaseProgram and synthesized purchasingmethodsof JGBs.Moreover,it hasdecided to expressthe target of JGBpurchasesasa netincreasein its JGBholdings– namely, at an annual pace of about 50trillion yen.We believethat these changeswill facilitateunderstanding of the Bank‘sintentionwithregard to monetary easingin a straightforwardmanner.As I mentioned earlier, theBank decided to adopt the monetary baseasan indicator for quantitativeeasing.This alsoreflectsour judgment that the monetary base – the total amountof currencythat the Bank supplies tothe economy asa whole – will be themost appropriate indicator for conveying the Bank‘s aggressive stance onmonetary easingto the public.Continuation of monetary easingTheBank will continuewith thequantitativeand qualitativemonetaryeasingthat I have explainedthusfar, ―aiming toachievethepriceInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 64stability target of 2percent, aslong asit isnecessaryfor maintainingthattarget in a stablemanner.‖Obviously, there will be both upsideand downsiderisksto economicactivityand pricesgoingforward.TheBank will examinethoseriskscarefullyand will not hesitate tomakeadjustmentsasappropriate, should circumstanceswarrant.Onemay ask, whyisthere a connectionbetweenwhat I have justmentioned and a time horizon of about two years?In our view, the latest decisionsincludeall thenecessarymeasurestoachievethe 2 percent target with that time horizon.Nonetheless, it is not appropriatetosaythat the monetary easingwillonlylast for twoyears.Theeconomy entailsuncertainty, and there is alwaysa degreeof latitudein people‘sexpectations;for example, some peoplemay not share theview that theinflation rate will reach 2 percent in twoyears.For everyone – includingthosewhoare somewhat skeptical – tobeconvinced that sufficient monetary easingwill be implemented, it isappropriateto statethat the Bank will continuewithmonetaryeasing, aimingto achievetheprice stabilitytarget of 2 percent, ―aslongasit isnecessary.‖Makingsuch a commitment will, in theend, further ensure theachievement of thetarget in twoyears.I alsowant toelaborate on the meaning of ―aslongasit is necessary.‖TheBank doesnot believe2 percent inflation achievedat a certainpointin time isenough; rather, it believes2 percent inflation shouldbemaintainedin a stablemanner.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 65Therefore,evenif theinflationratehits2percent at some point, theBankcould continuewiththe quantitativeand qualitativemonetaryeasingif itis judged necessarytodo soin order tomaintainthat rate in a stablemanner.Theoppositecould alsobe true. In short, analyzing thefundamentalmovement of prices, the Bank intendsto continuewith monetary easing,aslong asit isnecessary.III. Effectsof the ―Quantitative and Qualitative MonetaryEasing‖Transmission channels of monetary easing effectsI will next explainthe mechanism of achievingthe 2percent target underthequantitativeand qualitativemonetaryeasing.TheBank expectsthat the effectsof monetary easingwill permeatetheeconomy and influencepricesprimarily through three channels.First, thepurchasesof JGBs,ETFs, andJ-REITswill encouragea furtherdeclinein long erterm interest ratesand lowerrisk premia of asset prices.This will raise firms‘credit demand through a declinein fundingcosts.Second, asa result of the Bank‘smassivepurchasesof JGBs,bothinvestorsand financial institutionsinvestingin JGBsareexpected toshiftfrom JGBsto such riskassetsasstocksand foreign-denominatedbondsand/ ortoincreaselendingwithin their portfolios.In economictextbooks,thisisreferredtoasa portfoliorebalancingeffect.Theextension of theaverage remainingmaturityof JGB purchasesreflectsour understandingof such an effect.Third, the commitment toachievetheprice stabilitytarget at theearliestpossibletime and thecontinuation of thenew phaseof monetary easingInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 66are thought to drasticallychangetheexpectationsof marketsandeconomicentities.This is what I referred to earlier asthe eliminationof deflationaryexpectations.Arise in the expectedinflationratewill not only influenceactual pricesbut alsostimulate private demand through a decline in real interest rates.Developments in economic activity and pricesLookingat recent developmentsin economicactivityand prices,it seemsthat the conditionsare beingpreparedtodemonstratethe effectsof thequantitativeand qualitativemonetary easingthrough the threetransmissionchannelsthat I just mentioned.Indeed, Japan‘seconomyhasshownsome bright signs of pickingup.Going forward, we expect the economy to return to a moderate recoverypath against the background of firm domestic demand and a pick-up ingrowth ratesof overseaseconomies.In recent months, conditionsin financial marketshave significantlyturned favorable dueto the abatement of global investors‘risk aversionand expectationsfor domesticpolicies.Theyear-on-year rateof changein the CPI hasrecentlybeen at around 0percent or slightlynegative, but lookingto the future, it is expected toturn positiveand start pickingup, mainly reflectingtheimprovement intheaggregatedemand and supplybalance.Looking at breakeven inflationrates– usingthe information content ininflation-indexedbonds– and the resultsof economists‘and households‘surveys, wehave increasingevidencethat inflationexpectationsarestartingto rise.Behind thisare expectationsfor policiesincludingmonetary policy.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 67This indicatesthat policiescan moveexpectations.TheBank expectsthat the quantitativeand qualitativemonetary easingwillsupport,inatimelymanner,thepositivemovementsthathavestartedtoappear in economic activityand financial markets,contributetoafurther pick-up in inflationexpectationsthat appear tohave risen, andlead Japan‘seconomy to overcome deflation that haslasted for nearly15years.IV. Some points of discussion in the monetary policy conductAfter theannouncement of this time‘sdecision, some wonderif the Bankcan carry out the quantitativeand qualitativemonetary easingwhileotherssaythat it hasgone too far.In addition, weoften receivequestionsabout therelationshipbetweenmonetarypolicy and other policiesconductedby the government.In thefinal part of myremarks, I wishtoanswersome of thesequestions.Execution of the quantitative and qualitative monetary easingThenewlyplannedpurchaseofJGBsat anannualpaceof50trillionyenismassiveand goesbeyond theconventional knowledgeof marketparticipants.In addition, theachievement of the monetary baseof 270trillion yen atend-2014requires that financial institutions‘current account balancesheld at the Bank reach175trillion yen.Again, this isextremely large.Furthermore, theextensionof the averageremainingmaturity fromslightlylessthan threeyears toabout seven years(i.e., allowingfor arangeof about six to eight years) necessitatesthepurchasesof JGBswithlonger maturity, including20- and 30-year bonds.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 68SuchJGBswithsuper-longmature tiesarelikelytobeheldtomaturitybyinstitutional investorsand their market is not soactive.Against this background, somemarket participantswonderif theBank isableto purchasetheseJGBsin practice.Toanswerthis question, wecan do this, in principle, solong asthe Bankpurchasesa widerange of JGBsthrough a competitiveauction.I assure you that wewill achieveour commitment.Having saidso, however,suchpurchasesby the Bank might not proceedsmoothlybecausetheygobeyond the market‘sconvention.Tostart with, thesemeasures aremeant toencourage a furtherdeclineininterest rates;thus, effectson the market are inevitabletosome extent.As the Bank wantstofacilitatesuchoperations,it is vital to have thecooperationofmarket participants,suchascounterparties‘activebiddingin the Bank‘smarket operations.TheBank hasdecidedto set forumsfor enhanceddialoguewiththosemarket participantsin order toexchangeviewspertainingtomoneymarket operationsand market transactionsin general.In fact, it hasalreadyinitiatedsuch dialoguewithvariousmarketparticipantssincelastweek.Relationship with financing the fiscal deficitOnce the Bank embarks on the large-scale purchase of JGBsunder thequantitative and qualitative monetary easing, some worry that this willresult in financingthefiscal deficit.TheJGBmarket remains stable,but if such purchasesby theBank wereregarded asmonetizing government debt, theJGBmarket might startdestabilizing, raisinglong-term interest ratesin a manner inconsistentwith the real economy.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 69This might not onlyoffset the monetaryeasingeffectsbut alsohavenegative effectson Japan‘sfinancial system and itseconomy asa whole.Of course,the JGBpurchasesunder thequantitativeand qualitativemonetary easingareexecutedfor thepurposeof conductingmonetarypolicy and not for the purpose of financingfiscal deficits.Moreover,in order toavoid a possiblearousal of doubt regardingtheBank‘s increasingpurchasesof JGBsasfinancingfiscal deficits,it is vitalfor the government toclearlyshow the future course of fiscalconsolidationand steadily make progressto reform the fiscalstructure.On thispoint, the government – in the joint statement releasedwiththeBank in January– stated that ―in strengtheningcoordinationbetweentheGovernment and theBank of Japan, theGovernment will steadilypromotemeasuresaimed at establishinga sustainablefiscal structurewith a view toensuring the credibilityof fiscal management.‖We stronglyexpect the government to move on that front.BecausetheBank synthesized thepurchasingmethodsof JGBsthistime,it temporarilysuspended theso-calledbanknoteprinciple.This principleindicatesthat thepurchasesof JGBsconductedforfacilitating moneymarket operationsare subjecttothelimitation that theoutstandingamount of long-term government bondseffectivelyheld bytheBank be kept below the outstanding balance of banknotesissued.In reality, however, after the introduction of theAsset PurchaseProgramin 2010,thetotal amount outstandingof JGBsheld by the Bank hasalready exceeded theoutstandingbalanceof banknotes.Basedon this recognition, the Bank hasdecided to temporarilysuspendthebanknoteprincipleasit pursuesthequantitativeand qualitativemonetary easing.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 70In anycase,letmereiteratethat theBank willnot financethefiscaldeficitduring or after theperiod of thequantitativeand qualitativemonetaryeasing, and thislineof thinking will not change.Effect on exchange rateWe also hear comments about the relationship between monetary policyand exchange rates against the background of the recent depreciation oftheyen.On thispoint, wehave no intention toconduct monetary policytargetingtheexchangerate.Theobjectiveof theBank‘s monetarypolicy is, obviously, topursuethestability of domesticprices.It is true that, when a central bank takesaccommodativeactions,there isa tendencyfor itscountry‘scurrencytodepreciate.This, however, is merely a general observation, ceteris paribus.For instance, if thegrowthpotential of theeconomy risesasa result ofmonetary accommodationaswell asappropriatefiscal policyand thegrowth strategy, its currencycould appreciaterather than depreciate.In any event, the Bank‘smonetary policyis focused on achievingthedomesticobjectivetoleadJapan‘seconomytowardovercomingdeflation.Achieving this goal will eventuallyprovide the global economy withfavorableeffects.I believe that the international community sharesa commonunderstandingonthesepoints.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 71Three-pronged strategy (three arrows)At present, the government is determined to addresschallengesthatJapan‘seconomy faces,includingtheovercoming of deflation, throughthecombination of three policy arrows– namely, bold monetary easing,flexiblefiscal policy, and a growth strategythat promotes privateinvestment.I think it is indeed an appropriate policy package.Achieving theprice stability target of 2percent at theearliest possibletime,throughthefirstarrow(i.e., monetaryeasing) istheroleof theBankof Japan.As I have explainedto you today, the Bank will achievethis target underitsown responsibility.In addition, paralleltomonetary easing, if the government createsrealdemand and wagesand employment improve through the expansion ofconsumptionand investment, thisis expectedtocontributetogeneratinga virtuouscycle that eventuallywill lead toa gradual pick-up in inflation.It is in thissensethat the implementationof the other twoarrows– namely, flexiblefiscalpolicy for the time being and a growthstrategy –will lead to raisingthe growthoutlook, therebycontributingto theachievement of theprice stability target more smoothly.We havehigh expectationsthat thegovernment will make steadyprogresson thesefronts.Concluding remarksFor eight years beforeassuming the position of Governor of the Bank ofJapan, I lookedat Japan from overseasasPresident of theAsianDevelopment Bank.No other country hassuffered from deflationfor nearly15 years.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 72Given that Japanesefinancial institutions, firms, and individualsplayactiverolesin eachAsian economy, I have often found it hard to acceptthecontrasting imageat home and abroad.Theworldiseagerlywaitingfor Japan to overcome deflationand forJapan‘seconomy torecover itseconomicstrength.I believe steadyeffortstowardachievingthesegoalswill alsolead Japantowardregainingitsinfluenceon the global society.Thank you.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 73RichardM. Ashton, DeputyGeneralCounselIndependent ConsultantsBefore the Subcommitteeon Financial Institutionsand ConsumerProtection, Committeeon Banking, Housing, and UrbanAffairs, U.S.Senate, Washington, D.C.ChairmanBrown, RankingMember Toomey, and membersof thesubcommittee,thank you for the opportunity totestify regarding therequireduseof third-party consultingfirms(consultants) in FederalReserveenforcement actions.Use of Consultantsby Regulated Banking OrganizationsAt the outset, it might be helpful topoint out that regulated bankingorganizationsroutinely choosetoretain consultantsfor a variety ofpurposesapart from anysupervisorydirectiveby regulatorstodo so.Bankingorganizationsdecidetoretain consultantsbecausethesefirmscan providespecializedexpertise,familiarity withindustry best practices,a more objectiveperspective, and staffingresourcesthat theregulatedorganizationsdonot have internally.In this respect, reliance on consultantscan significantlycontribute totheoverall efficient governance and management of these organizationsaswell asto their safeand sound operation and their compliance withsupervisoryexpectationsand legal requirements.Use of Consultantsin Federal Reserve Enforcement ActionsIn the vast majorityof Federal Reserve enforcement actions,theorganizationitself, usingitsown personnel and resources, isdirected totake thenecessarycorrectiveand remedial action.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 74In appropriatecircumstances,the Federal Reserve hasfound that it canbeaneffectiveenforcement tool torequire regulated organizationstoretaina consultant toperform specific taskson behalf of thatorganization.However,the mandatory useof a consultant hastypicallynot been afrequent requirement in Federal Reserveenforcement actions.And, importantly, consultantsare used to conduct workthat ordinarilytheorganizationitself wouldbe required to conduct.At all times,theFederalReserveretainsauthorityto,anddoes,reviewandsupervisethe consultants work in thesame manner asif theinstitutionconducted the work directly.In all cases, theregulatedorganization isitself ultimatelyresponsible foritsown safeand sound operationsand compliancewith legalrequirements.As a general rule, our enforcement actions require the use of consultantsto perform specific functionsthat the organization involved should do buthasshown that it cannot perform itself.This may be becausea particular organizationlacksthenecessaryspecialized knowledgeor experience.Similarly, the organizationmay not havesufficient staffing resourcesinternally.In addition, it may be necessaryto havea third partyundertake aparticular project becausea more objectiveviewpoint isrequired thanwouldbe provided by theorganizationsmanagement.Over the last 10 years, for instance, there were consultant requirementsinan average of less than 15 percent of all formal enforcement actionstakenbythe agency.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 75In additiontoformal enforcement actions,Federal Reserve examinersmay informallydirect organizationstoretain consultantsto undertakedesignatedengagementson behalf of the organizationwherecircumstanceswarrant.In our enforcement actions,werequired theuseof consultingfirms toperform several limited, specializedtypesof work.In many of theseenforcement actions,an expert third party must beretainedto review and submit a report on a specific area of theorganizations operations.Thesemandatedreviewsbyconsultantshaveofteninvolvedanevaluationof an organizationscomplianceprogram, its accounting practices,or itsstaffing needsand the qualificationsand performanceof seniormanagement.These enforcement directives usually require the organization toincorporate the findings of the report into a plan to improve thatparticular area of operations.Federal Reserve regulatorsmay alsousetheproduct of a consultantsworkasa guide in developingtheongoing supervisionof theorganization.Another type of enforcement actionwhereuseof consultantshasbeenrequiredinvolvessituationswhereexaminershave found seriouspastdeficienciesin anorganizations systemsfor monitoring compliancewithBank SecrecyAct and anti-moneylaundering (BSA/ AML) requirements.In thesecases, our actionshave required a consultant retained by theorganizationto review certain kindsof transactionsthat occurredat theorganizationover a specificpast period of time and determinewhetherBSA/ AML reportswerefiled asrequired with regard to thosetransactions.Thesereviewsrequire the consultant to identify situationswhereasuspiciousactivityreport or a currencytransaction report should haveInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 76been filed, rather than to perform an assessment of the organizationscomplianceprogram.After receivingthe resultsof theconsultantsreview, the organizationwouldthen file all the required reportswiththeappropriategovernmentagencies.Finally, in severalrecent enforcement actionsthat requiredorganizationstoidentify and then compensateor otherwiseremediateinjuredconsumers, the organizationshavebeen requiredtoretain consultantstoadministerthat process.In theseactions,theconsultantswererequired tomake recommendationsabout theappropriateremediationtoindividual consumersor tomakeremediationdecisionsabout individual consumersor review theorganizations remediationdecisions.Federal Reserve Oversight of Consultant PerformanceWhen enforcement actionsrequire a regulated banking organizationtousea consultant tocarry out a particular function, the Federal Reserveoverseestheorganizations implementationof thisdirective.Our standard practiceis torequire theorganizations retention of aconsultingfirm tobe first approved by theFederal Reserve.Wetypicallylookat theparticularexpertiseandexperienceoftheselectedconsultant.Theresourcesand capacityof the firm tocarry out the particularengagement are alsoexamined.Whether theconsultant hasthe appropriate objectivityand separationfrom management isalsoa keyfactorinassessingtheacceptabilityof thefirm.Toassessobjectivity, weexaminethe extent and type of workthat theconsultant hasdone for the organizationin thepast.