Risk Compliance News September 2012


Published on

Risk Compliance News September 2012

Published in: Career
1 Comment
  • download here link 100% working: https://app.box.com/s/olzwnk240vfm2ir8yfdw
    Are you sure you want to  Yes  No
    Your message goes here
  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Risk Compliance News September 2012

  1. 1. _____________________________________________________________International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  2. 2. International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.comDear Member,Modelling risks …… this is really one of the most interestingtopicsAgathe Côté: Modelling risks to the financial systemRemarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, tothe Canadian Association for Business Economics, Kingston, Ontario, 21August 2012.***IntroductionIt has become a summer tradition for the Bank ofCanada to address the Canadian Association forBusiness Economics.This year it is my pleasure and I thank you for the kind invitation.An audience of colleagues and fellow economists offers me anopportunity to delve into a complex subject, and one that is particularlytimely: financial system risk. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  3. 3. We continue to see today the enormous costs to the global economy of thefinancial crisis that started five years ago.Of the many lessons we have learned from the crisis, a key one is this: weneed to pay more attention to the stability of the financial system as awhole.This means understanding better how risks get transmitted acrossfinancial institutions and markets, and understanding better the feedbackloop between the financial system and the real economy.From a policy perspective, this means taking a system-wide approach tofinancial regulation and supervision.Major reforms of the global financial system now under way address thisneed.System-wide risk has been a focus of attention at the Bank of Canada, andat other central banks, for some time.Ten years ago, the Bank issued the first edition of its semi-annualFinancial System Review in which it identifies key sources of risks to theCanadian financial system and highlights the policies needed to addressthem.A year later, in 2003, we organized our annual conference on the theme offinancial stability.In the wake of the global financial crisis, the Bank has intensified itsresearch efforts in this area.In particular, a priority is to improve the theoretical and empirical modelswe use to analyze elements of the financial system that can lead to theemergence of risks and vulnerabilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  4. 4. With more finely tuned quantitative models and tools, the Bank will bebetter able to identify risks on a timely basis so that the private sector andpolicy-makers can take corrective action to support financial stability.Let me acknowledge upfront that this task is complex.While macroeconomic models have long been used to guide monetarypolicy decisions by central banks, models of financial stability andsystemic risk are much less advanced.In my remarks today, I want to talk about the progress that we have madeat the Bank in modelling risks to the financial system.I will start by briefly describing the notion of systemic risk and variousapproaches used to identify and measure it.I will then discuss two state-of-the-art quantitative models that we havedeveloped to improve our assessment of risks to the Canadian financialsystem.The multiple dimensions of systemic riskSystemic, or system-wide, risk goes beyond individual institutions andmarkets.It is the risk that the financial system as a whole becomes impaired andthat the provision of key financial services breaks down, with potentiallyserious consequences for the real economy.Systemic risk manifests itself in different ways.There is a time dimension, which refers to the accumulation ofimbalances over time, and a cross-sectional dimension, which refers tohow risk is distributed throughout the financial system at a given point intime. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  5. 5. Procyclicality is the key issue in the time dimension.It reflects the tendency to take on excessive risk during economicupswings – too much punch from the punchbowl, if you will – and tobecome overly risk averse during the downturns.Procyclicality makes the financial system and the economy morevulnerable to shocks, and increases the likelihood of financial distress.Risk concentrations and interconnections are the key issues in thecross-sectional dimension.Financial institutions can have similar exposures to shocks or be linkedthrough balance sheets.As a result, losses in one institution can lead to fears of contagion thatamplify the adverse effects of the initial shock.For instance, uncertainty about the viability of counterparties can lead tohoarding of liquidity, which may seem like an appropriate action for theindividual institution but can have disastrous consequences for thefinancial system as a whole.System-wide surveillance requires that we regularly assess the importanceof various types of systemic risk.How we judge a particular risk will be based on the probability that it willlead to financial system distress, and on the extent of its impact shouldthat distress materialize.Early-warning indicatorsA fundamental challenge is to detect the risks arising from both globaland domestic sources in an environment with a vast number of potentialindicators. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  6. 6. Therefore, one direction of research at the Bank has been to isolate thekey signals from this broad information set by identifying a smaller groupof variables that can serve as early-warning indicators of emergingimbalances.Since financial crises in Canada have been rare, international data areused to help establish numerical thresholds for each domestic indicator.For example, if international evidence suggests that credit growth above acertain rate tends to be associated with increased risk, then a period withcredit growth above the threshold would suggest an elevated probabilityof financial stress.Selecting the level of thresholds involves a difficult trade-off between falsealarms and failure to signal an event, so in practice the early-warningindicators are used mainly to identify areas where more detailedinvestigation may be warranted.They provide an objective, practical starting point to detect the buildup ofimbalances in the financial system.One early-warning indicator that we regularly track is the deviation of theaggregate private sector credit-to-GDP ratio from its trend (thecredit-to-GDP gap), which serves as a rough measure of excessiveleverage across the financial system (Chart 1). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  7. 7. This indicator has been shown to provide some leading information as apredictor of banking crises, and has been proposed by the BaselCommittee on Banking Supervision (BCBS) as a useful guide fordecisions about when to activate the countercyclical capital buffer – animportant macroprudential policy instrument in the Basel III agreement.Given the complexity of systemic risk, it is unrealistic to expect a singlemeasure or indicator to serve all purposes.Combining indicators can produce better signals with fewer false alarmsand undetected crises.For example, research shows that combining the Credit - to - GDP gapwith a measure of real estate prices produces an indicator that performsbetter than either variable on its own.Our own work at the Bank reinforces findings elsewhere that aggregateprivate sector credit and real estate prices are among the most reliableindicators of financial stress. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  8. 