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 77Oneguidingprincipleis that a consultingfirm should not beallowedtoreview or evaluate work that it haspreviouslydone for the organization.How thesefactorsare evaluated is necessarilydetermined on acase-by-casebasis,depending on thespecific type of task theconsultantis beingrequired to perform.However, the approval of particular consultants is not perfunctory; wherewarranted we have disapproved a consultant that has been selected by anorganizationunder an enforcement order requirement.Additionally, our general practice is toexplicitlyrequire that theletterbetweentheorganizationand theconsultingfirm orother documentationthat describesthescope, terms, and conditionsof the particularengagement be approved by the Federal Reserve.Thus, we are able to assesswhether the consultantsplanned work will beconsistent with what was intended in the enforcement action and whethereffectivesafeguardsof objectivitywill be maintained.We alsooverseetheconsultantsperformanceduring thecourse of theengagement.This oversight can involve obtainingand reviewinginterim progressreportsfrom the consultant.We alsocan call for periodic meetingswithconsultant personnel, whichcan be asfrequentlyaseveryweek.If a consultant is not meetingthe required standardsof performance, wewill inform theorganizationof the needed improvements, applying thesamecriteria asif the organizationwasperformingtheworkwith itsownpersonnel.In sum, it is important tonote that consultantsretained under FederalReserveenforcement actionsworkfor the organizationthat retainedthem, and the organization, not the consultant, is responsibleforInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 78correcting thedeficienciesthat triggeredissuanceof the enforcementaction and for preventing their reoccurrence.Requiring the use of consultants to assist in implementing corrective andremedial measures is just one tool available to Federal Reserve regulatorsin fashioningformal enforcement actions.Our experiencehasshownthat consultantscan be expectedtoprovidetheexpertise, experience,and third-partyperspectiveneeded by theregulatedbankingorganizationtobetter meet supervisoryobjectives,includingassistingthe regulatedorganizationswithcorrectingparticulargovernanceor operational deficienciesidentified through the supervisoryprocess.However,in decidingto usethistool in appropriatecases, theFederalReservedoesnot cede itsregulatory responsibilitiesor judgment tothoseconsultants.We require that regulatedorganizationscomply withthesame basicstandardsof prudent practicesand compliancewith applicablelawsandregulations,irrespectiveof whetheran organizationhas relied on theassistanceof a consultant or not.Use of Independent Consultants in the IndependentForeclosure ReviewAlthough it is not the specific subject of thishearing, it might be helpfultonotebrieflytheindependent foreclosure reviewsrequired by theconsent ordersissued by the Office of theComptrollerof theCurrencyandtheFederal Reserve againstmajor mortgage servicingfirms, and theroleof theindependent consultantsrequired under thoseorders.In those mortgage servicing orders, the servicers were required to retainindependent consultants to review foreclosure files of borrowers within atwo-year period toidentify financial injurycausedby servicer error.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 79Recently, the regulatorsand 13 of theservicerssubject to theforeclosureordersentered intoagreementsunder which theseservicersmust makecash paymentstoborrowersand provideother borrower assistance.Thesepaymentsandotherassistancereplacetheindependent foreclosurereview by independent consultantsthat had been required of theseservicersunder the initial orders.As wehaveexplained, theregulatorsacceptedtheseagreementswiththe13servicersbecausethe agreementsprovided the greatest benefit toborrowerspotentiallysubjectedto unsafeand unsound mortgage -servicingand foreclosurepracticesin amore timelymanner than wouldhaveoccurredunder thereview process.In practice, for theseservicers, the scopeof the inquiry required of theconsultantsto conduct the independent foreclosurereview proved overtimeto be more expansive, time-consuming, and labor-intensivethanwhat is typically required of consultantsin Federal Reserve enforcementactions.Theresult wassignificant delaysin providing fundstoconsumers.Accordingly, the decisionto replacethe review of individual foreclosurefiles by the consultantswith agreementsto pay cash and provideotherassistancetoborrowerswasbased on the specializedand unprecedentednature of theparticularreviewsthe consultantswererequired toundertake.Thank you again for the invitation toappear beforethesubcommitteetoday. I wouldbe pleased to answeranyquestionsyou might have.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 80Joint CommitteeReport onRisksand Vulnerabilities in the EU Financial SystemExecutive SummaryTheEuropean financial system continuestoface a dauntingrange ofinterrelated risks, necessitatinga concerted responseby policymakersboth at the political level and from theEuropean System of FinancialSupervision, includingthe European SupervisoryAuthorities(ESAs), inorder to restorethe confidenceand trust that hasbeen erodedduringrecent years‘financial crisis.Compared withtheSeptember 2012report, near-term risksto the EUfinancial system from the euroarea debt crisis(especiallybank funding)havegenerallyabated withimproving market confidence.However,financial institutions,in particular banks, remain vulnerabletoa sudden switch in sentiment.There have alsobeen delaysto some of thekey policy responses(e.g.SolvencyII, CRD IV) whichmayexacerbatesomeof thelongerterm riskshighlighted in this report.Many of the risksarisefrom the still weak EU macro-economicoutlook, whichaffectsthe financial positionsof governmentsand privatesectorborrowersand the outlook for propertymarkets,and whichmayleadtofurther deteriorationin the profitability and asset qualityofbanks,insurersand other financial market participants.Policy announcementsby European leaders– especiallyon OutrightMonetaryTransactions(OMT) and theSingleSupervisoryMechanism(SSM) – have significantlyreduced market perceptionsof tail risksandledto a narrowingof bank and sovereign credit spreads.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 81But totruly break thebank-sovereignlink and create foundationsforsustainablemacro-economicgrowthwill require continuedprogressonimplementationof announced policies.Financial regulations(includingSolvencyII and CRR /CRD-IV) mustremain economicallyand actuariallysound topromote a stablefinancialsystem that cansustainablyprovidefinancialservicestotherealeconomyandview risksconsistentlyacrossbalancesheets.Low interest ratesare an essential macro-financial policyresponse, butcan over a longer period of time havevariousnegativeside-effects:Solvencypressureson insurersand defined-benefit pension fundsfromhigher present valueof long-term liabilitiesand depressed reinvestmentreturns,incentivesfor searchfor yield behaviour by institutionalinvestors,profitabilitypressureson bank net interest marginsand risk ofhidden forbearance,with build-upof latent credit risk and inefficientmarket allocationof credit resources.Financial regulationand supervision need to ensure that, consistentlyacrosstheEU, financial institutionsfullyrecognizeand managetheserisksto ensure resilienceagainst therisksboth of a prolonged periodoflowinterest ratesand of any sharp adjustment tointerestrates.Thecontinueddelayof SolvencyII representsa particular challengeforachievingthis in theinsurancesector.Risksof further fragmentationof theEU SingleMarkethavebeenevidentthrough increased home bias and reduced cross-border financial activityof financial institutions.This trend hasbeen driven mainlyby financial institutions‘revisedbusinessstrategies(e.g. focuson corebusinesses), changesin riskappetite,higher funding costsand the challengingmacro environment.But it hasalsobeenexacerbated by uncoordinatednational policymeasures,includingring-fencingof local bank capital and liquidity,International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 82whichhindersthe free movement of capital, increasesfundingcosts,signals supervisorydivergenceand risksfurther safeguard measures.Market clusteringis alsoevident in securitiesmarkets,withdivergingequityreturns and credit spreadsincreasinglycorrelated within countriesor country groupsrather than acrosstheEU.For theinsurancesector, progresson supervisoryconvergenceand theSingleMarket remainsstalledduetofragmented national solvencystandardsand delaysto Solvency II.Tohalt fragmentation and strengthentheSingleMarket, theESAsneedtofoster supervisoryconvergence, amongst others,through a strong roleinsupervisorycollegesandthroughthedevelopment ofboththeEU-wideSingleRulebook and Supervisory Handbooks.At thepoliticallevel, EU leadersneed topressahead withtheestablishment of BankingUnion, includingSSM, and bank resolutionschemes.Thefinancial crisishasincreasedfinancial institutions‘attentiontocounterpartycredit risk, and lossoftrustinimplicit guaranteesand creditratingshave ledtoincreasedrelianceon collateral.This increasingdemand for collateralhasbeen reinforced by regulatoryinitiatives,includingmandatory central clearingof some derivatives(EMIR) andbank capitalrules(e.g. CVAcharges), aswellastheneedforbanksto hold high-qualityliquiditybuffersand use of securities for accessto central bank funding.Collateral safetyand liquidityis increasinglybeingpriced, incentivisingmore efficient use of collateral through collateral transformation (e.g.liquidityswaps)and reuse, leadingto increasedfinancial sectorinterconnectednessand cross-sectoralcontagion risks,encumbranceandrisksof pro-cyclicaleffectsin responsetoshocks to market pricesorratingsof either market participantsor collateral.TheESAs need to ensure that prudential ruleskeepup with theInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 83evolution of market practicesand encourage practiceswhichare bothmacro- and micro-prudentiallysound, and contributetoefficient, fair andstablemarkets.Financial market participantsremain concerned about thebalancesheetvaluation and risk disclosuresof financial institutions,and valuetheequityof many EU financial institutionsat a significant discount to theirbook values.Financial institutionsshouldvalue all their assetsand liabilitiesproperly,in full accordancewithapplicableaccountingstandardsand regulations,toensure valuation consistencywithintheEU, and should alsoanalyseandunderstand the sourcesof valuationuncertainty.This uncertaintyaffects both bankingbook and tradingbook assets,andultimatelythevaluation of capital.Supervisorsarestronglyencouraged to monitor and review thequalityofbanks‘assetsand the practisesof bankstomeasurethe qualityof theirassets.Aparticularproblem for the insurancesector (dueto delays toIASBconvergenceworkand SolvencyII) is thecontinued absenceofEU-harmonisedaccountingstandardsand regulatoryvaluationrules.Valuationand risk measurement (especiallyof complex instrumentsandlonger term risks)is generallybasedon quantitativemodels.For assetsand riskswherefirmsusesimilar or identical models, they areconsequentlyexposed to risksof valuationshocks arising from modelfailures and recalibrations.Additionally, much of thevaluation uncertaintyrelatestofinancialinstitutionsexposurestothe aforementioned common risk factorsofmacro-economicoutlook, interestratesand collateral values.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 84Supervisorsareencouragedtoset appropriate incentivesto correct forpotential distortionstovaluation and tocontributeby thesemeanstotheultimate goal of theprotection of consumersand investors.Confidencein financial market benchmarkssuffered in 2012, aspreviousmisconduct in banks‘submission of benchmark interest ratescame tolight.ESMA and EBA have acted, in coordination withthe EUCommission, IOSCO and national authorities, to addressthe flawsinbenchmark rate settingfor Euribor and other key benchmarks.While more workneedstobe done in designing sustainableresilientsolutionsfor settingof financial benchmarks, continuityof existingbenchmarks(whichare referencedby an enormousnumber and value offinancial contracts) alsoneedsto be maintained, e.g. by mitigatingtherisk of disruptivewithdrawalsfrom existingrate-settingpanels.Theaboveisnot an exhaustivelist of risksfacingthe EU financialsystem, but comprisesthosewhichtheJoint Committeeof the ESAsfeltweresufficientlycross-sectoralin nature tomerit co-ordinatedCommunity-widecross-sectorallyconsistent policyresponse,withbroadpoliticalsupport.INTRODUCTIONTheEuropean financial system facesa rangeof risks and challenges:1.Risksfrom theweak macroeconomic outlookfor thefinancial health ofreal-economyand sovereign borrowers,and consequentlyfor financialinstitutions‘asset qualityand profitability;2.Risksofaprolongedperiodof lowinterestratesimpactinginsurersandpension funds,increasingsearchfor yield behaviour and facilitatingwidespreadforbearanceby banks;International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 853.Risksof further fragmentation of thesinglemarket in financial servicesduetoevidencesof national retrenchment, home bias, reducedcross-border activityand clusteringof markets;4. Risksfrom increasedrelianceon collateralin financial transactions;5. Risksto confidencein financial institutionsbalancesheet valuationsand risk disclosures;and6. Risksof lossof confidencein financial market benchmarks.Theserisks, although presented individuallyin thisreport, are highlyinterlinkedand require aconcertedresponsebypolicy makersboth at thepoliticallevel and from theEuropean System of Financial Supervisionincludingthe European SupervisoryAuthorities (ESAs).Suggested policy actionstorestorethe confidencein the financial systemare presentedat theend of somedescribed risks.Thechallengefacingpolicy makersis nothinglessthan to restoretheconfidenceand trust in the financial system that hasbeen eroded duringrecent years‘financial crises.1RISKSFROM AWEAK MACRO-ECONOMIC OUTLOOKDespiterecent improvementsin financial markets,the macro-economicoutlook(aspresented in the ECB‘sMonthlyBulletin of January 2013)remainsweak, withresidual downsiderisks.This weak EU macro-economic outlook has implicationsfor the financialposition of governments and private sector borrowers and for the outlookfor propertymarkets, and maylead to deterioration in the profitability andasset qualityof both banksand insurers.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 861.1BANKING SECTOR ASSET QUALITY, PROFITABILITYAND FUNDING RISKSProspectsof a depressed macro-environment going forwardexacerbateconcernson bank asset qualityand their valuation.While bankshave significantlystrengthened their capital positionsoverthelast twoyears, supported by the EBA recapitalisation exercise, thereare concernsabout impact on capital from potential future loanlossesasasset qualitydeteriorates.Non-performingloanshavebeen rising fast, while at the same time loanlosscoverageratioshave remained steady(seeFigure1and Figure 2).Acontinued adverseenvironment wouldcontributeto further risingnon-performingloans(NPL) and loan lossprovisions.Thenecessaryworkingout of problem loansin banks‘bookswilladditionallycontinueto generate risks,adding to challengestorestoremarket confidenceon credit portfolios.Asset quality concerns are aggravated by widespread loan forbearance, asthis practice may have contributed to underestimate the scale of problemloans.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 87In many banksdeteriorating asset qualityhas resultedfromover-exposuretothereal estatesector.Theoutlook for residential and commercial real estatepricedevelopmentsremainsweak, reflectingsubdued demand for housing, aswell astheneed tocorrect the still relatively high degreeof propertymarket overvaluation in several countries.Thedeterioratingeconomicoutlook alsoaddstotheuncertaintysurroundingfuture developmentsof real estateprices.For that reason, a number of banksremain vulnerable toincreasesinnon-performingloanswithany additional property pricecorrectionsleadingtofurther deteriorationin asset quality.Somebanks may now need toaddressthe issueof distresseddebt andunsustainableloanforbearancein a more structured and efficientway, constructively dealingwiththe issueof unsustainabledebt, whileensuring that borrowersstill have appropriate incentivestoservicedebt.Theweakeconomicenvironment may furthermore leadtocontinuedlowrevenuesand continuedlow profitabilityof banks.Low-profitability banks havedifficultiesfindingequityinvestorsandthereforedepend on lowerretained profitsin order tomeet regulatoryrequirements.Profitability may befurther hamperedbyconduct redresscoststhat somebanksfaceasa consequenceof past conduct of businesspractices.Fundingconditionsfor bankshave significantlyimproved in mostgeographiesin the past monthsfollowingconcretemeasuresandannouncementsof the ECB‘s Outright MonetaryTransactions(OMT)andtheSingleSupervisory Mechanism(SSM), amongst other importantinitiatives,and there arehopesthat the bank sovereignlink is weakened.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 88However,a largenumber of bankscontinuetobe heavily supported bycentral bank funding, leavinga return to lastingand stablesourcesofmarket funding a challengefor manybanks.Benign market fundingconditionsof thepastmonthsare still fragile, inparticular in light of potential implicationsfor banks stemming from aweakeconomicoutlook and asset qualityconcerns.Supervisorsarestronglyencouraged to make further progressonreviewingthequalityof banks‘assetsand the practisesof banks tomeasure thequalityof their assets.While policy announcementsand concretemeasuressucceededinsignificantlyreducingtail risksfor European banks,at leasttemporarily, the current environment neverthelesscontinuestoprovidesignificant challenges,in particular in banking systemswithfinancially-stressed sovereigns, assignificant structural stressesstill prevail.Elevatedsovereign risk premia for financiallystrainedEU countries havenarrowedmarkedlysinceAugust 2012,suggestinga reduction in marketperceptionsof euro area sovereign risk, particularlyin the periphery.However,uncertaintiesremain over important aspectsandimplementationof EU institutional reforms,suchuncertaintiesaboutfutureactionsmay negatively affect thecurrent respitein sovereign debtandbank fundingmarkets.1.2 DECLINING PREMIUM GROWTH IN THEINSURANCE SECTORAweakmacroeconomic environment impactstheinsurancesector in anumber of ways.Generally, premiumstend todrop duringrecessions(although often witha lag), in particular in the life sector.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 89Figure 3 showsthe effect on grosswrittenpremiumsduring therecenteconomicdownturnfor the largestEuropean life insurerson anaggregated basis.Indeed, premium growthwasnegativethroughout 2011asthemacro-economicenvironment hasput pressure on thesaleof lifeinsurancepoliciesin countrieswhere household wealth and income hasbeen reduced.Fiscaladjustment toreduce publicsector deficitsin many countrieswouldalsolimit thepotential growthof insurance volumes.This could happen both directly, through increasedtaxation onpremiumsor reduced tax incentivesfor long-term life and savingsproducts,or indirectlyfollowinggeneral tax increasesand reduceddisposableincome.Moreover,high levelsof unemployment combinedwith lowlevelsof interest ratesmay alsolead to earlysurrendersin the life sector, inparticular for productswithout guaranteed returns ascustomersavoidsurrenderingpolicieswith(high) guaranteed returns.Thiswouldnaturallyleadtoanadverseselectionfrom thepoint of viewoftheinsurer.