8. Identifying sources of risk is essential, but so is determining thelikelihood that these risks will materialize.Therefore, another important aspect of ongoing research is thedevelopment of statistical models to help us forecast the probability that acrisis will occur based on a group of indicators.Macro stress testsEarly-warning indicators are useful to gauge the probability of financialstress, but a thorough assessment also requires an analysis of what couldhappen if the risk materializes.This is the goal of macro stress testing.A good part of the Bank’s efforts in recent years has been devoted todeveloping and refining stress-testing models.This class of models takes a large but plausible macroeconomic shock asa starting point and analyzes its impact on the balance sheets of banks orother sectors of the economy.The Bank now has two main stress-testing models to help monitor risksto the financial system.These models can also be used to assess the potential impact of policytools or regulatory actions in mitigating financial system risks.Assessing risks from elevated household debtThe first, the Household Risk Assessment Model, or HRAM, is amicrosimulation model that assesses how the debt burden of Canadianhouseholds can affect financial stability. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  9. 9. Using microdata from household balance sheets, the model allows us toestimate how various shocks would affect the distribution of debt withinthe household sector.The simulations take into account changes over time in individual debtlevels, as well as changes in household wealth from savings andfluctuations in the value of financial assets.Tracking the asset side of household balance sheets gives us a moreaccurate picture of systemic risk since changes in wealth affecthouseholds’ ability to pay their debt.Household vulnerabilities depend not only on the average level of debt,but also on how debt is distributed across individuals.One strength of the model is precisely its ability to account for thisdistribution.For instance, while record-low interest rates in recent years havecontributed to a relatively low aggregate household debt-service ratio, theshare of Canadian households that are considered most vulnerable –those with a debt-service ratio equal to or higher than 40 per cent – hasclimbed to above-average levels, as has the proportion of debt held bythese vulnerable households (Chart 2). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  10. 10. Using HRAM, we estimate that if interest rates were to rise to 4.25 percent by mid-2015, the share of highly indebted households would risefrom slightly above 6 per cent in 2011 to roughly 10 per cent by 2016, whilethe proportion of debt held by these households would rise from 11.5 percent to about 20 per cent over the same period.So while the aggregate household debt-service ratio paints a somewhatrosy picture, taking into account distributions gives us a clearer and morecautionary indication of how vulnerable our financial system actually is tohousehold debt.Another strength of the model is that it provides a flexible tool forsimulating the impact on household solvency of a wide range of potentialshocks, such as an increase in unemployment.HRAM indicates that household loans in arrears would more than doubleunder a severe labour market shock similar to that observed in therecession of the early 1990s. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  11. 11. Despite the model’s strengths, we continue to enhance our analysis byimproving HRAM.Expanding the behavioural aspects of the model is one way to do this.For instance, the model currently allows distressed households to paytheir debts by selling their liquid assets, but not their homes.Work is also under way to improve the design of the shock scenarios.Results of stress tests using HRAM are regularly reported in the Bank’sFinancial System Review and constitute an important element of ouroverall assessment of the risks associated with household finances.Assessing contagion effects in the banking systemHRAM provides invaluable information on vulnerabilities in thehousehold sector, but the Bank is also interested in assessing risks morebroadly within the Canadian financial system.To this end, we have been working for several years on developing aMacro Financial Risk Assessment Framework (or MFRAF).Drawing on detailed data from bank balance sheets, MFRAF is aquantitative model that tracks the contribution of individual banks tosystemic risk.Traditional stress-testing models focus exclusively on solvency risk, andestimate the overall risk to the financial system by simply aggregatingcredit (or other asset) losses that would materialize at individual banks inthe event of a severe shock.MFRAF goes beyond this traditional approach by taking into accountlinkages among banks arising from counterparty exposures – or networkspillover effects – as well as funding liquidity risk, that is, the risk ofmarket-based runs on banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  12. 12. The financial crisis illustrated the significant risks associated with adeterioration of funding liquidity.The collective reactions of market participants led to mutually reinforcingsolvency and liquidity problems at banks around the world.As funding liquidity evaporated, many well-capitalized institutions had totake writedowns on illiquid assets, or sell them at a loss, creatinguncertainty in the market about their solvency and adding to thedownward pressure on asset prices.MFRAF has been built to integrate funding liquidity risk as anendogenous outcome of the interactions between solvency concerns andthe liquidity profiles of banks.This strong microeconomic foundation constitutes a major innovation inmacro stress-testing models.MFRAF also incorporates network externalities caused by the defaults ofcounterparties, with the size of a counterparty’s interbank exposuresincreasing the likelihood of spillover effects.A key lesson from the model is that failure to account for either fundingliquidity risk or interbank exposures could lead to significantunderestimation of the risks to the financial system as a whole if thebanking system is undercapitalized and relies extensively on theshort-term funding market.Importantly, the loss distributions generated by the model exhibitfat tails, a key feature of the actual distribution of financial system risks(Chart 3). _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  13. 13. The fact that the model is able to replicate this important stylized factdemonstrates that it has significant potential as a tool for assessingsystemic risk.Nevertheless, while MFRAF is already somewhat complex, the layers ofinteraction will need to be further augmented.For instance, the model misses any negative feedback that could occurbetween heightened risks to the banking system and the real economy.The model could also be expanded over time to include other types offinancial institutions and markets.Compared with other approaches that use market-based data, such as theasset-pricing approach, the transmission channel in models like MFRAFis transparent, and this improves our interpretation of results.Because of this “story-telling” ability, many central banks have begun touse this type of framework in their financial stability analysis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  14. 14. In addition to assessing risks, MFRAF can be used to examine the meritsof policy or regulatory initiatives such as capital and liquidity rules.As the model becomes more refined, the objective is to use it more tocomplement other existing macro stress-testing exercises and to sharpenour analysis and communication of risks in the Bank’s Financial SystemReview.ConclusionLet me conclude.The Bank of Canada is conducting extensive research into findingmethodologies and tools to identify and measure systemic risk.While work in this area is extremely complex, the Bank has madesubstantial progress in recent years.We now have two state-of-the art models. And with HRAM, the Bank ofCanada is one of the few central banks at the leading edge of usingmicrosimulation models to assess vulnerabilities in the household sector.Our efforts to build these models have provided us with importantlessons.First, distributions matter – we cannot rely solely on aggregate data:distributional features and complex interactions are very important forassessing risks.This means developing models that capture these effects.Our household simulation model is aimed directly at understanding howthe distribution of debts, assets and income affects financial stability. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  15. 15. MFRAF uses information about the interconnections of individualfinancial institutions because these can lead to non-linear network effectsthat are also important for assessing systemic risks.Second, predicting behaviour under stress conditions is very difficult.Models need to be able to handle a variety of “what-if” scenarioscorresponding to different assumptions about behaviours under stress.Finally, we need to consider the many different sources of risk to thefinancial sector and take into account their cumulative effects andinteractions; otherwise we may underestimate risks.Obviously, quantitative measures alone will never be enough to get acomplete picture, especially since the financial system evolves rapidly.Intelligence gathered from discussions with the financial sector, as wellas information shared with other policy-makers and supervisors here inCanada and in the international community, will always be critical to theoverall assessment of the risks.While we are making progress, it is important to remember that financialsystem modelling is still in its infancy.The goal – understanding, preventing, and reducing systemic |risk –deserves our attention, diligent research and hard work. It has been mypleasure to share some of the Bank’s efforts with you today. Thank youvery much. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  16. 16. Progress note on the Global LEIInitiativeThis is the first of a series of notes onthe implementation of the legal entityidentifier (LEI) initiative.The G-20 in Los Cabos endorsed the FSB recommendations and askedthe Board to take forward the work to launch the global LEI system byMarch 2013.Progress reports on the LEI initiative will be prepared approximatelyevery three weeks.Implementation Group: The FSB set up an Implementation Group (IG)to take forward the work.The IG comprises 55 experts from the global regulatory community, andincludes members from 20 jurisdictions, as well as representatives fromstandard setters and international financial institutions.There are three main workstreams:- legal and governance;- operations; and- corporate hierarchy data.A co-ordination group of 5-7 members guides each work stream,providing a geographic balance.Private Sector Preparatory Group (PSPG):A call for members of a private sector expert group to collaborate on thework solicited widespread interest – about 170 members from almost 30jurisdictions are participating actively in the group. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  17. 17. Following an inaugural meeting in New York on 25 July, working groupshave been set up to provide input in each of the three main areas,facilitated by members of the IG.A dedicated secure web based forum has been launched forcommunication and knowledge sharing, hosted by the Cleveland FederalReserve.Charter for the Regulatory Oversight Committee (ROC) and otherGovernance Issues:A key task for the IG is to prepare a draft Charter for the ROC for approvalby the FSB in October and G20 in November.A first full draft will be reviewed by the IG in early September, prior toreview by the Steering Committee in mid - September.The IG is working through a number of challenging issues, including:delivery of adequate regulatory enforcement power over the global systemby the ROC; membership criteria (including the treatment ofsub-national regulatory bodies and international bodies); decisionmaking if consensus cannot be reached; what is an appropriate minimumregionally balanced quorum of support from authorities to launch thesystem that ensures balanced representation of early, medium and latemovers; and the structure of the not-for-profit Global LEI Foundation(the legal form of the operational element of the LEI system).The choice of location and hence jurisdiction for the Foundation will havean important influence on the legal framework for the LEI system,including possibly the legal form of the ROC and the means available forexpressing governance: the FSB Secretariat is seeking pro bono advicefrom legal experts on the location issue by early September.To facilitate the ultimate acceptance of the Charter by the FSB Plenary,IG members are seeking feedback from legal staff on the document aswork proceeds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  18. 18. Operations:The private sector has a key role in the operational implementation of thesystem: the Central Operating Unit (COU) of the system will be formedvia the establishment of a not-for-profit global LEI foundation under theoversight of the ROC.A number of the PSPG Working Groups are focusing on operationalaspects – a structured framework (Enterprise Architecture) is being usedto organise the work.Early results will be reviewed in October. A number of potential LocalOperating Units (LOUs) are involved in the analysis of operationalsolutions to ensure that the proposed model is acceptable to participantsaround the world.Ownership and Hierarchy data:An important short term objective is to develop concepts and plans forextending the basic data on entity identification (which will be availablewhen the system is launched) to include information on corporateownership and other relationships.The extension is necessary to support risk aggregation and consolidationand thus capture the full benefits of the LEI system.Additional data, however, implies an expansion of scope and thus thebenefits and costs of any particular extension must be consideredcarefully.The IG is working closely with the PSPG to develop preliminaryrecommendations by end-2012.Early movers:The CFTC announced on July 24 that DTCC/SWIFT had beendesignated as the provider of CFTC Interim Compliant Identifiers(CICIs) for a limited period of two years.The CFTC also confirmed that the Commission plans to adopt the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  19. 19. governance principles and LEI reference data requirements endorsed bythe FSB, and that once these steps are completed the CICI system willsubsequently transition into the global LEI.IG members are currently reviewing a number of technical issues toensure that decisions by early movers do not have an adverse impact onthe costs or operational flexibility of the global system, for instance bylocking the future global LEI system into early, local technical systemdesign choices. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  20. 20. OCC Updates Stress Testing ImplementationTimelineWASHINGTON — The Office of the Comptroller ofthe Currency (OCC) today announced it isconsidering changes to the implementation timelinefor the company-run stress testing required by theDodd-Frank Wall Street Reform and Consumer Protection Act.The changes under consideration would delay implementation untilSeptember 2013 for covered institutions with total consolidated assetsbetween $10 billion and $50 billion.On January 24, 2012, the OCC published in the Federal Register a noticeof proposed rulemaking to implement section 165(i) of the Dodd-FrankAct, which would require certain financial companies, including certainnational banks and federal savings associations, to conduct annual stresstests in accordance with regulations prescribed by the OCC.In the notice of proposed rulemaking, the OCC stated that “[a] nationalbank or federal savings association that is a covered institution shall besubject to this part on [the effective date of the rule] and will conduct itsfirst stress test under this part using financial statement data as ofSeptember 30, 2012, with results reported as required under this part inJanuary 2013.”The OCC received a number of comments on the proposed immediateeffective date identifying concerns about resources, readiness, and abilityto conduct stress tests given the likely short period between publication ofa final rule and the start of the stress-testing process.A key priority in implementing this section of the Dodd-Frank Act is toensure that banks have robust systems and processes to conduct thestress tests.In response to the concerns expressed in comments, the OCC isconsidering delaying the effective date of the rule to conduct the annualstress tests for certain institutions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  21. 