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 90In addition, thedeleveragingobjectivesestablishedfor thebankingsectorhave ledtoincreasedcompetitionfrom bankstrying toincreasetheir deposit fundingbase, which in turn isreflectedin decreasinglifeinsurancebusiness.In some countries, household investment in government bondsis alsoaform of saving whichcompetesdirectlywith certain life insuranceproducts.Finally, the current lowlevel of risk free interest ratesfollowingthe weakmacroeconomicclimateisa particular concern in the life insurancesector, both in termsof lowerprofit from investment income, but alsointermsof increased value of liabilities.In the non-life insurancesector, Figure 4 showsthat year-on-year growthhasremained positive, but the differencebetweenthebest and the worstperformers(indicated by theshaded areacovering the10th and 90thpercentile) is increasing, indicatinga diverging development in Europe.It is likely that increasingunemployment and reduced net householdincome will decreasethedemand for non-life productssuchasmotorpolicies(with exception of compulsory third-partyliability) and workerscompensation insurance.Fraudulent claimsin thenon-life sector may alsorisein a recessionaryenvironment, although the impact on insurersis generallyseen assmallcomparedtothepeak in claimsfollowingnatural catastrophes.SolvencyI ratiosaregenerallyadequate, even if some insurersareexperiencingpressure on their solvencycoverage.However,SolvencyI ratios generallydonot reflectthecapitalpositionsofinsurerson a market value basis.Market valuation wouldmost likelyresult in higher valuationof liabilitiesandpossiblylowervaluation of (partsof) the asset portfolio.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 91Thecapital position of insurerswouldthereforebe worseon a marketvalue(i.e. SolvencyII) basis.1.3 IMPLICATIONS FOR FINANCIAL MARKETSA continued weak macroeconomic environment and the prospect of anextended low-interest rate environment impose several potential threatstomarket participantsin securitiesmarkets.First, lowreturnsincentivize search-for-yield strategies,eventuallyincreasingthelikelihood that investorstake on positionswith elevatedrisk levels, and promote theacceptanceof leverage.Second, liquidityon short-term marketsaswell asthe revival of any formof unsecured fundingareboth negativelyaffected by lowinterestrates,becausepotential buyers‘appetitesare rather subdued.The latter effect also implies an increasing demand for collateral and theassociated potential for a relative scarcity of collateral discussed in moredetail in section 4.Third, prolongedmacroeconomic weakness, low interest ratesand thedistinctivetreatment of sovereign bondsin term of risk weightsmayincentivizeregulated firms‘investment in sovereignbondsand(indirectly) the issuanceof sovereign debt.This could implypotential bubblesin sovereign bond prices,especiallyfor markets exposedto severe public debt problems,but alsofor marketson whichsubstitutesare traded.Fourth, a prolonged weak macroeconomic environment associated withpotential increases in unemployment rates is likely to affect households‘saving volumesnegatively.Hence, ultimately domestic retail funding sources would be reduced inthe most troubled markets and negative impacts on assets prices and ahigher dependenceon international fundingwouldbe generated.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 92All thoseeffectswouldimpact on the assetssideof financialintermediaries‘balancesheets,beit banks, insurersor other financialintermediaries.Thus, cross-sectoralfeed-back effectswouldbe highlyprobable.1.4 FINANCIAL REGULATION AND ECONOMICPERFORMANCETheemergingregulatorylandscapefor banking, insuranceand financialmarket participantsin general createsa resilient frameworkfor the EUfinancial sector.Many important elements of the future framework are still in the processof being finalised, and uncertainties on timing and cumulative effects ofvariousinitiativescreatesome short term challenges.Moreover,theneed tore-establish economicgrowthhasledtopoliticalpressuresfor encouragement of the supplyof credit totherealeconomy, whetherfrom banks, insurersor pension fundsor via market-based intermediation.For instance,duetotheir long-termliabilities,insurersandpensionfundsare seen aspotential sourcesof financefor long-term investments.TheEuropean Commission hasthereforeasked EIOPA and EBA toanalysethe effect of financial regulationon availabilityof financingforthereal economy, particularlyinfrastructureinvestments,private equityor SME financing, toinform on-goingnegotiationsof SolvencyII andCRR/ CRD IV.Onephenomenon revealedby the2008financial crisiswasthecross-sectoralinterconnectednessand complexityresultingfrom therepackagingof variousdebt forms by meansof securitization, financialengineeringand similar techniquesinvolving thechange of riskcharacteristicsalongthe way.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 93Inadequate accounting, disclosure and prudential requirementshid theunderlying financialand behavioural risksbehind such complexintermediation.Thecrisisledtoalossof confidenceinsuchfinancialintermediation, andconsequent regulatoryreforms totighten up prudential and disclosurerequirementsto restoreconfidencein thefinancial system.Howeverthecommercialandpoliticalpressuresforthefinancialsectortoprovidelongterm financingto the real economy, whilenot overtlyexposingretail depositors,policy holdersand retail investorstothe risksinherent intheprovisionof long-term risk financing, areagain increasingtheincentivesfor firms toarbitrage around new regulatory requirementsandincreasecomplexcross-sectoraltransformationoffinancialpromises.Unlessproperly designed, initiativestostimulate growth run the riskofdivertingscarcefundsawayfrom their most productiveuses, and notnecessarilyincreasingaggregate demandin theeconomy.But, for the caseof liquidityhoardingby financial marketparticipants,additional demand stimuli can have potentiallypositiveeffectson expectationsand investment plans.Nevertheless, makingchangesin light of a financial crisisrunstherisk ofa short term fix insteadof a viablelong term solution, and may lead tocomplacencyand reduced commitment tostructural reformsand theinternationallyagreed Financial RegulatoryReform agenda.Regulation should be designed in such a waythat it is not amajorobstacletogrowth, but is hasto view risk consistentlyacrossbalancesheets.Thiswouldfor instanceimplythat anyrecalibrationof SolvencyII capitalrequirementsneedsto be actuariallyand economicallysound.Finally, anychangesfor one financial industryneed totake account ofdevelopmentsin other sectors, soastoprevent regulatory arbitrageandmaintainconsistencyacrosssectors.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 942RISKSFROM PROLONGED LOW IN TEREST RATESThemacro-economicdown-turnfollowingthe financial crisishasnecessitateda concertedpolicy response, especiallyfrom monetaryauthorities, whohave loweredpolicy interest ratesand expandedtheirrangeof monetary operations(seeFigure5).Market expectations, influencedby central bank communications,areincreasinglyfor interest ratestoremain low for significantlylonger time.Aprolongedperiodof lowinterestratesmay haveprofound distributionaleffects,supportingborrowersand reducinginterest incomefor savers.Withinthe financial sector, lowinterest ratesgenerallysupport banksbyreducingfundingcostsand credit risk, but hurt insurersbyincreasingthepresent valueof liabilitiesand depressingreinvestment returns.Somebanksmay alsobenegatively affectedbyanoverall reductionin netinterest margins(see 2.2).Thechallengefor financial regulationand supervision is toensurethat, consistentlyacrossthe EU, financial institutionsfullyrecogniseand managethe direct and indirect interest rate risksto ensureresilienceInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 95against the risksboth of a prolonged period of lowinterestratesand ofanysharp adjustment tointerest rates.Thecontinueddelayof SolvencyII representsa challengefor achievingthisin theinsurancesector.Oneof the reasonsfor thedelay, however, is the continued discussionofcertaintechnicalaspectsofSolvencyII includingthelongterm guaranteepackage.EIOPA is currentlyassessingthisissue.2.1INSURANCE SOLVENCY PRESSURESTheexistenceof a prolongedlow interest rate environment harmsinsuranceundertakingsby increasingthe present value of liabilitiesandbydepressingreinvestment returns.In turn, ascapital market ratesapproach the guaranteed rate, insurersfaceincreasingdifficultiestomeet performance guaranteesprovided oncertaininsurancecontracts.Consequently, compression of this margin beyond a given point wouldcausean erosion of thecapital positionof somesegmentsof theindustry.In general, lowinterest ratesare particularlydetrimental for life insurersanddefined-benefit pension funds, giveni)Their largeexposure topredominatelyfixed-income assets,ii)Thefact that theytypically have a negative duration gap, withliabilitiesof longer duration than assets,andiii)Thefact that their productsmight includeperformanceguarantees.Wherehistoricalcost accountinginsteadof market consistent valuationisapplied, theeffect of the lowinterest ratesis not immediately visible.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 96However, the impact of a prolonged low-interest environment dependsonthe type of insurance business, itsexposure tointerest rate risk and periodover which interestratesare depressed.It alsodependson the market in whichthe insurer operates,and on therelevant government bondsyield curves.Individual reports on theinterestratesensitivityof European insurerscollectedby SwissRe show that companiesdomiciled in central andnorthernEuropean marketsare the most exposedtofurther declinesininterest rates.Thesensitivityis generallydue to long and rigid guaranteesoffered topolicy holders.SwissRe findsthat interest ratesensitivityis generallylowerin southernEurope and France, aswell asin the UK.Thedimensionsof the potential problems associatedwith a prolongedperiodof lowinterest ratesare difficult toestimate,althougha number ofstudieshavebeen produced.TheEIOPAstresstestonalow-yieldscenario carriedout in 2011revealedthat 5% to10% ofthecompaniesincludedin thesamplewouldfacesevereproblemsif theprolonged low interest environment remains, in thesensethat their ratioof solvencytothe minimum capital requirement (MCR)wouldfall below 100%.In addition, many companieswouldonlybe able tomaintain solvencyratesslightlyabove the 100% mark, makingthem vulnerable tootherpotential external shocks.The EIOPA stress test clearly showed that the effects of low interest rateson the liabilityside outweigh anytemporary asset valuation gainson fixedincome investments.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 97Internal researchby EIOPA hashighlightedthe challengesfacedbynational supervisoryauthorities and individual insurersin responding totherisksposed by lowinterest rates.EIOPA is therefore working with national supervisors to identify suitablesupervisory measuresand to further quantify the extent of the detrimentaleffect of the current low interest rates.In this regard, EIOPAhaspublished an opinion on the supervisoryresponseto a prolongedlowinterestrateenvironment.Theopinion addressesthe main challengesthe for the insurancesectorposed by a low interest rateenvironment, promotesadoption of privatesector solutionsand expressesEIOPA‘sviewson thesupervisoryresponsestothis environment.EIOPA will alsocarryout a follow-upexercisewithMemberswiththeaim toassessthescaleof this issueand wherethe greatest impactslie.As the likelihood of a prolonged period of low nominal interest ratesincreases, individual insurersalsoneed tofind suitabletoolstomitigatetheeffect of such periods. Onepossibilityis to re-priceproducts.However,thissolution is generallyonly possiblefor new businessanddoesnot addressthosecontractsthat arealready on the booksof theundertakings.Guaranteeson current contractswouldgenerallyneed to be honouredand funded through cross- or intra-product subsidization, or throughreserves.Immediatechallengesmay be somewhat relieved if life insurancecompanies are allowedto smooth the returnsover the life of the contract.Insurerscould alsoaim to redesign their product portfolio.Thiswouldgenerallyinvolveamovetowardsproductsthat perform betterin thecurrent market conditions(e.g. unit-linkedproducts, in whichtheInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 98risk is shifted tothepolicyholder) and the discontinuationof sellingnewguaranteed products.Ashift towardsproductsthat are not heavily dependent on investmentincome (e.g. productswithindexed annuities) wouldbe beneficial.Under certain circumstances,insurersand pension fundsmay be able torenegotiateor unilaterallyadjust existingcontractswith the aim ofaccommodatingthetermsof the guaranteesto the current marketconditions.Reputational considerations,however, oftenmake thisunrealistic,sincefuturebusinesswouldbe likely to be severelyharmed aspolicyholderswouldshy awayfrom buying insuranceproducts.Policyholders are naturallynot willingtogive up relativelylucrativeguaranteesand insurerswill generallyhave to continueofferingthesetypesof products.Legal constraintswould also, in most jurisdictions, not allow or onlyallowthis as a last resort measure, when there is an overall risk of failure of theinsurer.2.2 BANKING SECTOR: MARGIN PRESSURES ANDCREDITOR FORBEARANCEPersistent low interestratesare alsoputtingpressure on thebusinessmodel sustainability of banks whichfind deposit interest margins,andthereforeoverall net interest margins,squeezed, contributingtoprofitabilitypressures.This hasledmanybankstoseekother sourcesof revenue, includingfeesand commissionsfrom cross-sellingother financial products, andincentivised searchfor yield behaviour, although some havefacedconduct redresscostsfor past salesof unsuitablefinancial products.Low interest ratesreduce near-term default risk on credit exposuresbysupporting borrowers‘abilityto servicetheir debt (helpingtopartiallyInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 99off-setthenegativeimpactfromtheweakmacro-economicenvironment), but alsoprovide direct and indirect incentivesfor creditorforbearance.Low interest ratesreduce the near term financial or opportunitycost offorbearingon loanswith risk of future impairments.And, indirectly, the decreasing margins, cost-reducing pressures anddepressed values of some of the assets pledged as collateral, may givebanksfurther incentivestoforbear on loans.There are, unfortunately, clear risksassociatedwithforbearance,especiallyif not properlyrecognisedand managed.However,prolonged lowinterestratesalsoposethe risk of a suddenrise, which wouldfurther aggravateshort term asset qualityconcerns, asborrowers‘abilityto repay loansdeteriorates.Asudden riseof interest rateswouldalsoincreasefunding costsandcould result in tighteningof interestmargin, especiallyin case of lendingwith longer repricingperiods.While protracted low interest rateshavecontributed topriceincreasesinsomeasset classes,in particularinthehousingmarket, anenvironment oflowinterest ratesinthecurrent junctureisthusprudentiallypreferable forthebanking sectorover an environment of sudden risesof interest rates.Suddeninterest rate riseswouldalsogenerate lossesin fixed incomeassets.Lowinterestratesneverthelesscontinuetocontributetodelaysin balancesheet repairs, to a slowerpaceof deleveraging, and tocompressedmargins.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 1002.3 FINANCIAL MARKETS:SEARCH FOR YIELDBEHAVIOURMany market participantsstill have target ratesof returnssignificantlyabovecurrent risk-freeinterest rates,whetherdrivenby existingcontractual liabilitiesor by stakeholder expectations.Low interestratesincentivize market participantsto seek higher yields invariousways, includinginvesting in lessliquid assetsand taking riskswith off-balancesheet investment vehicles.FinancialmarketshaveralliedsinceAugust 2012,astheECB‘spromisetodo‗whatever it takes‘reassuredinvestorsthat tail risksfor financialmarketshad receded.Sovereign and corporate bond yieldsin both advancedand emergingeconomieshavenarrowedmarkedly.Spreadsare again closeto long-term historical averages.However, a reassessment of credit risksmay make these spreadstowidenagain given the potential increase of defaults against the backdrop of theweakmacro-economicoutlook.Recently, concernshave been raisedbytheECB‘sBond Market ContactGroupthat thenegativenominal yields for somenon-distressedsovereignbondsin the short end might not reflectfair values; and that the recenthunt for yield wasleadingto lowerbond yieldsin thosecountries wherethegrowthoutlookwasstill unsatisfactory,whichpointedtoadecouplingbetweenflowsand fundamentals.Thesedevelopmentsimplysome risksof thedevelopment ofmis-valuationsin sovereignbond markets.Market improvementshave alsospread downthecredit spectrum tohigh-yieldbonds, withnarrowingcredit spreadsand increasingissuanceactivity.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 101This hasmainlybeen in the establishedUS high-yield bond andleveragedloan markets, wherethere have alsobeen a sign of areemergenceof lessprudent pre-crisisactivities,suchasCLOs,covenant-liteloans,payment-in-kind toggles,CMBSand non-agencyRMBS, suggestinga return of investor riskappetite.Sofar, the search-for-yield has mainly occurred in wholesale markets, anddid not reach retail marketsin which a continued decline of the volume ofstructured productssold to retail investors has been observed (see Figure6).Nevertheless, thenumber of structured productssoldincreased(seeFigure 7), whilethe maturitydecreasedover the last few years.Retail investorsmay wellbemorerisk awaresincethefinancial crisisandremaincautiousabout returningtoa somewhat tainted asset class, whilelowinterest rateshave made it more difficult for financial institutionstooffer compellingproducts.Market volatilityindices,whichhavebecome a tradableasset class, havealsonarrowed.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 102This has the effect of reducing the value-at-risk (VaR) measures andcapital requirements for some trading book activities, and making itcheaper (in capital terms) to take financial risks.However,historicaltime seriesfor volatilityindicesexhibit patternsofprolonged declinespunctuated by sharp jumps in volatility.Suchvolatilityjumps, if theyweretohappen, wouldsharply increaseVaRmeasuresand capital requirements, whichcould trigger and reinforcenegativemarket dynamicsfrom forced sellingby VaR- orcapital-constrainedmarket participants, risk-sensitivemargin andcollateral requirements– a phenomenonknown asVaR shocks.Lifeinsuranceundertakingsand occupational pension fundswhich offerproductswithguaranteedinterest ratesmight strugglein earningtheseinterest rateswithout adaptingtheir original investment policy.It is, however,difficult to quantify the actual extent of searchfor yieldbehaviour.Asurveyrun by EIOPAamong national supervisoryauthoritiesinAutumn 2012revealed no clearpicture for the period from 2011to2012.Althoughthenumberof jurisdictionsreportingat leastsomeobservationsofanincreasedsearch-for-yieldbehaviourwasgreaterthanthenumber ofjurisdictionsnot reportingsuch findings, aggregated data on theinvestment portfoliosof largeinsurancegroupscannot underpin anytrendof switchingbetweenmajor asset classes(e.g. from sovereign tocorporatebonds, or from bondsto equity).Potential searchfor yield behavior involvinginvestingintolowerratedassetsor bondswitha longer maturity is alsodifficult to identify withaggregateddata asany such investment pattern could be masked byvariousother factorslike a downwardratingmigration in thebondportfolio witha subsequent changein thevalue of theseassets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 103Lack of flowdata makesportfolio shifts difficult to identify and thegeneral problemsin quantifying thesearchfor yield are alsorecognisedbyother institutions, like e.g. theOECD.However,aslongasthe regulatoryframeworkis not risksensitive,insurershaveincentivestoincreaserisksin order toincreasereturnson their portfolios.3 RISKSOF FURTHER FRAGMENTATION OF THESINGLE MARKETTheSingleMarketisoneoftheEuropeanUnion‘sgreatestachievements.However,the current economic situationis characterisedby strongon-goingevidencesof fragmentation of the EU SingleMarket and ofnational retrenchment witha biasfor domestic markets.3.1INCREASED HOME BIASAND REDUCEDCROSS-BORDER BANKING ACTIVITYTheprocessof EU and Euro-areafinancial integration and cross-borderbankinghasstalledduring the financial crisis, and bankshave reducedinternationalexposures,increasingtheriskof fragmentationof theSingleMarket.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 104Asignificant decreaseof interbank flowsacrossborders,a reduction offoreign claims(seeFigure 8) and a substantial wideningof crossborderlendingratesprovide further evidencesof increasingretrenchment.There is alsosomeevidenceof increasedhome biasin asset holdingsintheinsurancesector(although a certain level of home bias isinherent inthebusinessmodels and risk management of insurerswith adomesticcustomer base).Theseon-goingstrongevidencesof fragmentation and retrenchment rollback some integrationgainsachievedsofar and risk underminingthefoundationsof the SingleMarket.Thisexacerbatesconcernsabout financialstabilityin Europeandassuchsignals a lack of confidence.Signsof fragmentationcan be traced to both ―public‖ and ―private‖drivers,with each reinforcingthe other.Private drivers of fragmentationreflect changesin therisk appetiteofinstitutionstowardsde-risking.This includesbusinessstrategiestowardsexitingor scalingback fromregionsor businesses.In recent times,many bankshave started to diminishtheir foreignexposuresduetohigher fundingcosts,general risk aversion, andchallengingconditionsto exploreoperational synergies.Also, banks havebeen under pressure todeleverageassetswheredifficultiesare experiencedtoobtain fundingtosupport theseassets.For instance, a lack of fundingin USD for somebankshascaused ascaling down of businesseswhereglobal transactionsare mainlydenominatedin USD, such asaircraft financing.At the same time, close-out transactionsamongbanksacrossbordersareleadingtoa severe slowdownin cross-border interbank activities.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 105TheEBA‘s RiskAssessment Report, in itssemi-annual survey, providessome evidenceof thison-goingretrenchment (seeFigure 9and Figure10).Publicdriversreflect, among other issues, uncoordinatednational policymeasurestaken by some national regulators,includingring-fencinglocalcapital and liquidity, diverging supervisory practisesand informalrequirements,e.g. to locallymatch liabilitiesand assetstomitigateperceived currencyredenominationrisks.While banksmaywant tooptimizefundingpositionsthrough intra-grouptransfers,some home and host authoritieshave undertakena series ofunilateralring-fencingmeasuresto localcapital and liquidity.For instance, measureswereimposed to reduceexposuresof bankstoaffiliatedentitiesmainlyimpactingtransactionsbetweensubsidiariesandtheir foreign parent banks, limitingintra-group lending.Uncoordinatednational policymeasuressuch asregulatory ring-fencingrequirements(evenwherethere is no clearlyspecifiedand EU-widestructural framework) risk hinderingthefree movement ofcapital, increasingthecost of funding, signallingsupervisorydivergences,influencingnegativerating actions,and provokingfurthersafeguardmeasures.Moreover,fundingchallengescan alsoexacerbatepressureson domesticbanksand their sovereigns.For instance, national bailouts and other localsupport measurestosupport localbankscan have a negativeimpact on debt dynamicsandincreasesystemic risk in a self-enforcingmanner.Concernsabout fiscal costsof bailing-out a largefinancial institutioncanadverselyaffect theborrowingcostsof thesovereignthe institutionisdomiciledin, partlybecauseof the anticipatedimpact on debt dynamics.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 106In the context of fragmentationin financial services, this isa particularrisk wherealreadycloselinksbetweenbanks and their stressedsovereignsare increasingfurther.Consequently, coordinatedpolicy responsesacrossMember Statesand aclearlyspecifiedand sustainableEU-widestructural framework forsupervisorycoordinationareneededtoreinforcesupervisoryconvergenceandtorapidlyreverseharmful trendsof fragmentationof theEU SingleMarket.Furthermore, the0% risk weight asassignedtosovereign exposuresinbankingand insuranceregulationmay havebeen a further driver ofmarket fragmentation to theextent that it hassupported purchasesofpredominantlydomesticgovernment debt, contributingnot only tofragmentation, but alsotoincreasingbank-sovereign links.3.2 INCREASED CLUSTERING OF FINANCIAL MARKETSFinancial marketswithin theEU havedisplayed since2011signsof aclusteringof marketsintotwobroad main groups.Main manifestationsof this clusteringcan be seen in an increasingdispersion of EU equityindices,a continuing high dispersion in theyieldson EU sovereign bondsand the formation of twogroupswithinternallyhighcorrelationcoefficientsbetweensovereignbondyields andInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 107lowcorrelationsbetweeneachother, neverthelesswithpotential spill-overeffects.Tobe sure, thisclusteringdoesnot mark a fragmentation of the EUsinglefinancial market.It rather reflectsa realignment of risk assessmentswithinthemarket,while the integrityof the singleEU financial market and itslegal and institutional infrastructureremainsunimpairedby thiseconomic development.In detail, the general upward trend in equityindiceshasnot included allEU countries, asat least one smaller country experienced a furtherdeclinein its equityindex therebyfurther increasingthedispersion ofequitymarket indices.SinceJanuary 2011theweakest performer haslost about 80 percentageofitsvalue, while the best performer hasgainedroughly20 percentagepointsin value.In particular, the European banking sectors have, since July 2012, beencharacterized by an increased dispersion of equity indexes (see Figure11).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 108At sovereign bond markets,the yieldsfor almost all EU countrieshavefallensinceJuly2012.However,sovereign bond yields for several member statesremain on anelevatedlevel, i.e. well above 4percentagepoints,and producea stillconsiderableamount of heterogeneityacrossEU membersreflectedin anabsolutedispersion of around 10 percentagepoints.This impression is alsoconfirmed by correlationsbetween sovereignbond yields of EU member states(seeFigure 12).In particular,fromApril 2012onwardsthecorrelationdataindicatesthat afirst group of countries comprisingdistressed economieshasbecomeseparatedfrom oneof lessdistressed members.This second group, representedby Finland in Figure12, is characterizedbya high correlation to membersof thesame group, but volatile anddecreasingcorrelationstomembersof thefirst group.Hence, in particular sovereign bond marketsdisplaythe tendencytoseetwomarket clusterswithinthe EU.Thedevelopment of sovereign bond yield volatilitiessinceApril 2012reflectsthis evidenceby displaying a similar structure witha group ofdistressedcountriescharacterizedby high volatilitiesand a group of lessdistressedcountries featuringsubstantiallylowervolatilities,wherebythedifferencein the volatilitylevel below thosegroupsis a littlebelow 100%of the second group‘svolatility.Similarly, the differencein thematuritiesof new debt issuedbysovereignsin 2012betweendistressedand non-distressedmarketsprovidesadditional evidencefor the clusteringof markets,assovereignsof distressedmarketsissued in 2012new debt withan averagematuritymore than threeyearslowerthan the average maturityof issuesbynon-distressedsovereigns.Liquidityindicatorsdeliver additional evidencefor the increasingheterogeneityof sovereignbond marketsthroughout theEU by featuringInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 109apersistentlyhighlevel of dispersionof bid-askspreadsbetweenselectedmarketsin late2012.Theincreasedheterogeneityin EU sovereign bond marketsis alsoreflectedin thedevelopment of rating decisionsfor newlyissuedsovereigndebt in whichtheshare of new issuanceswith lowerratingsincreasedthroughout the entire year 2012.Thus, in 2012,54% of sovereignbondsissued wereratedAAA orAA+, against 60%in2011;13%betweenAAandA- (40%in2011) and33%belowA(0.2% in 2011).While thetendencyfor an increasingmarket clusteringmay contributetoconcernsfrom a SingleMarket perspective, it alsomitigatescontagionriskasinvestorsareincreasinglyusingdivergingrisk levelstodistinguishcategoriesof sovereign debt in Europe.Nevertheless, contagion risks remain high withinthe group of countriesexposedtosovereigndebt problemsandpotential spill-overeffectswithintheEU cannot be neglected.In addition, thenegativecorrelationpattern betweendistressedandnon-distressed European sovereign debt markets indicates that investorsare increasingly treating the two types of sovereign debt as substitutes intheir portfolios.Consequently, the issuanceof new debt getsmore demanding forindividual sovereign issuersunder distress.In addition, theassociatedmaturity reduction preservesthismarketpressure whichcurrently generatessizeablesovereignspreads.From a cross-sectoral perspective, the simultaneitybetweentheincreasingdispersion in themarketsfor equity, and in particular theequityof banks, and sovereign debt documentsthe risk of feed-backloopsbetweensovereign debt problemsand balancesheetsof thedomesticbanking sectors.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 110In sofar asdomesticbanksare the main purchasersof sovereign debt,while sovereignshave to bail out endangeredbankingsystems, anynegative eventsin one of the twosubsystemsimpliesnegative contagioneffectsfor the other.Hence, the involved feed-back effectshave thepotential tocreatea self-reinforcingpersistenceof theunderlying problemscontributingtoeventual strainson the SingleMarket framework.3.3 ESA‘SRESPONSE TO REVERSE THE TREND OFFRAGMENTATIONAll EU institutionsand member statesneed toworktogetherto reversetheharmful trendsof fragmentation of the EU SingleMarket.Arange of initiativeswill be relevant, especiallyin theEurozone,includingthe SSM, whichwill be instrumental in breakingtheadversebank-sovereignlink.TheSSM should beimplemented without delay, and shouldbe followedbya sound bank resolution mechanism.To supplement those measures, an increased emphasis should be placedon the ESAs role to promote convergence of supervisory practices and tocoordinatepolicyresponsesacrossMember States.Here, a strong role of the ESAsin supervisorycollegesand thedevelopment of both theEU-wideSingleRulebooksand SupervisoryHandbookstofoster supervisoryconvergenceare of particularimportance.Theproper functioningof collegesof supervisors,asa keyforum foreffectivesupervisorycoordination and exchangeof information, is a veryimportant element in achievingsupervisoryconvergenceandcoordinatedsupervisoryresponses.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 111Supervisorycollegesare very well placedtoplay a significant role inaddressingcurrent risks of uncoordinatednational actionsand inassessingunintended consequencesof such actions.Tothis end, theESAs‘ engagement in collegesof supervisorshelpstoensure that supervisorymeasuresare properly discussedand coordinatedex-ante,and that collegestake potential unintended consequencesintofull accountin their joint assessmentsand decisionsoninstitution-specificprudential requirements.Consequently, the ESAsshould have a strong rolein supervisorycollegesin order toefficientlycoordinatethepotential implicationsof nationalpolicy measuresacrossMemberStates,and thustoprevent furtherfragmentation of theEU SingleMarket.Astrong involvement of theESAs in collegescan be viewedasa naturaldevelopment duetotheir EU wideexpertise and oversight of theoperational functioningof colleges, enablingthem tocollateinterpretationsof existingstandardsand regulation, and toprovideorientation and feedback on how supervisorscan substantiatetheirassessmentsof risksin financial institutions.Moreover,thedevelopment oftheEU-widesinglerulebookshouldset theright signal for a long-term structural regulatory framework.Such a frameworkwouldset a level playing field and improvecompetitivenessof thefinancialsectoraswellasoverall confidenceinEUfinancial markets.It should build on theeffortsand progressesmade sofar by the ESAstowardsthis objective.Already, primary legislations,includingEMIR,AIFMD, SSR and CRA2, aswell astechnical standardsand guidelines,e.g. forAIFMD, EMIR, UCITS,CSD, MiFiD and CRA2 mark significantprogresstowardsthesinglerulebook.Further measures to promote the single rulebook are planned in the areaof the transparency of investment products, the enforcement for financialinformation and theworktowardsMiFiD2.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 112With regard tothe bankingsector, thedevelopment of an EU-wideSupervisoryHandbook (Handbook) by the EBAcould be a veryimportant element tocomplement the EU-wideSingleRulebook.In particular, a Handbook would ensure consistencyof supervisorypractisesandcouldaddressfragmentationrisksbyminimisingtherisk ofregulatoryarbitrageand by ensuring consistencyof supervisory practisesbetweencountriesinsideand outsidetheSSM.This is particularlyimportant in relationtocross-borderbankinggroupswithinthe EU in order toprovidea common reference point to decide ontheapplicationof supervisorymeasures,and in the processof jointdecision on institution-specific prudential requirements.TheHandbook wouldbe based on good supervisorypractisesand wouldprovidecommon referencepointsto decideon the application ofsupervisorymeasures.All theseimportant elementsshould counteract signalsof supervisorydivergencesthat arecurrentlycompromisingtheunityandintegrityoftheEU SingleMarket.In this sense, an effectiveand credibleframeworkfor theSSM must notcompromisetheunityand integrityof theEU SingleMarket, andshould, in fact, contributetoan effectiveapplication of these crucialelementsof converge betweenthe SSM and non-SSM countries.With regard tothe insurancesector, thepresent solvencyrulesareoutdated.Theyare not risk sensitiveand theydonot properlydeal withgroupsupervision.Importantly, they have alsobeen supersededby industry, internationaland cross-sectoraldevelopments.SolvencyII will ensure the harmonizationof valuation methodsandsupervisorypracticesand help rectify theseshortfalls.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 113Thecontinueddelaysin theimplementation of SolvencyII, however, area sourceof uncertaintyboth for supervisorsand insurers.There is a clear risk that, in the absenceof a final agreement on SolvencyII, Europeansupervisorsmay be forcedtodevelop national solutionsinorder to ensure sound risk sensitivesupervision.Instead of reaching consistent and convergent supervisionin theEU, different national solutionsmay emergetothedetriment of agoodfunctioninginternalmarket.It is thereforeof key importancethat national authoritiesensure aconsistent and convergent approach with respect to thepreparation ofSolvencyII.In particular, an interim implementation of key areas of Solvency II isimportant in order to ensure proper risk management in undertakingsandtoensurethat supervisorshave sufficient information at hand.Thesekeyareascompromisethe system of governance, includingriskmanagement system and a forwardlookingassessment of theundertakingsownrisks,preapplication of internal models, and reportingtosupervisors.4 RISKSFROM INCREASED RELIANCE ONCOLLATERALThefinancial crisis, and especiallythe failure of Lehman, increasedfinancial institutions‘awarenessof and aversion tocounterparty defaultrisk.Having lostconfidencein credit ratings,firmsand investorshaveincreasedtheir relianceon collateral in managing counterparty defaultrisk.This tendencyhasbeen reinforced by regulatoryinitiativessuch asmandatorycentral clearingof derivativesasstipulatedin the EuropeanMarket InfrastructureRegulation (EMIR) aswell asCVA charges.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 114Hence, funding through unsecured interbank and bond markets haspartially been replaced by funding through secured repo and coveredbond markets.At the same time, the collapseof largeparts of the US shadow bankingsystem, includingformerlyAAA-rated securitisedproducts,and theon-goingEuropean sovereign crisishaveweighed on the supplyofhigh-qualitycollateral.An additional factor hasbeen a reduction in the velocity(or reuse) ofcollateralamong market participants,which may put further pressure onthesupplyof collateral and the smooth functioningof financial markets.According to ESMA‘sestimates,the supply of high quality collateralwithintheEU isaround EUR 11.8tnasof 2012,thebulk of whichconsistsof sovereign bonds.TheEU-widedemand for collateral is around EUR 4.1tn, mainlyfor repooperations,exchange-tradedand OTC derivativesand securities lending.On thewhole, theseestimatesdo not point tosubstantial imbalancesinthecurrent juncture, although theexpectedincreasein demand in thenext few years (tomeet further mandated collateralisationrequirements)may exceedthe increasein supply, resulting in relativescarcityofcollateral.In addition, a pure aggregationdoesnot fully reflect the distribution ofcollateralavailability and collateral needsover individual institutions.Hence, eventual local scarcitiesof collateral cannot be ignored.4.1COLLATERAL TRANSFORMATION, RE-USE ANDINTERCONNECTEDNESSThesafetyand liquidityvalueof collateral is increasinglybeingpriced,providingincentivesfor more efficient use of collateral.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 115Institutionswith idleportfoliosof high-gradeliquid securitieshave moreincentivestolend thesesecuritiesto institutionsthat have greater needfor liquiditybuffers.Institutionswith lower-gradesecuritieshaveincentivesto optimisetheircollateral use (e.g. posting cheapest-to-deliver collateral whereallowed)andtotransform their collateral(throughcollateralupgrade transactions)toimprove their accessto liquidityor extract liquiditypremium fromhigh-gradesecurities.Specific examplesof such increasedinterconnectednessand contagionrisk includethecollateral-basedtransaction chain betweenhedgefunds,prime brokersand the repomarket, and the collateral upgradetransactionsbetweenbanks (needing better collateral) and insurers(needingextra income from idleholdingsof high-gradesecurities).Such collateral transformation should increasethe efficiencyof collateraluse,but may alsoreinforceseveral risksfor the financial system:- Financialinstitutionsmay pledgesome assetstoget secured funding,resultingin further asset encumbrance,whichraisesrisksforunsecured creditors(depositorsand bondholders);- Financial institutionsfacingfundingissuesand lackinghigh qualitycollateral may enter intocollateral swaps(alsocalled collateralupgrade) with other institutionssuch asinsurancecompanies,resultingin an increasein the interconnectednessin the financialsystem;- Lower-qualityassetscould be used ascollateral. Sharp declineinpriceswouldthen lead to margin callsor changein haircuts,whichunder stresscould lead to procyclical effects.- Collateral reusemay increasefurther in order to addressthe relativescarcityof collateral.This wouldalsoincreaseinterconnectednessin the financialsystemandmay alsogenerateuncertaintiesfor beneficial owners.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 116- Variationsin collateral demandsgeneratedby fluctuationsin theratingsof the counterparty, the ratingsof the collateral, and theValue-at-Risk (VaR) of the financial contract against whichcollateral isrequired can triggerforced sellingsor close-outs,whichwouldreinforcenegativemarket dynamics.Again, in a distressed situation, thiswould generateadditionalprocyclical effects.