21. The proposed delay would help ensure that all covered institutions havesufficient time to develop sound stress testing programs.Specifically, the OCC is considering a timeline under which coveredinstitutions with assets from $10 to $50 billion would be required toconduct initial stress tests in accordance with the rule in late 2013.The OCC is considering requiring covered institutions with assets greaterthan $50 billion to begin conducting annual stress tests under the rule thisyear, although the OCC would maintain its reservation of authority toallow covered institutions above $50 billion to delay implementation on acase-by-case basis where warranted.As part of efforts among the federal banking agencies to coordinate theimplementation of Dodd-Frank stress test requirements, the OCC hasconsulted on this proposed implementation delay with the FederalReserve Board (Board) and the Federal Deposit Insurance Corporation(FDIC).The Board and FDIC are considering similar changes to timelinesincluded in their proposed rules implementing Dodd-Frank stress testrequirements.The final implementation timeline for all covered institutions will bespecified in the final rule.Note:Section 165(i) of the Dodd-Frank Act created two types of stress testingrequirements: stress tests conducted by the company and stress testsconducted by the Board of Governors of the Federal Reserve System(“Board”).Section 165(i)(2) requires certain financial companies, including nationalbanks and Federal savings associations, to conduct stress tests andrequires the primary financial regulatory agency of those financialcompanies to issue regulations implementing the stress testrequirements. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  22. 22. A national bank or Federal savings association is subject to the stress testrequirements if its total consolidated assets are more than $10 billion.Under section 165(i)(2), a financial company is required to submit to theBoard and to its primary financial regulatory agency a report at suchtime, in such form, and containing such information as the primaryfinancial regulatory agency may require.The primary financial regulatory agency is required to define “stresstest,” establish methodologies for the conduct of the company -conducted stress test that must include at least three different sets ofconditions (baseline, adverse, and severely adverse), establish the formand content of the institutions report, and compel the institution topublish a summary of the results of the Dodd-Frank institutional stresstests.In general, section 165 of the Dodd-Frank Act sets forth a number ofrequirements and responsibilities for the Board related to supervisionand prudential standards for nonbank financial companies and bankholding companies with total consolidated assets equal to or greater than$50 billion.In addition to the company stress tests required under section 165(i)(2),section 165(i)(1) requires the Board to conduct annual analyses ofnonbank financial companies supervised by the Board and bank holdingcompanies with total consolidated assets equal to or greater than $50billion to determine whether such companies have the capital, on a totalconsolidated basis, necessary to absorb losses as a result of adverseeconomic conditions.The Board published a proposed rule implementing this supervisorystress testing on January 5, 2012.As required by section 165(i)(2), this proposed rule implements thecompany-conducted stress test requirements for national banks andFederal savings associations. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  23. 23. Under this proposed rule, a national bank or a Federal savingsassociation with total consolidated assets of more than $10 billion,defined as a “covered institution,” would be required to conduct anannual stress test as prescribed by this proposed rule.The OCC is developing this rule in coordination with the Board and theFederal Insurance Office, as required by section 165(i)(2)(C).The Board and Federal Deposit Insurance Corporation (“FDIC”) areplanning to issue separate proposed rules with respect to theirsupervised entities.For purposes of this rule, the proposed rule defines a stress test as aprocess to assess the potential impact of hypothetical economicconditions (“scenarios”) on the capital of a covered institution over a setperiod (the “planning horizon”), taking into account the currentcondition of the covered institution including its material risks,exposures, strategies, and activities.The Purpose of Stress TestsThe OCC views the stress tests conducted by covered institutions underthe proposed rule as providing forward-looking information tosupervisors to assist in their overall assessments of a covered institutionscapital adequacy and to aid in identifying downside risks and thepotential impact of adverse outcomes on the covered institutions capitaladequacy.In addition, the OCC may use stress tests to determine whetheradditional analytical techniques and exercises are appropriate for acovered institution to employ in identifying, measuring, and monitoringrisks to the financial soundness of the covered institution, and mayrequire a covered institution to implement such techniques and exercisesin conducting its stress tests. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  24. 24. Further, these stress tests are expected to support ongoing improvementin a covered institutions stress testing practices with respect to itsinternal assessments of capital adequacy and overall capital planning.The OCC expects that the annual stress tests required under theproposed rule would be only one component of the broader stress testingactivities conducted by covered institutions.In this regard, the OCC notes that the federal banking agencies haverecently issued for public comment proposed joint guidance on “StressTesting for Banking Organizations with More Than $10 Billion in TotalConsolidated Assets.”These broader stress testing activities should address the impact of arange of potentially adverse outcomes across a set of risk types affectingaspects of the covered institutions financial condition other than capitaladequacy.In addition, a full assessment of a covered institutions capital adequacymust take into account a range of factors, including evaluation of itscapital planning processes, the governance over those processes,regulatory capital measures, results of supervisory stress tests whereapplicable, and market assessments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  25. 