- Theextent towhichbankshave alreadypledged assetsin securedfundingmarkets(includingrepoand covered bonds), and therisks offurthercollateralcallsunderstress, isnotgenerallywelldisclosed,andpresentsanother source of uncertainty.Theseeffectswouldall make it more challengingto achieve(and lesscredibletopromise)orderly resolutionintheevent of financial institutionfailure, therebyincreasingmoral hazard.4.2 THE ROLE OF CENTRAL COUNTERPARTIES (CCP)TheEuropean MarketsInfrastructureRegulation (EMIR) requiresallOTC derivativecontractsmeeting predefined eligibilitycriteria to beclearedthrough an authorised CCP.Mandatoryclearingrequirementswill increasethequalityof riskmanagement, reducecounterpartyrisk acrosstheEU and allowthenettingof contractsacrossdifferent counterparties.Thustheygeneratethebenefitsofapotential reductioninthedemandforcollateral.Competition pressuresbetweenCCPsare another aspect that hasattractedregulatoryattention and hasled to stringent minimumrequirementsfor risk management on collateral, margin and the overalldefault waterfall.On the other hand, EMIR alsoleadsto an increaseof transactionsvolumesclearedby largeEuropean central counterparties.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 117In addition, it will contributetoa further increasein the demand for highqualitycollateral in the financial system, sincecollateral hastobeprovided for certain non-clearedOTC derivativecontracts.Thusrisk concentrationswill increase, since a few large European marketplayers characterised by very high transaction volumes will play a criticalrolefor the functioningof financial markets.Consequently, financial institutionswill be highly exposed to potentialproblemsin a CCP.Also, proceduresin caseof a CCP distress(recapitalization, bail-inprocedures)remain unclear.Harmonisedresolution and recovery regimesfor CCPs acrossthe EUwouldhelp avoidingpotential regulatoryarbitrageand thuspreventingcustomer and taxpayer detriment.5 RISKSTO CONFIDENCE IN BALANCE SHEETVALUATIONS AND RISK DISCLOSURESThefinancial crisishasledtoa lossof confidencein the balancesheetvaluation and risk disclosuresof financial institutions.This is clearlyevidenced by thelow equitymarket valuationsof financialinstitutions,with many trading significantlybelowtangiblebook value.In order topre-empt those pressures,financial institutionsshould valueall their assetsand liabilitiesproperly, in full accordancewithapplicableaccountingstandardsand regulations,toensure valuation consistencywithinthe EU.Institutionsshould analyse and understand thesourcesof valuationuncertainty, usingprudent valuationmethodologies, and sharethesewithsupervisorsand potentiallyin published risk disclosures.This callsfor consistencyin the approachestaken in bankingandinsuranceregulation.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 118Aparticularproblem for the insurancesector (due to delays toIASBconvergenceworkand SolvencyII) is thecontinued absenceofEU-harmonisedaccountingstandardsandregulatoryvaluationrules,andin particular thewidevariability in accounting for insurancecontractliabilitiesand holdingsof lessliquid securities, such ascorporate bonds.For banks, the value of their assets(and in the end their level of capital) isdirectly linked to the economic situation of the borrowers and their abilitytorepaytheir loans.As the number of borrowers in financial difficulty increases duringperiods of macro-economic weakness, banks may choose to offer acertainrelaxationof termsof the contract (forbearance).This would avoid an actual or prospectivebreach of the original termsofthecontract.Thelow interestratesalsoprovidedirect and indirect incentivesforforbearance,asdiscussedin section 2.2.Forbearancemay disguisethe actual credit risk of individual banksand lead to theoverestimationof itscapital and resilience.Therisk that banksmay not have adequatelyprovisionedagainst likelyfutureimpairmentsisalsoa sourceof uncertaintysurroundingaccountingvaluationsof banks‘balancesheets.Individual problemsof this kind can easilyreduce the trustin otherfinancial companiesand increasesystemic risk.In addition, theassociatedrisk delays the necessaryde-leveragingofhouseholdsand non-financial corporatesand constrainslendingto moreproductiveborrowers,consequently delaying recovery.Existingloanstoborrowerswithquestionablelong-term viability mayalsotie up capital and funding and limit financial institutions‘ability toprovidecredit tonewborrowers,distortingthemarket allocationofcredit.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 119Supervisorsand policymakershave to ensure a common understandingof forbearance acrossEurope.Astep in this direction wasachieved in December 2012whenESMAissuedapublicstatement onthetreatment of forbearancepracticesin theIFRS financial statementsin which it suggesteda common definitionofforbearanceand pointed out tothe relatedmeasurement and disclosurerequirementsof IFRS.The EBA is in an advanced stage of identifying a common definition forforbearance, aiming at providing supervisors with a tool to monitor assetqualitydevelopment in a coordinatedfashion and on a comparable basis.Authoritieswill haveto design thepath totheexit of thesituation byestablishingthe appropriaterhythm of cleaning the balancesheets.At the same time, banks‘governanceof such a practice will haveto becloselymonitored and evaluated.This valuationuncertaintyaffectsnot onlybanking book loanportfoliosbut alsotradingbook holdingsof securities, wherefair-valuepointestimatesof the expected re-salevalue of securitiesdonot capture thevaluation uncertaintyin lessliquid market conditions.Onepotential remedyisprudent valuations,basedonahigherconfidenceintervalfor the re-salevalue of thesecurities Valuation and riskmeasurement – especiallyfor complex financial instrumentsand forlonger term (e.g. actuarial) risks – isgenerallybased on quantitativemodels.For assetsand riskswherefinancial institutionsusesimilar or identical(external) models, theyare consequentlyexposed tovaluation risksstemmingfrom model failures, imperfect calibrations,inappropriatemodellingchoicesand diverging decisionsof supervisorsin respect ofmodel approvals.Similar methodologicalrisks exist in thevaluation of goodwill, i.e. thevalueof intangibleassetswitha quantifiablevalue.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 120Thesearespecific examplesof exposure to a common risk factor, in thisinstanceexposureto model parameter risk.This report hasalreadydiscussedseveral other examplesof financialinstitutions‘significant exposuresto common risk factors, such asmacro-economicrisk (Section 1), interest rate risk (Section 2) andcollateral risk (Section 4).Financial institutionsshould stresstest their businessplanscomprehensivelyagainst arangeofscenariosforthosemaincommonriskdrivers,includinginterest rates(lowfor longer or suddenadjustment), latent credit risk and legacyredressand litigationcosts.Such forward-lookingstresstestsshould be used by financial institutionstodevelop crediblemanagement actionsto mitigatethe risks,and byfinancial regulatorstoinform supervisoryjudgmentsabout requirementsfor capital or management action.6 RISKOF LOSS OF CONFIDENCE IN FINANCIALBENCHMARKSFinancial market referenceratesand their calculationprocedureshaverecentlycome under closepublic scrutiny.Especially in the area of reference rates for unsecured inter-banklending, recent events 13 have led to a weakening of the credibility ofreferencerate systemsin theEU and beyond.TheESAs areconcerned by theweakeningof the credibilityof referencerate systemsand havetaken an immediateinterest in thisissue, giventheseriousflawsin thewayinter-bank interestratebenchmarksarebeingset, and their widespreaduse in securitiesand other financialmarkets,and potential implicationsfor market integrity.Consequently, ESMAand EBA recentlytook decisiveaction, incoordinationwith theEuropean Commission and IOSCO, to contributetoaddressingtheseflawsin theinterveningperiod until a formalregulatoryand supervisory frameworkisin force in the EU.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 121Inter-bank referencerates– in particularthosecalculatedwithin theEU, such asLibor and Euribor – are the most widely-used referenceratesin the European and global financial markets.Theyprovide thebasisfor the specificationof contractsin keymarketsworldwide, includingforwardrate agreements,short-term interestratefuturescontracts,interestrate swaps,inflationswaps,floatingratenotes,syndicated loansand variablerate loansand mortgages,but alsoplaya rolein currency tradingand in the calculationof benchmarksandhurdlerates for managed funds, includingmoney market funds, andprivateequityfunds.According to their widespreaduse, the value of financial contractsbasedon inter-bank referenceratesis high, underliningthe centralityandimportanceof well-defined, robust, and crediblebenchmarks.Libor hasbeen estimatedtobe utilisedasa referencerate for USD 500trtoUSD 600tr in notional interest-ratederivativescontractsalone.Other benchmark rates and their usesincluded, the total volume ofdependent contractsis likely tobe substantiallyhigher.From the perspectiveof cross-sectoralsystemic risksin the EU, theproblemsassociatedwithbenchmarksmayposeconsiderablechallenges,resulting from their potential impact on the continuityof suchsystems.Anydisruptionin theprovisionofsuchreferenceratesmaynaturallyhavefar-reachingconsequencesfor the financial instrumentsand entiremarketsresting on their availability.Such disruptionsmay result from a lack of liquidityof the market onwhicha transactions-basedbenchmark draws,or thenon-availability ofsufficient quotestocalculate a reporting-basedbenchmark.Recently, inter-bank reference systemssuch asEuribor-EBF haveexperienced withdrawalsby banksfrom their panels, reflectingtheirgrowingconcernsover litigationor political consequencesof misconductaspanel contributors.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 122No concreteindicationof an imminent waveof withdrawalsfromreporting panelscan be discerned at the time of writing.However,herdinglogic in combinationwith a rising potential burdenassociatedwithpanel contributionsmay in adversecircumstancestriggeran exodusfrom reportingpanels.TheEuropean Commission‘sintention toproposethemandatoryparticipationof bankswithinreportingpanels,whichisalsosupportedbytheECB, has thepotential tocorrect for thoseincentives.Any critical situation may be complicatedby the fact that there is nopractical experiencewith benchmark continuityissues.In addition, there iscurrentlynodesignatedsupervisory authority totakeownership in a critical situationaround Euribor-EBF reference rates.Finally, there is a marked lack of contingencyplanning amongbenchmark providersaswell asusersfor such situations.Theinitiativestakenby EBA and ESMAon 11January 2013should becontinued, and theEuropean Commission should be encouragedtoinitiatelegislationaimed at providinga regulatory and supervisoryframeworkfor benchmarksin theEU.In particular, thecontinuityrisksdiscussedabove stronglysuggest that afutureregulatory frameworkshould require:- Contingencyplanning by benchmark providersand users,and inrelevant financial contracts.In addition, theremay be need for:- Enforcement powerson thepart of competent authoritiesenablingthem tomandatecontributorsto maintaintheir commitment tocertain benchmark system at timesof distressIn addition, competent authoritiesshould take intoconsiderationin theiron-goingsupervisorywork,for exampleon implementingcapital andliquidityrequirements,anypotential effectson the incentivesforInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 123contributorsto maintaintheir commitment tobenchmark panels.ESMA and EBA will continuetheir surveillanceof benchmark activitiesintheEU, and their contribution to regulatoryand supervisoryactivityinthisarea.Consumer concernsand redresscoststhat some financial institutionsfaceasa consequenceof past businessconduct practisescan lead to financialstabilityimplicationsnot only becauseof potentiallyhighfines,compensation paymentsand legal costsarisingfor theseinstitutions,but alsothrough generallygrowingmistrust in the financialsector.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 124EU Bank Capital RequirementsRegulation and DirectiveTheEU Capital RequirementsRegulation (CRR) and Directive(CRD)aim tostabilize and strengthenthebanking system bymakingbanks setaside more and higher qualitycapital asa cushion against crises.Thenew rules should alsofoster a convergence of supervisory practicesacrosstheEU.Banks that are better ableto withstandfuture crisesshould be morecapableof financinginvestment and growth.Thisbackgroundnotelooksat whythenewruleshavebeenset out intwolegal instruments,a regulationand a directive, and how theyhavechangedcompared tothepreviousrules in force.After Parliaments vote, the Council needsformallyto approvethe rules.TheRegulation and the Directivewill then be published in the OfficialJournal (OJ) and enter intoforce.Thenew rules will apply from 1January 2014,if publishedin the OJ by 30June2013,otherwisefrom 1July2014.Whytwolegal instruments?Thenew legislationconsists of twoinstrumentsgoverningcapitalrequirementsfor investment firmsand credit institutions,includingbanks.TheCapital RequirementsRegulation (CRR), a new instrument addedduringthe current revision of theexistingCapital RequirementsDirective,laysdownprudential requirementsfor capital, liquidityand thecredit risk for investment firms and credit institutionsin EU memberstates.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 125As a regulation, theCRR appliesdirectlyin every member state.It canthereforeimposeasinglesetofrulesacrosstheEU, thusleavingnoscopefor arbitraryinterpretation and ensuringcertaintyastothelaw forall EU singlemarket players.Thedirective, bycontrast, will have to beincorporatedintothe nationallawsof the member states.The rules on bankers remuneration and bonuses, prudentialsupervision, corporate governance and capital buffers will remain theresponsibilityof themember states national competent authorities.Capital Requirements Regulation - single rule bookTheCRR introducesthefirst singleset of prudential rules for banksacrosstheEU.It aimstocloseregulatoryloopholesand createharmonised rulesthatlevel theplaying field and guarantee legal certaintyfor all singlemarketplayers.TheCRR rule book should alsohelp toensure that the BaselIIIinternationalstandardsforbank capitaladequacyarefullyrespectedinallEU member States.EU member stateswill beabletomakeexceptionstothesinglerulebook, but only if theynotifycompetent authorities of theseexceptionsandensure that theycomply withthe ruleson flexibilityand capital bufferslaid down in the CRD IV directive).Capital Requirements Regulation - capital and riskThepurposeof setting asidecapital istoenablea bank toabsorblosses.Theamount of capital that a bank isrequired to hold, compared toitsassets,should be enough tocover unexpectedlossesand keep it solventin timesof stress.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 126Theamount ofcapitalrequireddependsonthekindsofassetsthat abankholds- generally, the riskier the asset, the more the capital that hastobeset aside.Cash is seen asa safeasset, and henceisdisregardedfor capitalrequirementspurposes.Other assets,such asshares,bondsor loansare considered riskier, andare assignedvariousrisk weightings,whichneed to be balancedbydifferinggradesof capital.For example, "Tier 1" capital allowsaninstitutiontocontinueitsactivitiesand keepsit solvent, whereasTier 2capital allowsan institutiontorepaydepositorsand senior creditorsin caseof default.EU banks will be required toset asidemore and better capital asacushionagainsthard times,i.e. aminimum of 8% good-qualitycapital, ofwhichjust over half must be Tier 1, the highest-quality, lowest-risk form (adoublingof todays Tier 1requirement).This capital must bereasonablyliquid, i.e. readilyconvertibleintocashneededto pay depositorsand creditorsin an emergencyTheCRR givesa comprehensivedefinitionof capital assetsthat qualifyasTier 1.For example, theseassetsneed to be issueddirectlyby theinstitution,paid up but not fundedby the institution, perpetual, clearlyand separatelydisclosedin thefinancial statements,andabletoabsorblosses.Theprincipal of Tier 1assetsmay not be reducedor repaid unlesstheinstitution isto be liquidated.Capital Requirements Regulation - liquidityThelatest financial crisisrevealed that bankswereholdinginsufficientliquidassets.TheCRR will require them toconstitute"liquiditybuffers" toenablethem toremain stablein timesof stress.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 127The30-day"liquiditycoveragerequirement" (LCR) buffer must sufficetocover part of the differencebetweena banks financial inflowsandoutflowsin timesof stress.It is to be phasedin at 60% of thisdifferencestarting in 2015,risingto100%in 2018.However,the European Commissionmay be able to delaytheintroduction of the100% requirement, if justifiedby internationaldevelopments.For themedium term (over one year), theCRR wouldalsointroducea"net stablefundingrequirement" (NSFR).Although member statesmay imposetheir ownnational liquidityrequirements,the CRR will require that bankshold liquid assetsequal toat least25% of outflows.Capital Requirements Regulation - leverage"Leverage" occurswhen a banksassetsexceed its capital base.TheCRR doesnot precludeleverage, asbuying assetsin the hope thattheir valuewill rise isa normal investment activity, but it doesaim toreduceexcessiveleveragewhichmay eventuallycompromise thebankssolvency.TheCRR could alsorequire banks todisclosetheir "leverageratio", definedasabanks Tier 1capitaldividedbyitsaveragetotalconsolidatedassets.This ratiogivesa measureof a banks abilitytomeet itslong-termfinancial obligations.Theleverageratio requirement isto be introduced from January 2018,ifagreedbytheCouncil of Ministersand European Parliament onthebasisof a European Commission report to bepresentedby 31December 2016.Banks will be required to notify the Commission of the leverageratiosduring an observation periodstartingon 1January2015.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 128Capital Requirements Regulation - lending to small firmsThe banking crisis hit EU small and medium-sized enterprises (SMEs)hard because it made bank loans difficult to get and they had few othersourcesof funding.Tomake it easier for banksto lend toSMEs, the CRR will reducethenominal risk that banks must assign toloans.Reducingnominal riskin thiswayalsoreducestheamount ofcapital thathastobe set asidetocover it, thusreleasingmore capital for loans.TheCRR wouldrequire supervisoryauthoritiestocheck periodicallythatbanks exposureto SMEs is properlyassessed.Capital Requirements Directive - remunerationThefourth Capital RequirementsDirective(CRD IV) aimstoensure thatevery credit institutionand investment firm, includingbanks, hassoundand fair remuneration policies, sothat payreflectseffectiveriskmanagement and performance, without encouragingunjustifiedrisk-taking.CRD IV distinguishesbetweenfixedremuneration, includingpayregularpension contributionsand benefits, and variable remuneration, whichincludesadditional paymentsor benefitsdepending on performance.Capital Requirements Directive - bonusesTocurb excessiverisk-taking, the basic salary-to-bonusratio will be1:1,but could be raised toa maximum of 1:2 withtheapproval ofshareholders.Toapprove this higher ratio wouldrequire the votesof at least 66% ofshareholdersowninghalf thesharesrepresented, or 75% of votesif thereis noquorum.Up to the 25% of variableremuneration should consist of long-termdeferred assets(at least 5 years).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 129TheEuropean BankingAuthority (EBA) is to prepare guidelineson thediscount factor applicableto suchdeferred assets.Thefirstbonusesdetermined inlinewiththesenewmeasureswill paidin2015for performancein 2014.Thenew rules will apply tothe employeeswhoseprofessional activitieshavea material impact on risk, such assenior management, risktakers,employeeswith control functionsand alsoto anyone receivingremuneration equal tothe that of thosein thesegroups.Thenew rules will apply toall credit institutionsand investment firmsincludingbanks in the EU, tosubsidiariesoutsidetheEuropeanEconomicArea (EEA) that have head officesin the EEAand tosubsidiariesin the EEA that have their head officesoutsidethe EEA.Capital Requirements Directive - flexibility and buffersAlthough the singlerulebook will ensure that a singleset of harmonisedprudential rulesapply EU wide, member stateswill retain theright torequiretheir home bankstohold more capital, e.g. for real estatelending, asa cushion against property price crashes.Theywill alsobe able to imposeadditional requirementson specificbanksaspart of a supervisoryprocessthat involvesnotifying theEuropean Commission, European BankingAuthority (EBA) andEuropean Systemic Risk Board (ESRB), wherestricter measuresarejustified.The Commission may oppose such measures if it feels that they coulddistort the single market, but the Council of Ministers may overrule itsobjections.TheDirectiveprovidesfor a mix of mandatoryand optional capitalbufferstohelp member statesto mitigatethepro-cyclical factorsthathelped start the financial crisis and aggravated itseffects.Banks will be required to hold a"capital conservation buffer" and a"countercyclical capital buffer" toensure that in good timestheyInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 130accumulatea sufficient capital basetoenablethem toabsorb lossesintimesof stress.Both thesebufferswereintroduced by theBasel III agreement.Thecapital conservationbuffer, equal to2.5 % of a banks total exposure,must be secured by an additional amount of thehighest qualitycapital(Tier 1capital).Thisbuffer,whichsupplementstheCRR capitalrequirement of4.5%Tier1,aims toprotect thebanks capital.If a bank breachesthe buffer, it will have to limit or stopdividendsorbonuspayments.Thecountercyclical capital buffer should reflect the economiccycleaffectingthe banks lendingactivityandhelpit provideastablesupplyofcredit.Member states may also require banks to hold a "systemic risk buffer"against financial market disruptions that threaten the financial systemand real economy of any given member state.From 1January 2014, member statesmay set thesystemic risk buffer ratebetween0 and 3%, and notify the Commission, EBA and ESRB.From 2015,theymay set this rateat between3% and 5% and must notifytheCommission, which givesitsopinion.Toset a buffer rate above 5%, a member statewouldneed theCommissionsauthorisation.TheEuropean Parliament ensured that a mandatory buffer of Tier 1capitalrequirement willbeincludedforbanksthat memberstatesidentifyas"global systemicallyimportant institutions" (G-SIIs) in order tocompensatefor the higher riskand potential impact of their failure.Parliament alsointroduced a voluntarybuffer for "other systemically"important institutions" (O-SIIs).TheG-SII buffer, of Tier 1capital equal tobetween1% and 3.5% of abanks total exposure, will apply from 1January2016.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 131TheO-SIII buffer,of Tier 1capital equal to2%ofabankstotalexposure, will applyfrom 2016.Where an authoritycould imposea systemic risk buffer or a globalsystemic institutionbuffer, the higher of thetwoshould apply.Where the systemic risk buffer requirement appliesonly to domesticexposures,it should applyin addition totheO-SII or G-SII bufferrequirement.G-SIIs should be identifiedon thebasisof size, interconnectednesswiththefinancial system, complexity, and cross-border activity.O-SIIs should be identifiedon the basisof size, importancefor theeconomy of theEU or member state concerned, cross-borderactivityandinterconnectedness.Capital Requirements Directive - benchmarkingEvery bank is entitledto useitsowninternal methodsto calculate itsriskexposure.However,it should submit itscalculationof this exposure, e.g. thereliabilityof its creditors,toitscompetent authorityat least oncea year.Competent authoritiesare entitledtocheck banks calculationstoascertain that their risk exposures, and hencetheir capitalrequirements,are accurate.Thesechecksshould alert them to casesin whichbankspresent differingown-fundrequirementsfor the same riskexposure, or a banksystematicallyunderestimatesitsown capital requirements.New transparency rulesCapital Requirements Regulation transparency rulesBankinginstitutionsmust disclosetheir risk management objectives.Thesedisclosuresmust include:International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 132strategiesand processesto manage risks,structure and organisationof the relevant risk managementfunction,scopeand natureof risk reportingand measurement systems,policiesfor hedgingand mitigatingrisk,a declaration approved by the management body on the adequacyof risk management,a concise risk statement , andbanks overall risk profile associated withthe businessstrategybody.Bankinginstitutionsmust disclosethe followinginformation, includingregular, at least annual updates,on governance arrangements:number of directorshipsheld by membersof themanagementbody,recruitment policyfortheselectionofmembersof themanagementbody and their actual knowledge, skillsand expertise,policy on diversity withregard to selection of membersof themanagement,objectivesand any relevant targetsset out in that policy, and theextent to whichthese objectivesand targetshavebeen achieved,whetheror not the institutionhasset up a separaterisk committeeandthenumber of timesthe riskcommitteehasmet, andthedescription of theinformation flowon risk to the managementbody.Capital Requirements Directive transparency rulesFrom1January2015memberstatesmustrequireeachbankinginstitutiontodiscloseannually, specifying by member state and by third country inInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 133whichit hasan establishment, the followinginformation on aconsolidatedbasis for the financial year:name(s) nature of activitiesand geographical location,turnover,number of employeeson a full time equivalent basis,profit or lossbeforetax,tax on profit or loss, andpublic subsidiesreceived.TheDirectivealsorequires member statestoestablisheffectiveandreliablemechanismsto encourage reportingto competent authoritiesofpotential or actual breachesand employees reportingbreachescommitted withintheir owninstitutionsshould be fullyprotected.New powersfor the European BankingAuthorityNew EBApowersunder the Capital Requirements RegulationEBA must monitor thequalityof own fundsassetsissued bybankinginstitutionsacrossthe Union and must notify theCommissionimmediatelywherethere is significant evidenceofthoseassetsnot meeting Tier 1criteriaCompetent authoritiesmust, at EBAsrequest and withoutdelay, supplyall the information that theEBA deemsrelevant onnew capital assetssoastoenabletheEBA tomonitorthequalityofownfundsassetsissuedby banking institutionsacrosstheUnion.EBA is toprovide technical advice to theCommissionNew EBApowersunder the Capital Requirements DirectiveEBA should enhanceharmonisationof supervisory practices.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 134It is entrusted withdeveloping draft technicalstandards and guidelinesandrecommendationsensuring supervisoryconvergenceandconsistencyof supervisoryoutcomeswithin theUnion.EBAs mediation poweris a key element in promoting coordination,supervisoryconsistencyand convergence of supervisorypractices.Themediation procedurecan be initiatedeither on EBAs own initiative,wherespecificallyprovidedfor, or at therequest of one or morecompetent authoritiesparty to thedisagreement.How the new EU rules relate to Basel IIITheBasel Committeeon Banking Supervision(BCBS), drawsupinternational minimum standardsfor banks capital.It hasmembersfrom, inter alia:Australia, Argentina, Canada, China,Hong Kong, India, Switzerland, Turkey, Japanand the United States.There arealsoEU members,includingGermany, the Netherlands,Belgium and the UK.TheEuropean Commission and theEuropean Central Bank are theobservers.Basel standardshave evolved with time, especiallyduring thecurrentfinancial crisis.TheBasel III proposalsfor more and better capital in banks,balancedliquidity, supervisedleverageand capital buffersare in linewiththeEUCRD IV and CRR legislation.However,the BaselIII agreement cannot be fully incorporatedintotheEU legislation.This agreement is not itselfa law but a set of internationallyagreedguidelinesand standards.Moreover,Basel standardsweredevelopedfor big internationallyactivebanks,whilethe European law must be applicablenot onlytoInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 135interconnectedinternational institutionsbut to eachof theEUs 8,300banks,many of whicharenational, regional or retail.Parliaments key changesto the Commission proposalTheEuropean Parliament haschangedthe original Commissionproposalwithregard to:- bonuses- thesalarytobonusratio of 1:1,or up to1:2withthemajoritysupport of the board,- a mandatory buffer of Tier 1capital requirement be included forbanksthat member statesidentify as"global systemically importantinstitutions" (G-SIIs),- transparencyrules,- management board diversity idea, and- benchmarking.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 136EIOPA Guidelinesonpreparing for Solvency IIOn 27 March2013the European Insuranceand Occupational PensionsAuthority (EIOPA) publisheditsConsultationson Guidelinesonpreparingfor SolvencyII along witha cover note tobe read inconjunction withtheconsultations.Theguidelinescover four areasof SolvencyII:- Systemsof Governance (SoG);- Forward-lookingassessment of theundertaking‘sownrisks(basedon theprinciplesof theOwn Risk and SolvencyAssessment (ORSA));- Submissionof information toNationalCompetent Authorities (NCAs); and-Pre-applicationfor internal models. TheEIOPAconsultationsclose on 19June2013.Final versionsof theguidelinesare expected to be publishedin Autumn2013,and are intendedto support both NCAs and firmsin theirpreparationsfor SolvencyII.NCAs will have to notify EIOPAwhether or not theywill complywitheach of the guidelines,withreasonsfor non-compliance, within twomonthsof publication.Theguidelinesare expectedtoapplyfrom 1January 2014.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 137TheEuropean processSolvencyII is beingcreated with a four-level process, whichbeganasthe"Lamfalussyprocess".This is an approach tothedevelopment of financial servicesregulationsused by the European Union.Originallydeveloped in March 2001,theprocessis named after the chairof the EU advisory committeethat created it, Alexandre Lamfalussy.It is made up of four "levels", each focusingon a specific stage of theimplementationof legislation.Level 1: The European Commission adoptsthe formal proposalfordirective/regulation.TheEuropean Council and European Parliament then adopt thelegislativeact.TheLevel 1Directivetext wasadopted bytheEuropean Parliament on 22April 2009, endorsedby the Council of Ministerson 5 May 2009andformallyadopted by theEuropean Council on 10November 2009.Level 2:In areasspecifiedat Level 1,theCommissionproposesdelegatedactsand implementingacts.EIOPA hasprovided advice on the former, and is currentlyinvolved indraftingthe latter in the form of technical standards.Level 3: EIOPApublishes"comply or explain" guidelines.Level 4: Strengthened enforcement (by EIOPA and the EuropeanCommission).Short DirectiveAshort amending Directivewasadopted on 3 July. Thismeansthat theoriginal implementationdate of 1November 2012in the SolvencyIIDirectivehaschanged.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 138Sonow Member Stateshave until 30June 2013totransposetheDirectiveand firms haveuntil 1January2014to implement it.OmnibusIITheOmnibusII Directivewasproposedin January2011bytheEuropeanCommission.It amendstheSolvencyII Directive, bringingit in linewiththeEuropeanUnion‘sLisbon Treaty.It hasalsobeen revisedtoreflectthe new supervisorystructure andpowerswithinthe European Union.OmnibusII amendstheSolvencyII Directivein three main areas:- Theproposal introducesa number of powersand responsibilitiesfortheEuropean Insuranceand Occupational PensionsAuthority(EIOPA).- Theproposal alsointroducestargetedchangestothe SolvencyIIDirective, and givesthe European Commission broad powerstodefineLevel 2 specific transitional arrangementsthat should applytotheSolvencyII Directive.- Omnibus II is expected to maintain bifurcation of the Directive,which was formally introduced by the short amending Directiveadopted on 3 July2012.Under bifurcation, responsibilitiesof national supervisory authoritiesandEIOPAare switchedon at 30June 2013(ie transpositionwouldhaveto be completeby 30June 2013), and SolvencyII requirementsare switchedon for firmsfrom 1January 2014.In the interveningperiod firmswouldcontinueto be regulated undertheexistingregimeand would be abletocompletethe necessaryapproval processes(eg internal models, ancillaryown funds), whilesupervisorscontinue to assessfirm preparednessfor thenew regime.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 139Theproposal doesnot mean that there will be transitionalperiodsin alltheareasmentionedor that themaximum period allowedfor will beapplied.It alsodoesnot mean there will be a delayof up toten yearsfor theimplementationof the Directive.TheCommission hasbeen very clearthat there wasand remainsnosuchintentionand that itsintended implementationdateis 1January2014.Discussionscontinue at the European level on OmnibusII. Oncetheseare finalised the Commission will be ableto publiclypropose itsLevel 2drafting, and thisshould includemore detail on specific transitionalmeasures.The pillarsand requirementsPillarsare definedby EIOPAasa wayof groupingSolvency IIrequirements(the concept of pillarsis not described in theDirective).SolvencyII is split intothree pillars,though Pillars2 and 3 are oftenreferredtogether asPillar 5 due tothe synergies between them.Pillar 1covers financial requirements. This pillar aimsto ensure firms areadequately capitalised with risk-based capital. All valuations in this pillarare tobe done in a prudent and market consistent manner.Pillar 2 imposeshigher standardsof risk management and governancewithinthefirm. It givessupervisorsgreater powersto challengetheirfirmson riskmanagement issues.TheOwn Risk and SolvencyAssessment requires a firm toundertake itsownforward-lookingself-assessment of itsrisks,corresponding capitalrequirementsand adequacyof capital resources.Pillar 3 aims for greater levelsof transparencyfor supervisorsand thepublic. There isa privateannual report tosupervisors,and apublicsolvencyand financial condition report that increasesthe level ofdisclosurerequired by firms.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 140Current returnswill be completely replacedby reportscontainingcoreinformation that firmswill have toprovide on a quarterlyand annualbasis.This will ensure that, overall, there is better and more up-to-dateinformation on a firm‘s financial position.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 141International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 142International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 143International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 144International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 145International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 146International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 147International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 148Monetary policy – many targets, manyinstruments. Where do we stand?Remarksby Mr Mervyn King, Governor of theBank of England, at the IMF Conferenceon―Rethinkingmacro policy II: first stepsand earlylessons‖,Washington DCI wouldlike tothank Charlie Bean,Alex Brazier, Spencer Dale,AndyHaldaneand Iain de Weymarn for helpful commentsand suggestionsinpreparingtheseremarks;and in particular Tim Taylor whoI regard asaco-author,although he is absolved of anyerrorsin thecurrent draft.IntroductionThepast five years hasbeen an extraordinaryperiod for central banks.Thebreadth and scaleof our operationshasexpanded in waysthat werepreviouslyunimaginableaswerespondedtoacrisisin thebankingsectorandthewidereconomy.In monetary policy, wehave moved intouncharted territory.But hasour notion of what central banksshould do, and how, changed?Now isa good timeto reflect on wherewestand.I want tofocusmy remarkson twoareas.First, I want to draw out what have welearned about theobjectivesofmonetarypolicy.Second, I want toreflect on theimplicationsof theproliferationofinstrumentsthat have been used to meet thoseobjectives.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 149ObjectivesFor over thirty yearsthe objectiveof central banks wasclear.It wasto set monetary policy to achievelong-run pricestability.But the eventsof thepast fiveyears haveraisedquestionsabout howcentral banksmanage thetrade-offsbetweenprice stability, outputstability and financial stabilityin order tomeet our overallmacroeconomicobjectives.Throughout the era of inflation targeting, the importance of the trade-offbetween output and inflation stabilisation in the short term has been wellunderstood.Monetarypolicywasseen asaimingat a target for inflation in the longrun, which wastobeachieved by bringing inflationback totarget over asuitabletime horizon soastoavoid excessivevolatility of real variablessuch asoutput and employment.Optimal monetarypolicywasseenasachoiceof howbesttonavigatetheshort-runtrade-off while ensuringthat thelong-run objectivewasmet.Failure todeliver pricestabilityis costly, asUK experienceamplydemonstrates.Chart 1showsthevarianceof inflation and of the output gap in theUK, using quarterlydata for two periods.Contrast theperformancein the 35years up to1992with thefirst 15 yearsof inflation targeting.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 150Betterpolicy cantakesomecredit for thisimprovement, astheanchoringof inflation expectationsled to a hugereduction in inflation volatility.It wastemptingto think that wehad moved ontothe ―Taylor frontier‖ –whichmapsfeasiblecombinationsof thesmallest variancesof the outputgapand inflation.TheGreat Stability appearedtobeapermanent breakfromearlierperiods– periodswhenmonetary policy exhibitedmore unpredictablebehaviourand left theeconomy to thenorth-east of theTaylor frontier (Chart 2).And inoneimportant senseit was–thedark daysofdouble-digitinflationwereconsigned to the past.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 151But the Great Stability wasnot representativeof a new normal.Thevarianceof theoutput gap– though not inflation – hasbeen muchhigher over thepast five yearsasthe financial crisis generated a deeprecession (Chart 3).Sowhat have welearned?International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 152Thebanking and broader economiccrisis hasdemonstrated thatmacroeconomicpolicycan facean additional trade-off betweenensuringthesoundnessof thefinancial system in the medium term, and keepingoutput in linewithpotential output and inflationon target in the nearterm.Such a trade-off arisesbecausefinancial vulnerabilitiescan build evenwhile output is growingsteadily and inflationis low and stable.Let me givethree examplesof thesort of underlying mechanismsat play.First, persistent misperceptionsof futurespendingpower may generateamix of demand that provestobe unsustainable.I believe this wasan important factor underlying thecrisis.Although output in deficit countries– like the UK – appeared to begrowingat a sustainablerate, that gave a misleading impression of thesustainability of theGreat Stability.