25. FSA statement regarding CRD IV implementationThe draft European Union legislation to update thecapital requirements framework, known as CRD IV, hasbeen under discussion between the European Parliament,European Commission and Council of Ministers.These discussions originally aimed to finalise an agreed position by endJune 2012 enabling adoption by the European Parliament plenary in earlyJuly 2012.Following the delay of the Parliament’s plenary vote and the recentstatement by the Rapporteur of the European Parliament and thediscussion of the Council of Economic and Finance Ministers, it is clearthe legislation will not be adopted earlier than autumn 2012.Following adoption it is necessary for verification, translation andsignature of the EU legislation to take place before it can be published inthe Official Journal of the European Union.Publication in the Official Journal is a necessary pre-cursor of EUlegislation entering into force.On this basis it does not appear feasible that the legislation can enter intoforce in line with the implementation date of 1 January 2013 as included inthe original European Commission proposal of July 2011.No alternative date has yet been communicated by the EU institutions.Furthermore, reflecting the delay in the negotiation process, theEuropean Banking Authority (EBA) issued a press release on 31 Julysetting out the potential need to phase-in or flexibly apply certaintechnical standards to ensure a practical approach to implementation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  26. 26. In light of these developments the FSA will keep the situation underactive review and continue to support the European institutions in theirefforts to reach a conclusion on the final version of the legislation.The FSA will continue to undertake all preparatory work that is possiblein the absence of finalised legislative text, in full expectation that the EUlegislation will follow the Basel III implementation timetable.We expect all firms in scope of CRD to do likewise.Banks must remain mindful of the vital importance of the direction set byBasel III for banking system stability.In particular the FSA will continue to undertake its supervision of banksin a manner consistent with the recommendations of the 22 June meetingof the interim Financial Policy Committee (FPC) of the Bank of England.The interim FPC recommended that: taking into account eachinstitution’s risk profile, the FSA works with banks to ensure they build asufficient cushion of loss-absorbing capital in order to help to protectagainst the currently heightened risk of losses; that cushion maytemporarily be above that implied by the official transition path to BaselIII; and banks should continue to restrain cash dividends andcompensation in order to maximise the ability to build equity throughretained earnings.The FSA reminds those investment firms that are currently subject to theCapital Requirements Directive that they will be impacted by the CRD IVlegislation and that they too should prepare accordingly.The introduction of Common Reporting, which is incorporated into therequirements in CRD IV, is dependent on delivery of the necessarytechnical systems and on implementing technical standards to be draftedby EBA under CRD IV and adopted by the European Commission. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  27. 27. The FSA is proceeding with the necessary preparatory work to be ready tobegin collecting data under Common Reporting for the period beginning1 July 2013, should the legislation and related standards be finalised bythis date.In line with the press release issued by EBA, the FSA will take account ofany phase-in plans incorporated into the implementing technicalstandards on supervisory reporting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  28. 28. An interesting article about China. We will beglad to discuss other opinions in our nextnewsletter.China’s Slowdown May Be WorseThan Official Data Suggestby Janet Koech and Jian WangIn the months following the 2008–09 economiccrisis, emerging-market economies robustlyrebounded.Output in China and India expanded more than10 percent in 2010, and Brazil’s gross domestic product (GDP) growth of7.5 percent was its best performance in 25 years. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  29. 29. Emerging-market economies retraced their precrisis level of industrialproduction by 2009, while advanced economies remained below theirprecrisis levels in 2012 (Chart 1).But the strong emerging-market rebound—most significantly in China—hasn’t endured.When China’s average GDP growth remained above 9 percent in 2011,hopes rose that a sustained recovery would prop up the world economyamid the European sovereign debt crisis and subpar growth in the U.S.However, China’s economy deteriorated rapidly in 2012, with GDPgrowth slowing to 8.1 percent in the first quarter from 8.9 percent atyear-end 2011.Second quarter GDP growth slid further, to 7.6 percent, the lowestreading since the height of the global financial crisis in early 2009.Even with the decline, there is speculation that these figures may stillunderstate economic slowing.Economists have long doubted the credibility of Chinese output data.For example, some studies indicate that GDP growth was overstatedduring the 1998–99 Asian financial crisis, when official figures reportedthat China’s GDP grew on average 7.7 percent annually.Alternative estimates using economic activity measures such as energyproduction, air travel and trade data ranged from 2 percent to 5 percent.The dubious character of the official figures is no secret in China.Senior government officials, including Vice Premier Li Keqiang, dismissofficial GDP data as “man-made” and “for reference only” because ofpolitical influence, particularly at the local level, on data reporting. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  30. 30. Data ReliabilityTo get a more accurate picture of China’s economy, economists examineother measures of activity that closely track growth but are less prone topolitical interference than output data.Industrial electricity consumption, a major production input, serves assuch a proxy.If industrial output grows at a slower pace, electricity consumptionshould behave similarly.China’s year-over-year growth rates of industrial electricity consumptionand industrial production are shownfor 2011 and 2012 in Chart 2. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  31. 31. Red dots, illustrating 2012 activity, are below the blue dots, depicting 2011,which indicates that the growth rate of industrial electricity consumptionis relatively lower this year.This is consistent with China’s recent economic slowdown.The chart also shows fitted linear trends—a way of extrapolating activityover a longer period—computed using 2011 data only (solid line) and 2011and 2012 data (dashed line).This depiction relies on just these two years because of limitedelectricity-consumption reporting by the China Electricity Council.Hence, these results should be viewed with caution.As expected, Chart 2 shows that there is a tight relationship betweenindustrial electricity consumption and industrial output.As industrial production growth expands, China’s industries consumemore electricity, and vice versa.However, a closer look at the chart raises questions.Consider a scenario in which electricity consumption doesn’t increase.To illustrate this, we extend the linear trend lines to the horizontal axis(representingno change in electricity consumption).The lines intercept the axis at 5 and 7.5, implying that China’s industrialproduction continues to grow 5 percent or 7.5 percent annually(depending on which trend line we use) even when electricityconsumption remains constant.Although heightened electricity consumption efficiency could inducepositive industrial production growth, a 7.5 percent growth rate seems toolarge to attribute to efficiency gains alone. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  32. 32. The solid line computed using just 2011 data is flatter than the dashed linecomputed using both 2011 and 2012 data.Extrapolating from the trend line that includes just 2011 data points yieldsa lower, more reasonable industrial production growth rate of about 5percent when the electricity consumption growth rate is zero.The same data are shown in Chart 3, with only the 2011 trend linedepicted.Suspiciously, all 2012 data (red dots) lie below the trend line.This suggests that given the amount of electricity consumed, China’sofficial industrial production figures for 2012 are higher than thoseimplied by the 2011 data trend. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  33. 33. For instance, China’s industrial electricity consumption grew 5.6 percenton a year-over-year basis in March 2012.Using the trend from 2011 data, the estimate for March’s industrialproduction growth is about 9.3 percent rather than the 11.9 percentreported in the official data.This discrepancy could be due to unintentional, random survey errors.However, it is hard to imagine that all available 2012 data erred on the sideof overstating industrial production growth.Rather, it suggests that China might have overstated its 2012 industrialproduction data to mask the economy’s weakness.In other words, the slowdown in China could be worse than the officialdata indicate.Composition of ProductionOf course, other factors may explain why all red dots lie below the trendline in Chart 3.For example, growth of industrial production varied across sectors whoseconsumption of electricity per unit of output differs.For a unit of output, a company involved in steel production will generallyconsume more electricity than a factory making T-shirts.If the growth rate of the steel industry slowed more than that of the textileindustry, we would expect to see the growth in electricity consumptiondecline faster than the growth of total industrial output.To address this industry composition effect, we include output growth oftwo different sectors in our data: the heavy and light industrial sectors. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  34. 34. The heavy industrial sector (for example, the steel industry) usuallyconsumes more electricity than the light sector (the textile industry).The relationship between electricity consumption and industrial outputcan be more accurately estimated by analysing the two sectors separatelythan by using aggregate industrial output data.Accounting for the sectoral difference yields more sensible results when2011 data are analyzed.When industry electricity consumption remains constant—that is, itshows a zero growth rate—light industrial sectors grow at an annual rateof 2.8 percent, a much smaller reading than the 5 percent for aggregateoutput.On the other hand, the heavy industrial sectors contract 1.9 percent,reflecting this industry’s relatively heavy reliance on electricity. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  35. 35. Chart 4 plots actual electricity consumption growth in China (purple line)together with estimated electricity consumption using 2011 output datafor light and heavy industries (orange line).The two lines track each other closely, indicating a tight relationshipbetween electricity consumption and output in the heavy and lightindustries.The blue line shows the forecast growth of electricity consumption in2012, computed from the relationship estimated from 2011 data.The official industrial production data square well with electricityconsumption in March 2012; predicted consumption data almost perfectlymatch the reported data. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  36. 36. During March, growth in heavy industries declined sharply to 11.2percent from 13 percent in December 2011, while growth in the lightindustries increased to 13.9 percent from 12.6 percent over the sameperiod.The difference in growth between the heavy and light industries explainsthe overall sharp decline in electricity consumption, while overallindustrial output growth remained strong in March 2012.In the subsequent months, however, the out-of-sample forecasts divergesubstantially from the actual data.Given the official industrial production numbers, our model suggests thatChina should have consumed about twice as much electricity as itactually did.This is not surprising after closer examination of the data.From April to June, growth in the light industries declined more than inthe heavy industries, a reversal of March’s activity.Given such a pattern in China’s official industrial production data,electricity consumption growth should have dropped only moderately.However, China’s actual electricity consumption continues to declinesharply from April to June, raising doubts about the accuracy of theofficial industrial production figures.Improving Data ReportingAlthough China’s economic growth has slowed sharply in recent months,evidence suggests that the situation may be worse than reported.Several factors contributed to China’s slowdown. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  37. 37. Demand for China’s exports in Europe and the U.S. has weakened amidthe deepening European sovereign debt crisis and sluggish U.S.economic activity.Additionally, China’s policy response following the global financial crisisis having unintended effects on its economy.China loosened monetary policy and undertook a massive fiscal stimulusprogram in response to 2008–09 developments.These policies, which cushioned the economy from the impact of fallingdemand for exports, had the unintended consequence of generatinghigher inflation and rising asset prices, particularly in the real estatesector.These developments forced China to reverse course and institute tightermonetary policy last year, creating another round of effects on theeconomy that continue this year.China’s abrupt policy changes during the past two years are nothistorically unusual and have been criticized as a source of the country’sbig economic swings, which hurt long-run growth.Future policymakers will need more, high-quality quantitative (asopposed to qualitative) economic research to avoid overshooting policytargets and to better stabilize the economy.A critical first step is acquiring highquality economic data, a processalready in the works.China’s National Bureau of Statistics started a new data-collecting systemunder which businesses report industrial production data online directlyto the national statistics agency in Beijing, reducing the chance ofmanipulation by local authorities.As the world’s second largest economy, China plays an increasinglyimportant role in the global economy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  38. 38. Acquiring accurate economic data isnot only useful to China’spolicymaking, but also helpful to other nations, allowing them to betterunderstand China’s current economic conditions and design theirpolicies accordingly.Koech is an assistant economist and Wang is a senior research economistin the Research Department at the Federal Reserve Bank of Dallas. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  39. 39. Some Thoughts on Global Risks and MonetaryPolicyCharles L. Evans, President and Chief Executive OfficerFederal Reserve Bank of ChicagoIntroductionThank you for the invitation to speak to you today. I amvery happy for the opportunity to participate in Market NewsInternational seminar and to offer my thoughts on the U.S. and worldeconomies.We live in an amazingly interconnected world — a world in whichfinancial markets are linked by the instantaneous transmission ofinformation and business activity is intertwined among nations.For a long time, U.S. consumers and firms have been an important sourceof demand for Asian economies.This comes with pluses and minuses: Without the robust growth in theU.S. in 1997–98, the Asian financial crisis may well have been much worsethan it actually was; in contrast, the recession and sluggish growth in theU.S. over the past five years have weighed heavily on the demand forproducts from Asia.My comments today will focus primarily on the outlook for the U.S., butwith an eye on its potential impact on Asian economies.Of course, here I have to cover the substantial downside risks to theforecast stemming from both the European debt situation and the U.S.fiscal cliff.I will also discuss how this outlook and other economic analyses shapemy views for the appropriate stance of monetary policy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  40. 