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 153In fact the level of domestic demand wastoohigh and the level of netexportscorrespondinglytoo weak.Second, asHyman Minsky described, periodsof stabilityencourageexuberancein credit markets, leadingeventuallyto instability.And third, lowshort-term policyratesmayencourageinvestorstotakeonmore risk than theywouldotherwiseaccept asthey―search for yield‖.It is arguablethat monetary policypaid insufficient heed to the potentialimpact of such financial vulnerabilities.Financial shocksare costlybecausetheir effects can be too rapid forpolicy easily tooffset, and becausetheyhit potential supplysocreatingatrade-offbetweenoutput and inflation.In other words,theTaylor frontier is lessfavourable(furtherfrom theorigin), whenaccount is taken of financial shocks, than wemight havebelieved.Takingthe entire period of inflation targeting – includingtherecent past– might give a more accurateindication of wherethis―Minsky-Taylor‖frontier liesthanusing data for the Great Stability period alone (Chart 4).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 154What implicationsdoesthis have for monetary policy?Possiblynone– if wecan rely now on macroprudential toolstoensurefinancial sector resilience.But set thosetoolstoone sidefor a moment.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 155Monetarypolicycould be used to reacha point more like P in Chart5, with lessvariation in theoutput gap and more variation in inflationthan wehave actuallyexperienced over thepast 20years.Put another way, higher interestratesin therun up to thefinancial crisismight have reducedthe impact of thesubsequent bust, at the costofbelow-target inflation and below-trendoutput beforethecrisishit.In practice new macroprudential toolsand better micro-prudentialsupervision will improve thepossibilitiesavailable tomonetarypolicymakers.Having additional instrumentsin effect brings about a favourable shift intheMinsky-Taylor frontier (or surface) whichdefinesthe possibilitiesopen to policymakers.Nevertheless, consistent withthenew remit given to the MonetaryPolicyCommitteeby the UK Government last month, theexperienceof recentyears suggeststhat there may be circumstancesin whichit isjustifiedtoaim off the inflationtarget for a while in order to moderate the risk offinancial crises.InstrumentsFor institutions generally regarded as conservative or evenhidebound, central banks have been remarkably innovative in theircreationof new instrumentsduring the crisis.Loweringofficialinterestratesvirtuallytozerowasextraordinaryinitself.But thewholesaleredesign of frameworksto supplyliquiditytothebankingsystem, theexpansion of the monetary baseby multiplesof itspre-crisislevel through the purchaseof assetsheld by the non-bankprivate sector,and theinvolvement of central banks in risky credit easingoperationshave all raised seriousquestionsabout the roleof centralbanks– and even challengedthe ideaof central bank independence.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 156Table1showsjust how largehas been thescaleof central bankexpansion.Themonetarybasehasrisenbyunprecedentedproportionsaswetriedtoprevent a collapseof broad money and credit ashappenedin theUSduring theGreat Depression and today in Greece.And central bank balancesheetshaverisenacrosstheindustrialisedworld, asshownin Table2.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 157That expansion hasreflectedboth moneycreationthrough assetpurchasesand lendingagainst collateral.All major central banks havecreatednew waystolend against collateral.Far from their imageasconservativecreatures,arecentralbanksat riskofthrowingtheir traditional caution tothewind and ignoring the limitsonmonetarypolicy?Twolimitsare relevant in current circumstances.First, no matter how much liquidityis thrownat thebankingsystem, lendingand the economywill not recover if the bankingsystem isinadequatelycapitalised and sufferingfrom excessiveleverage.That is whythe Bank of England‘sFinancial Policy Committeehasplaced weight on theneed for the weaker UK bankstoraisecapital.It is not surprisingthat themore strongly capitalisedbanks in theUK areexpanding lendingand thepoorlycapitalisedbanks are contractinglending.Second, there are limitson the abilityof domestic monetary policy toexpand real demand in theface of theneed for changesin therealequilibrium of theeconomy.I donot believethat the present problemsin the United Kingdom stemonlyfrom a largenegativeshock toaggregate demand.In common withmany other countries,our problemsalsoreflect theunderlying need torebalanceour economy, requiring a reallocationofresourcesboth withinand betweennations.It is not simplya questionof boosting aggregate demand, but of helpingtobring about ashift to a new equilibrium.That in turn impliestheneed for both large changesin relativeprices,especiallybetweentradableand non-tradablegoodsandservices,and a shift in the relativelevelsof domesticdemand at homeand overseas.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 158There are, therefore,limitson what anyonecountry‘sdomestic monetarypoliciescan achievewithout thesupport of others.Despitetheselimits,circumstanceshavedemandedthat central bankstake extraordinarymeasures.Such measurescan risk moving into territorymore normallyassociatedwith fiscal policy and, in doingso, put at risk their hard-wonindependence.There are, it seemstome, three threatstocentral bank independence.First, there isthe risk of appearingto promisetoo much or allowingtoomuch tobe expected of us.With constraintson other policyinstruments,central banks are seen as―theonlygame in town‖.But failure tomakeclear the limitsto monetary policyrisksdisillusionment withcentral banksandtheinevitablepoliticalpressureonthem that wouldfollow.Second, at the zero lowerbound thereis no cleardistinctionbetweenmonetary and fiscalpolicy.But it is still important to ensure that central banks do not take on to theirbalance sheets risks to the taxpayer that are properly matters that shouldbedecided by elected politicians.Toensure pricestability in the long run it is vital to maintaintheoperational independenceof a central bank.Any decisionsthat put taxpayers‘moneyat risk must be made by financeministries,and central banksmust protect their balancesheetsbyimposingappropriatehaircutson collateral, and avoidingthepurchaseofrisky private-sectorassets.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 159Third, and important even whenwemove awayfrom the zero lowerbound, theexpansion of central bank responsibilitiesto includemacroprudential policy and, in thecaseof the Bank ofEngland, responsibilityfor regulatingthebankingsystem, hasmadeindependencemuch harder todefine.Thedeployment of responsibilitiesoutside monetary policy cannot bedivorcedfromthegovernment in thesamewayasispossibleformonetarypolicy.For example, in thearea of financial stability and bankingsupervision, therewillbetimeswhenpublic fundsmaybeput at riskwhenrescuingor resolving a failing institution – and that decision isproperlyone for thefinanceministry.It is far from straightforwardfor a central bank governor tobecompletelyindependent in termsof monetary policy, somewhat independent in termsof financial stability, and not at all independent in termsof operationsthatrisktaxpayers‘money.Thefinancial crisishaschallengedour understandingof theobjectivesofmonetarypolicy and exposed itslimits.And, through the proliferationof instrumentsand resultingincreaseinresponsibilities, it hascomplicated the question of central bankindependence.Sohow should werespond tothis more complex environment?We must keep sight of three important principles.First, although they should be realistic about what can be achieved, it isright that elected politicians and parliaments decide on the objectives ofpolicy.Second, aswelearned in the 1970s, if thecentral bank is toachievepricestability – itsfundamental role – it must be sufficientlyindependent.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 160And third, in order toprotect that independence,itslimitsshould be veryclearlycircumscribed, and weshould be exceptionallycareful withdecisionsthat put public fundsat risk.Thechallengeremains,asit wastwentyyears ago, to make ―constraineddiscretion‖ workin practice.But it hasgot harder.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 161SME financing, market innovation andregulationSpeechby Mr Benoît Coeuré, Member of theExecutiveBoard of theEuropean CentralBank, at the plenarySession 11―Challengesand feasibilityof diversifying the financingofEU corporatesand SMEs‖, at the EurofiHigh Level Seminar, organised in associationwiththeIrishPresidencyof theCouncil of theEU, DublinI wishtothank Annalisa Ferrando, Petra Köhler-Ulbrichand BalázsZsámboki for their inputs.I remain solely responsiblefor theopinionscontainedherein.WhySMEs are specialSmall and medium sized enterprises(SMEs) arespecial.They are the backbone of the euro area economy: they constitute about98% of all euro area firms, it employs around three quarters of the euroarea‘semployees, and theygeneratearound 60% of value added.Thesefigureshappen to be even higher in thosejurisdictionswhichhavebeen most affected by the crisis.SMEs arealsospecific in their financingstructure.Theyturn more often to banksfor their external financingthan largefirmsbut, at thesame time, they aregenerallymore likely toexperiencegreater difficultiesin obtainingfunds.There arestructural reasonsfor this, notablytheyaremore opaque andtheir corporatecapabilitiesmore difficult to assess, becausetheirInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 162financial statementsare lessinformativeand their credit histories areusuallyshorter.Thesecharacteristicsare compounded by fixed costsin externalassessment and monitoring.All this leadstohigher transaction costs, especiallythosestemmingfromasymmetric information, for SMEs.It is thereforetosome extent inevitablethat credit sourcesfor small firmstend to dry up more rapidlythan for largecompanies duringeconomicdownturns,therebydisruptingthebusinessand investment activitiesofthesefirmsto a greater extent.And this hasindeedbeen the caseduringthecrisis in theeuro area.Thecreditworthinessand financial health of SMEs have deterioratedmore sharply than thoseof largefirms, and theprotracted period of weakeconomicconditionshasexacerbated theasymmetric informationchallengesof SMEs.Thestatisticscurrentlyavailabledo not provide timelyand high -frequencyhard data on the balancesheet position of a representativesetof SMEs for theeuro area.Yet, based on surveyinformation provided by theECB (the Survey onAccesstoFinanceof Enterprises, SAFE), weseethat SMEs‘profits,liquiditybuffersand owncapital have developed lessfavourablythanhavethose of largefirms during thecrisis(Charts 1and 2).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 163From the viewpoint of commercial banks‘risk management, it may thusbepartlyunderstandablethat bankstake a more selectiveapproachinsupplying loansin arecession in order topreservethequalityof the assetsideof thebalancesheets.But, in general, suchcredit tighteningcurrentlyappearsto bevery severefor SMEs, becausetheyare perceived bybanksto have a higherprobabilityof default than larger firms, and becauseSMEsare oftenunableto switchfrom bank credit toother sourcesof external finance.As a result, SMEsare more likely tobe affectedby excessivebank riskaversionand thusby outright rationingof credit provision than are largefirms.Difficultiesin borrowing, whichinfluencenot only their day-to-dayactivities, but alsotheir abilityto grow,may then easilytransformliquidityconstraintsintosolvencyrisk.Toillustratethis point, twofactsare worthmentioning.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 164First, SMEs tend to facehigher costsfor bank finance.Asimplecomparison betweensmall loans(typicallytoSMEs) and verylargeloans(typicallyto largecorporations)showsthat euro area SMEswerepaying onaveragearound160basispointsmore thanlargeeuroareacompanies in thesix monthsup toJanuary 2013.There is alsoa substantial divergenceacrosseuro area countries whichhasworsenedsincethe beginningof thefinancial crisis(Chart 3).For instance, in thesame period, the spread wasaround 50basispointsfor SMEs inAustria and Belgium, but 261in Spain and 174in Ireland.Just to put this in a ―historical‖ perspective:between2003and 2008thesamespread was84basispointsin the euro area, 79basispointsin Spainand 44basispointsin Ireland.Thesecond fact that is worthmentioningis thehigher rejection ratesofloanapplicationsof SMEs, astheECB survey shows(Chart 4).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 165SMEs aresystematically reporting that theyfacemore financingobstaclesthan largefirms acrossmajor euro countries (except here inIreland, wherefirmsare reporting tobehighly constrainedirrespectiveoftheir size).This appears, at least in part, tobe related to their financial position.Indeed, when linkinginformation on thefinancial health of SMEs withtheactual financingobstaclestheyexperience,it turnsout that firmsincountrieswithhigher leverageand interestpayment burdensaswell aslowerprofitstend tobe more affected byfinancingobstaclesthanSMEsin other euro area countries (Chart 5).International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 166However, it is worth noting that in conjunction with creditconstraints, several other issues have an impact on the environment inwhichSMEsoperate.For instance, theyare more affectedbydownwardtrendsin theeconomyand structural rigidities, i.e. a lack of demand for their products,highinput prices, unfavourable regulation, heavy administrativeburdens,inflexiblelabour and product markets,etc.Sincesuch factorsdiffer acrosscountries,the financingcostsof SMEswill inevitablyalsovary acrossthe euro area.Obviously, theEurosystem cannot influencethesefactors.In periodsof bindingbank lendingconstraints,a mitigatingfactor is theabilityof corporatestoreplacebank credit withalternativesourcesoffinancing.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 167Sincethe outbreak of the financial crisis, internalfinancingand externalfinancinginstrumentsother than bank loansin generalhaveincreasedinimportancerelativetobank loans.Depending on the financingenvironment, substitutioneffectshavedifferedmarkedlyacrosseuroarea countries (Chart 6).On the onehand, enterpriseshave replacedbank loanswithmarket-basedfinancingor financingvia unquoted equity during thecrisis.In thisrespect, therelevanceofdebt securitieshasincreased,especiallyinsome countries,such asFrance.On theother hand, inter-companyloanshave gained importancein othercountries,such asGermany.In the same period, trade credit appearsto have taken on a buffer roleinsome euro area countries.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 168We know, however, that some of thesesubstitutionactivitieshave mainlyaffected larger companies,asin thecaseof debt securities,while tradecredit, leasingand factoringare closersubstitutestoloansfor SMEs(Chart 7).But trade credit, leasing and factoring are strictly related to the businessactivity of companies and in recessionstheir buffer role might be limitedbythereduction in the exchangeof goodsand services.Takinga macroeconomicperspective, credit supplyconditionshavecertainlybeen found to have an impact on real economic activityduringthecrisis.Analyses carried out by ECB staff suggest a rather limited contribution ofcredit supply conditions to euro area economic activity between 2007 andthefirst quarter of 2008.By the fourth quarter of 2008, however,the impact of credit supplyconditionsappearssizeable.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 169At thepeak of the crisis,namelyin the first half of 2009, model-basedanalysispointsto credit supplyeffectsaccountingfor an almost 2–percentage-point contraction in annual real GDP growth, namelyaroundone-third of the overall contraction.As the sovereign debt crisisunfolded, credit supplyfactorsturneddetrimental togrowthagain.In this context, riskierborrowingsegmentsare highlyvulnerabletotheself-reinforcingdynamicsof weakeconomicconditions,low financialbuffersand tight bank lendingpolicies.Actually, theEurosystem Bank LendingSurveyshowsover the recentquartersthat both healthyand stressedbanksreport risk perceptionsastheir main concern and significantlytightenmarginson riskierborrowers.Policy actions supporting lending to SMEsDuring the crisis, theECB took exceptional monetary policyactions,distinguishingbetweenstandard and non-standard measures.Standard measureshave includedthe reduction of all key interestrates.Non-conventional measureshave comprisedfixed-rate full allotmentmode in refinancingoperations,the lengtheningof the maturityof suchrefinancingoperationsup to 36 months, the extension of thelist ofeligiblecollateral (see Chart 8), the liquidityprovision directlyin foreigncurrencies,the reductionin the reserve requirementsfrom 2% to 1%, thecoveredbond purchaseprogrammes,thesecuritiesmarketprogramme, and, finally, the announcement of theoutright monetarytransactions.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 170Such actionshaveproved to be effectivein alleviatingbank fundingconstraints, containingthe risksof a disorderlybank deleveragingprocess, and supporting the effectivetransmission of interest ratesacrossthe euro area, amid a dysfunctional financial market.Thesemeasureswereexceptional in nature, scope and magnitude, andyet appropriatefor theseverityof thecircumstances.Theseinterventionshave served toconsiderably easethe downsidepressurestopricestabilitybyavoidingan abrupt credit crunchstemmingfrom sudden shortagesof liquidityand fundingfor banks.However,at times,the effectivenessof monetary policy itself hasbeenhinderedbyfinancial fragmentation, in particularagainstthebackdropofa sovereign debt crisis in some euro area jurisdictions.As a result, the accommodativemonetary policy stanceset bytheGoverningCouncil hasaffectedfirms rather unevenly.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 171TheECB will provideample liquidityaslong asneeded,but marketparticipantshavetocontinuetheir effortsto facilitate the transition to alesscentral-bank reliant, more market-basedfinancial system.Against this background, attention has turned to the role of publicpolicies in reducing impediments and unclogging credit channelstowardsSMEs.As a first measure, most governmentshave expanded credit guarantees toSMEs for the purpose of inducing banks to reopen their lendingfacilities, thereby reducing the risk that banks need to take on theirbalancesheetswhengranting new loans.Other measureshave tended to stimulatethechronic shortageof supplyof capital into new seed, start-up and early-stage firms.Venture capital (VC) fundshavebeen channelledthrough public/privateco-investment VC fundsmanaged by private sector fund managers.Innovativeinstrumentshave includedthe promotion of investment inSME equity tocopewith theundercapitalisationproblem.Some of these measures have a longer-term structural perspective, ratherthan something that can addressthe immediate conjunctural weakness ofSMEs.Overall, loan schemes,especiallyguarantees, tend to have a much largerimpactin termsof thenumber of firmsaffected, whileventure capital andsimilar schemesaremuch more targetedandrestrictedtospecific groupsof firms.However,they haveproved tobe of limitedeffectivenessin stressedcountries,given thehigher fundingcostsfaced by stressed sovereignsthemselves.In termsof impact, whilegovernmentshave strengthened their supportmeasuresfor SMEs during thefinancial crisis,it seems that SMEs inInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 172most countrieshavenot yet seen a visibleimprovement, at leastbased onevidencefrom survey results(Chart 9).Apparently, while a range of government support measuresexistsforalleviatingSMEs‘accesstofinance, it hasproved difficult to reach thepolicy targets, i.e. theSMEs.Beyond government financinginstrumentstosupport SMEs‘accesstofinance,other policyactionsmay be considered.This includesthedevelopment of deeper capital marketsaccessiblealsofor SMEs and a wideruseof ratingsfor SMEs.In addition, combating payment delays in tradecredit financinghelpstoalleviateliquidityconstraintsand hasalreadybeen put in placein somecountries.Besides governments, supranational institutionsalsooffer supportmeasuresto SMEs – measureswhichcould be enhanced.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 173Traditional instrumentsof intervention are relatedtothe EuropeanInvestment Bank (EIB) lendingtoSMEsand theEuropean InvestmentFund‘s(EIF) actionsin theABSmarket designed to revive investors‘interest and confidence,by facilitatinglargeand liquidtransactions.An interesting pilot project on tradefinancewaslaunchedby theEIB inDecember 2012for Greece.For thefirst time, theEIB is involved in a short-term credit supportinstrument.Theregulatory frameworkIn additiontodirect support measuresbynational governmentsaswellasbyEuropean and international institutions,theregulatoryframeworkmayalsohave an impact on the incentivesof banks regarding their exposurestoSMEs.Let me note in thiscontext that theEuropean BankingAuthority (EBA)hasrecentlypublisheda detailed analysisof the estimatedimpact ofbankingsolvencyregulation on SME lending, witha particular focus ontherelevant provisionsof the forthcomingcapital requirementslegislationin theEUIn this regard, a clear distinction should be madebetweenmicro- andmacro-prudential policy objectivesand toolsthat may have relevanceforsupporting SME lending.From amicro-prudential perspective, minimum capital requirementsandtheunderlying risk weightscan be consideredasthemain factorspotentiallyaffectingbanks‘incentivestolend toSMEs.In the current regulatory framework, there are different provisionsaffectingSMEs, dependingon whethera standardisedapproach or moresophisticated approachesare used.As regardsthestandardisedapproach, loansize plays an important rolewhendefiningthe riskweight and thusthepertinent capital requirement.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 174Toclarify: small-sizedloansup to €1million aretreated asretailexposures,and benefit from a lowerrisk weight of 75%, compared with arisk weight of 100% for unratedcorporateloans.Hence, the current regulationtreatssmall-sizedloans,whichare likely tobetakenup mainlyby SMEs, in a more favourablemanner.However,for larger (over €1million) loansthereisnofavourabletreatment for SMEs under the standardised approach.For unrated loansexceeding€1million, the treatment of exposurestoSMEs and largecompaniesis thesame.Onlycompanies withgood credit ratings– whicharetypically largercorporates– benefit from lowerrisk weights.Importantly, forbanksusingthemoresophisticatedapproachesforcreditrisk, namely theadvanced internal ratings-based(IRB) approaches, thecurrent regulatory frameworkfurther providesfor preferential treatment ofSME loansvis-à-vis largecorporate exposures.TheCapitalRequirementsRegulationandDirective,orCRD IV, entailsasignificant increasein thequalityand quantityof capital.While thephasing-inis rather long and expectedtoend in 2019,theimplementationof variouscapital buffersand the higher level ofminimum capital requirements– though clearlybeneficial for enhancingfinancial stabilityin the longterm – are estimatedtoincreasethe overallcost of funds.This is likelytobe reflectedin theinterestratescharged toall clients,includingSMEs.Aware of thepotential implicationsfor SMEs and withthe aim of partlyneutralisingthe potential adverseimpact of increasedminimum capitalrequirements,EU co-legislatorshaveagreedon theinclusionof aspecificdiscount factor for exposurestoSMEs,for loansup to €1.5million.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 175This measure is expectedto reducecapital requirementsfor SMEs byabout 25%.TheECB supportsthis proposaland considersit asan important policytool that may help SMEs in their accesstobank finance.Taking a long-term perspective, together with micro-prudentialconsiderations, the CRD IV will also provide a harmonised legalframeworkfor a range of macro-prudential tools.In this regard, the first policytool that is explicitlydesigned toaddresssystemicrisk isthecountercyclical capital buffer, whichwill bephased ingraduallyfrom 2016onwards.While theprimary objectiveof thisbuffer is toenhancethe resilienceofbanksby buildingup buffers in periodsof excessivecredit growththatcan be released when thesystem asa wholeis in distress,a positivesideeffect of the application of themeasure isthat it may contributetosmoothingthe credit cycle, thusproviding fundsfor corporateclients,includingSMEs,alsoin recessions.Thishoweveralsoimpliesthat aslongaswedonot havesufficient capitalbuffersthat could bereleasedtoabsorblossesor toloosenprudentialmeasuresregulatedby EU law,theuseof macro-prudential toolstosupport SME lendingis very limited.Finally, in a broader context, there is a need for structural marketinnovation to improve SME financing.Such an innovationwouldcreate a market for asset-backedsecurities,wherethe underlying assetsare loanstoSMEs.It could alsosupport the revival of thismarket segment by increasingitstransparencyand thereforeinvestor confidence.Having accessto a diversifiedsourceof financefor SMEswill enhancetheir resiliencethrough the businesscycle.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 176BecauseSMEsarecharacterisedbytheir relativelysmall sizeandbecauseit is costlytocollectinformation on their projects,theyhave limitedaccessto capital markets.In this context, securitisationoffersan opportunity for the custodiansoflargepoolsof European savings,i.e. insurance and pension funds, tochannel resourcestoSMEs.In this vein, the effortsput in placein the Prime CollateralisedSecurities(PCS) initiativeshould be commanded.ThePCShasdefinedcommon criteria on standardisation, quality,simplicity, and transparencywith the aim toimprove market depth andliquidityfor theABSs.It alsoincludesspecific criteria on SME ABS.Prudential reforms could alsohelp torevive securitisationactivity.Akey initiativein this field is the socalled SolvencyII Directivefor theinsurancesector, which aimstoalign capital requirementswithrisksthatinsurancecompanieshave actuallytakenin their investing activities.In the current proposal for SolvencyII, whichwill probablycome intoforceon 1January 2016with a 10-year phase-inperiod, the capitalrequirementsfor certain securitised productswill increasesignificantly,thuspotentiallyreducinginsurers‘willingnesstoallocatefundsto suchasset classes.Theappropriatenessof thecapital chargesin SolvencyII and theirconsistencywiththecapital requirement rules under the CRD IV arecurrentlybeingreviewedby EIOPA.In this regard, particular attention needstobe paid to providinga levelplaying field for banks and insurersaswell asto enhancing long-termfinancingof thereal economy through thesecuritisation of debt.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 177ConclusionIn thenearerterm,howcantheimpedimentstobank fundingofSMEs beaddressed?In essence,theseimpedimentsareof threetypes:thebanks‘ownfundingconditions,their perception of the credit risk of their clients,and lack ofcapital.TheECB doesnot havea magic wand.Thecentral bank cannot compensatefor a shortage, or a misallocationofequity.That is somethingthat hastobe addressed, in one form or theother, byother stakeholders.Neither can thecentral bank alter thecredit riskof individualborrowers,although governmentscan have an impact here throughreformsthat improvethe operatingenvironment of thosefirms – labourandproduct market regulation for instance.Where the central bank hasa direct role, withinits mandate, isprimarilywith respect to bank funding conditions.Indeed, the ECB has taken and will continue to take appropriatemeasures to ensure that bank funding is not a source of financialfragmentationor animpediment tobank lending.It is reasonableto think that simultaneousaction on all three counts, bytherelevant stakeholdersin each case, would be mutuallyreinforcing.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 178Financial inclusionOpeningaddressby Mr DentonRarawa,Governor of CentralBank of Solomon Islands,atthe10th Meetingof the PacificIslandsWorking Group (PIWG) on ―Financial inclusion‖, HoniaraSalutationsGovernorLoi Bakani; Deputy Governor Peter Tari; DeputyGovernorGaneSimbe; Co-Chairs MsLana Lome-Ieremia and Vereimi Levula;Resourcepersonsfor the Data workshopMsSandford and Mr Dermish;Representativesfrom our key partners:Mr Reuben Summerlin and JeffLiew from Pacific PFIP and Mr Eliki BoletawafromAFI; Otherparticipantsof the Pacific IslandsWorking Group (PIWG) meeting;Ladies and Gentlemen;Welcome to Solomon IslandsGood morning and let me warmly welcomeyou all to SolomonIslands.Thank all of you for makingtime to attend this10th PIWG meeting.I am delightedto seea lot of familiar faces.And it isgood toseeeveryone smilingthis morning even though some ofyou havetravelleda long wayto behere.Pacific IslandsWorking Group – a family committed to eachotherTheideato set up thePacific IslandsWorking Group wasendorsedduringthe South Pacific Governorsmeetinghere in Honiara in 2009.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 179Sothis meetingcan be described asthePIWG coming back toitsroots.Theexcitingagendasbeforeusand the opportunitiesto share countryexperiencesamongst membersduring thesethree days are the mainreasonswhyweareall here.I think it is important toregularly remind ourselvesof the objectivesofPIWG, whenit wasestablishedfour yearsago.Theobjectivesof PIWG are asfollows:•Toidentify barriersand challengesto financial inclusionuniqueto thePacific, and formulate appropriate policyresponses.• Toworktogether toadvancefinancial inclusion policy in theregion,•Tolearnfrom each other asmembersdevelop and implement policysolutionsfor financial inclusion.I commend the PIWG for taking a collaborative approach to addressingthefinancial inclusionissuesand challengesin the region by workingtogether and sharingour individual experiences.We face similar but alsodifferent ―country-specific‖ challenges.For example, our countries are separated by the seabut thelevel ofseparation differsbetweencountries.With theseinherent challenges,wehavenochoicebut toworktogetherasa group.I believe that is what wehave done and already wehave made progressand achieved a lot in our respectivecountries.We have ensured our voicesare heard.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 180Internationalgroupingslike theAlliance for Financial Inclusion (AFI)haverecognisedourworkandotherregionsaretryingtoemulatewhatweare doing.We oweall that recognitionand successto the PIWG.I am sure a lot of theseachievementswill be highlightedduring thecourse of this meeting.Another major achievement in my view isthat all of you here attendingthismeeting represent a pool of financialinclusion expertsin theregion.This is a key resource for our region and I would like to encourage us tomake use of our regional expertsso that we continue to build our pool ofexperts.Financial inclusion activities in Solomon IslandsLadies and gentlemen, let me brieflyshare some of the effortswearemakingin addressingfinancial inclusionissuesin Solomon Islands.Our current focusis on the twinpillarsofAccessto and Use of financial services in the country.Thequestion ofAccessrequiresmakingfinancial servicesavailableandaffordableto asmany peopleaspossible.At the moment financial servicesin Solomon Islandsare availableonlyinHoniaraand in theprovincial centres.If wedefineaccessbysay, lessthan 2 hours walk(or paddle) tothenearest financial servicesaccesspoint astheideal, then more than80%oftheSolomonIslandspopulationisbeingdeniedaccesstofinancialservices.This is huge challengefor the country.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 181Sotheprimarytarget in our nationalfinancialinclusionactionplanisthatby2015an additional 70,000peopleshould have accesstofinancialservicesin thecountry.In order toachievethis, wearefocusingon technologyasa meansoffinancial distributionchannelsand communitybasedapproachestopromotingand deliveringsavingsand credit activities.And to ensure that our legal framework supportsthese efforts, wehave, withADB support, completeda review of our current lawsandpolicieslast year toensure any legal impedimentsto financial servicesinnovationare identifiedand addressed.Thesecond pillarof our approach to financial inclusion ison the Use offinancial services.Financial servicesand productsshould be used by anyone anytime.This meanswehaveto unlock and remove barriersthat deny ordinarypeoplefrom usingthe available financial services.This requiresfurther effort in twoareas:first to enablepeoplewhoarebeingdenied using financial servicesbecauseof legal and administrativebarriers and secondlyto assist peoplewhocannot useand benefit fromfinancial servicesbecauseof lack of knowledgeand understanding.Our approachin trying to addressboth areashasbeen toidentify andremove the legal and policybarriersthat inhibit usageand to enhancepeople‘sunderstandingof financial servicesthrough financial educationand literacy.We have madeprogressin some areasbut a lot of workstill needsto bedone.Someof our recent achievementsinclude:•New CBSI Act: A new CBSI Act was passed by Parliament in Novemberlast year and one of the new provisionsin the law is to specifically includefinancial inclusionasa mandateof the Bank.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 182This now formalisesthe Bank‘sinvolvement in financial inclusionactivities.•Review of Legal Framework:And to ensure that our other lawsalsosupport these efforts, wehave, withADB support, completed a review ofother lawsand policieslast year to ensure any legal impedimentstofinancial servicesinnovation are identifiedand addressed.•SimplifiedKYC requirements: Oneof the barriersis thestringent bankrequirementsfor opening bank accounts.Soin collaboration with theAnti MoneyLaunderingCommission, wehaveissued to the commercialbanks simple requirementsfor identifyingcustomerswhen openingbank accounts.This will make it easier for more rural peopleto open accountswiththebanks.•Financial Education: In partnership withthe Ministryof Education, wehaveset up a Working Committeetointegrate financial education intothenational school curriculum, targetingclassone up to form three.Therevisionof thecurriculum hasbeendonebut furtherwork is requiredtoprepare course materialsand train teachers.•Adult Financial Literacy: This isa very important area for us, giventhelowliteracylevel in the country especiallyamong rural adults.TheCentral Bank is actively engaged in financial literacythrough itsMoney Smart Day programs, itsweeklyMoney MattersRadioprogram,and alsothrough financial literacyworkshopsfor communitiesandwomengroups.Theseachievementshave been possiblebecauseof closecollaborationandpartnership with keystakeholders.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 183Workingtogether withother stakeholdersis critical if weare toachievethe goalsand objectiveswehave set ourselves in termsof financialinclusion.I am sure thisis alsotrue for your respectivecountries.But I think ourbiggest weaknessistryingtomeasurewhatwehavedone.How are weperforming against our set targets?This is wheredata and indicatorsbecomevery important. We needrelevant data tomeasure progressand review our performance.And I am delightedtonote that thewholeof tomorrow is devoted to thisvery important issue.Concluding remarksI would like to conclude by reiterating the importance of continuing towork together to address our common challenges aswe strive to enablemore of our people benefit from financial services.At the same time I wouldliketo register our appreciation to both of ourkey partners,the Pacific Financial Inclusion Program (PFIP) andAlliancefor Financial Inclusion(AFI) for the tremendoussupport toPIWG.This support hasenabledthe group toprogresstheir financial inclusionagendasandhopefullytomake an impact in our countriesandalsoontheinternational stage.Finally, I wouldlike towishyou all a lively, interestingand productivemeeting. Thank you for your kind attention.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 184DisclaimerThe Association tries to enhancepublic accessto information about risk andcompliancemanagement.Our goal is to keep this information timely and accurate. If errorsarebrought to ourattention, wewill tryto correctthem.This information:- is of a general nature only and isnot intended to addressthe specificcircumstances of any particular individual or entity;- should not be relied on in the particular context of enforcement or similarregulatoryaction;- is not necessarily comprehensive, complete, or up to date;- is sometimeslinked to external sites over which theAssociation has no controland for which theAssociation assumesnoresponsibility;- is not professional or legal advice (if you need specific advice, you shouldalwaysconsult a suitably qualified professional);- is in no wayconstitutive of an interpretative document;- doesnot prejudge the position that the relevant authoritiesmight decidetotake on the same mattersif developments, including Court rulings, wereto lead it torevisesomeof the viewsexpressedhere;- doesnot prejudgetheinterpretationthat theCourtsmight place onthemattersat issue.Pleasenote that it cannot be guaranteed that theseinformation and documentsexactly reproduce officially adopted texts.It isour goal to minimize disruption causedby technical errors.However some data or information may have been created or structured in files orformats that are not error-free and we cannot guarantee that our service will not beinterrupted or otherwiseaffectedby such problems.The Association acceptsno responsibility with regard to such problemsincurred asaresult of using this site or any linked external sites.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 185Certified Risk and Compliance Management Professional(CRCMP) distance learning and online certification program.Companies like IBM, Accenture etc.consider the CRCMP a preferredcertificate. You may find more if yousearch (CRCMP preferred certificate)using any search engine.The all-inclusive cost is $297.What is included in the price:A. The official presentations we usein our instructor-led classes (3285 slides)The 2309 slides are needed for the exam, as all the questions arebased on these slides. The remaining 976 slides are for reference.You can find the course synopsis 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 officialpresentations and try again, but you do not need to spend money. Upto 3 exams are included in the price.To learn more you may visit:www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdfwww.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdfC. Personalized Certificate printed in full colorProcessing, printing, packing and posting to your office or home.International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
  • P a g e | 186D. The Dodd Frank Act and the newRisk Management Standards (976slides, included in the 3285 slides)The US Dodd-Frank Wall Street Reformand Consumer Protection Act is themost significant piece of legislationconcerning the financial servicesindustry in about 80 years.What does it mean for risk andcompliance management professionals?It means new challenges, new jobs, newcareers, and new opportunities.The bill establishes new riskmanagement and corporate governanceprinciples, sets up an early warningsystem to protect the economy from future threats, and brings moretransparency and accountability.It also amends important sections of the Sarbanes Oxley Act. Forexample, it significantly expands whistleblower protections under theSarbanes Oxley Act and creates additional anti-retaliationrequirements.You will find more information at:www.risk-compliance-association.com/Distance_Learning_and_Certification.htmInternational Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com