40. Before I turn to the focus of today’s discussion, I would like to remind youthat the views expressed are my own and do not necessarily representthose of the Federal Open Market Committee (FOMC) or the FederalReserve System.OutlookLet’s start with the economic outlook.We are all too familiar with the fact that the financial crisis that unfoldedin 2007 and 2008 precipitated a global recession that was unusually deepand lengthy in the U.S. and other advanced economies.Perhaps this shouldn’t have been surprising.The detailed analysis by Carmen Reinhart and Kenneth Rogoff (2009)concludes that recessions caused by financial crises generally are severeand are followed by anemic recoveries.By any yardstick, this certainly describes the U.S. recovery to date:Output growth has averaged only 2-1/4 percent annually, and resourcegaps remain huge.In particular, the unemployment rate remains over 8 percent — wellabove the 5-1/4 to 6 percent rate most FOMC participants view as beingconsistent with a fully employed labor force over the longer run.Both public and private sector forecasts see relatively modest rates ofgrowth over the next few years.For example, most recent forecasts by the private sector have 2012 grossdomestic product (GDP) growth at less than 2 percent; a pace that maynot even be enough to keep up with potential.Growth in 2013 is expected to be only moderately higher.Moreover, both the European debt situation and the looming U.S. fiscalcliff impart substantial downside risks to the forecast. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  41. 41. Even absent any negative shocks, such tepid growth rates would close thelarge existing resource gaps only very gradually.Indeed, I expect that we will face unemployment well above sustainablelevels for some time to come.Implications for AsiaIn the aftermath of the Great Recession, most Asian economies enjoyed areturn to solid levels of growth.Today, however, growth in Asia faces some new challenges.One of these challenges is that Asian economies will not be immune tothe tepid growth prospects facing the world’s advanced economies.Forecasts for growth in Asia have been marked down over the past year,reflecting in part the impact of the downgrade in the outlook for Asianexports for the U.S. and the euro area.For example, the U.S. and the euro area account for about one-third ofChina’s merchandise exports.The recession and weak recoveries in those economies were big factors inthe Chinese current account surplus falling from about 10 percent of GDPin 2007 to less than 3 percent in 2011.This weakness remains a consideration as we look forward; indeed, it isan important reason why the International Monetary Fund (IMF) isprojecting that the Chinese current account surplus will fall even more by2013.International trade is an excellent thing: Exploiting comparativeadvantages raises living standards for all nations.However, all countries can’t simultaneously export their way out of theirproblems. For the world as a whole, the current account has to balance.Thus, countries with large external surpluses face risks to their economiesposed by slowdowns in their trading partners. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  42. 42. Aggregate world growth must reflect aggregated domestic demands. So ifdemand is going to be sluggish in a large share of the world economy,other nations must take up the slack, or world growth will fall.InflationWith regard to inflation, as you know, the FOMC’s long-run inflationobjective is 2 percent as measured by the price index for personalconsumption expenditures (PCE).For a number of reasons, I don’t foresee much risk that inflation will riseabove reasonable tolerance levels relative to this objective.First, we see evidence of low expectations for inflation and growth in thetoday’s historically low Treasury yields.If there were warning signs of dangerous inflationary pressures, theten-year rate wouldn’t be in the neighborhood of 1-3/4 percent!Second, even with the latest increase in oil prices, energy and commodityprices remain well off their recent peaks as the global outlook dims.Third, as I just noted, the output gap remains large and is likely to closeonly slowly.In this economic environment, wage pressures are practicallynonexistent.And it is hard to envision how major persistent inflation pressures willemerge without a parallel increase in wage costs. Such parallel price andwage increases were a big part of the 1970s inflation, a scenario some fearrepeating today.Fourth, inflationary dynamics depend in large part on the momentumgenerated by people’s expectations of future inflation; currently, inflationexpectations are well anchored, which will tend to keep inflation frommoving either up or down.Putting all of these factors together along with the fact that core inflationaveraged 1.8 percent over the past year, I conclude that inflation will likelyremain near or below our 2 percent target over the medium term. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  43. 43. Sources of Risk and Their ImplicationsI would now like to turn to two important downside risks to the outlookfor growth.This will be a bit of a U.S.-centric view, but clearly these risks also haveimportant implications for growth here in Asia and the rest of the world.EuropeLet me begin with the European debt situation.Obviously, the developments in Europe pose a significant downside riskto the U.S. economy and world economic growth more broadly.The direct effects of slower European growth on the U.S. economy wouldbe relatively small.The eurozone nations account for less than 15 percent of U.S.merchandise exports.Thus, according to standard elasticity estimates, even a moderateeurozone recession would reduce U.S. exports by only a couple of tenthsof GDP.The indirect effects of eurozone developments could, however, be moresevere, both in the U.S. and Asia. One possible channel would be throughfinancial contagion.If losses on euro-centric assets put a large enough dent in the balancesheets of financial institutions that lend to U.S. households andbusinesses, the increases in the cost and availability of credit wouldreduce growth in the U.S. with possible spillover effects into Asia as well.Clearly, this is a risk worth monitoring.Fortunately, though, U.S. financial institutions are in much better shapeto handle such potential losses than they were in 2008.Recognizing the risks posed by the European debt situation, U.S.institutions have reduced their direct exposure to European assets andtightened lending standards to European banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  44. 44. On the regulatory front, the most recent stress tests made large U.S.banks demonstrate that they would have adequate capital even in theevent of a sharp European recession with contagion to global financialmarkets.A second possible channel would be through the effects of uncertainty oncurrent demand.Throughout the recovery, U.S. business and household sentiment hasbeen very fragile.Every hint of bad news seems to generate a wave of increased caution andan associated pullback in spending as firms and families seek to protecttheir individual balance sheets.After what the U.S. economy went through in the Great Recession, thisskittishness is understandable — particularly if one can envision a verylarge downside to the news event.And, as I just noted, given developments in Europe, there certainly aresome serious downside scenarios one can envision, even if they are notthe most likely outcomes.So it would be no surprise if yet another wave of uncertainty put a furtherdent in consumption and investment.U.S. fiscal cliffAnother risk to the U.S. economy comes from the so-called fiscal cliff.Under current U.S. law, numerous tax and spending provisions enacted invarious stimulus packages dating as far back as 2001 are scheduled toexpire on January 1, 2013.In addition, if no budget agreement is reached by Congress, there will besignificant automatic spending sequestration and other spending cuts inJanuary.According to projections made by the Congressional Budget Office(CBO), if all these things took place, real GDP growth would be reducedby about 4 percentage points in 2013. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  45. 45. I’m not saying that a pullback of this magnitude should be the base-casescenario.The orders of magnitude are just too big to be a base case.But when you go through the various items and make guesses at whichmay stay and which may go, it is easy to envision scenarios that include amarked increase in fiscal restraint in 2013.In addition, given the political process, it seems unlikely that we willknow much about the size or composition of the cuts until late in theprocess.It’s also easy to see how the rhetoric of public negotiating stances couldproduce an atmosphere that causes already jittery households andbusinesses to put some spending plans on hold.In sum, a messy resolution to the fiscal cliff problems presents animportant downside risk to U.S. growth prospects and, by extension, toworld economic growth.And even the possibility of such an outcome could be a drag in the secondhalf of the year.Policy ChoicesLet me now switch gears and talk about my views regarding the choicesfacing monetary policymakers in the U.S.Yes, we have substantial liquidity already in place in our financial system.On the surface, this looks like substantial monetary accommodation.But as a large body of economic theory tells us, for this liquidity to besufficiently accommodative, the public needs to expect that we will keepit in place for as long as is necessary to restore the economy to a soundfooting.This is why I believe we should clarify the Fed’s forward guidance withregard to the future course of policy. Let me now go into the detailsbehind these thoughts. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  46. 46. An explicit economic state-contingent policyIn weighing alternative policy approaches, I think the best way to provideforward guidance is by tying our policy actions to explicit measures ofeconomic performance.There are many ways of doing this, including setting a target for the levelof nominal GDP.But recognizing the difficult nature of that policy approach, I have a moremodest proposal: I think the Fed should make it clear that the federalfunds rate will not be increased until the unemployment rate falls below 7percent.Knowing that rates would stay low until significant progress is made inreducing unemployment would reassure markets and the public that theFed would not prematurely reduce its accommodation.Based on the work I have seen, I do not expect that such policy wouldlead to a major problem with inflation.But I recognize that there is a chance that the models and other analysissupporting this approach could be wrong.Accordingly, I believe that the commitment to low rates should bedropped if the outlook for inflation over the medium term rises above 3percent.The economic conditionality in this 7/3 threshold policy would clarify ourforward policy intentions greatly and provide a more meaningful guide onhow long the federal funds rate will remain low.In addition, I would indicate that clear and steady progress towardstronger growth is essential.Because we are not seeing that now, I support further use of our balancesheet to provide even more monetary accommodation.In June we decided to continue our Maturity Extension Program, whichputs downward pressure on long-term interest rates by extending theaverage maturity of the Federal Reserve’s securities portfolio. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  47. 47. I thought that was a useful step.However, I believe it is time to take even stronger steps, such as thepurchase of more mortgage-backed securities, to increase the degree ofmonetary support for the recovery.As suggested recently by my colleagues Eric Rosengren and JohnWilliams, these could be open-ended purchases, meaning that they wouldcontinue at a certain rate until there was clear evidence of improvement ineconomic conditions.To me, one example of clear evidence would be a resumption of relativelysteady monthly declines in unemployment for two or three quarters.Once this momentum was confidently established, the Fed could stopadding to our balance sheet but keep the funds rate at zero.The funds rate would remain unchanged in my thinking, until theunemployment rate hit at least 7 percent or the medium-term inflationoutlook deteriorated dramatically and rose above 3 percent.Later, reductions in the Fed’s balance sheet assets would occur sometimeafter the first increase in the funds rate.This corresponds to the general exit principles the FOMC agreed uponlast year.Presumably, the pace of asset reductions would be measured andconsistent with a continued, robust recovery in the context of pricestability.Accommodation in the Context of a Symmetric Inflation Targetand Balanced PolicyI can’t tell you how often people look at me in horror when I say that weshould adopt a conditional policy that tolerates the risk of inflationexceeding our target by as much as 1 percentage point.How can I accept inflation rising above our stated target? Isn’t thisblasphemy for a central banker? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  48. 48. In January, in the same framework document that announced our 2percent inflation target, we also stated a number of principles for theconduct of monetary policy.One was that policy would take a balanced approach in achieving the twolegs of the Federal Reserve’s dual mandate — maximum employmentand price stability.An explicit real-side mandate makes the Federal Reserve different thanmost central banks.While just about all central banks follow a flexible inflation targetingapproach, in which they seek to minimize real-side fluctuations in pursuitof their inflation objective, most are explicitly charged only with aninflation objective.But for the Fed, maximum employment is an explicit part of our policymandate.I strongly support the policy principles document we released in January.But we’re still hearing questions about whether our inflation goal issymmetric and about the specifics of how policy will be implementedunder the balanced approach articulated in this framework.As Chairman Bernanke (2012) stated at his April press conference, the 2percent inflation goal is a symmetric objective and not a ceiling oninflation.Symmetry means that inflation below 2 percent should be viewed as thesame policy miss as if inflation overran 2 percent by equal amount.We need to take symmetry seriously.If we disproportionately recoil at inflation a little above 2 percent versus alittle below, then we are not symmetrically weighing policy misses.And we will not average 2 percent inflation, which is our goal.There is some risk of this misperception taking hold. Consider theFOMC’s latest Summary of Economic Projections (SEP), which includesthe projections of all FOMC participants, voters and non-voters alike. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  49. 49. In it, several forecasts have the funds rate rising before 2014, even thoughthroughout the projection period most see inflation at or below 2 percentand unemployment well above the sustainable rate indicated by thelong-run projections.Without further explanation, it’s difficult to see how this is consistent witha symmetric inflation goal and a balanced approach to achieving the twolegs in our dual mandate.I believe the FOMC can do better at describing our thinking with respectto tolerance bands around our long-run inflation and unemploymentgoals.Clarification would increase both transparency and accountability.Importantly, it would reassure economic agents that Fed policy would nottighten prematurely.To me, a symmetric inflation goal and a balanced approach to policymean that if we are missing our employment mandate by a large amount,but are close to our inflation target, then we should be willing toundertake policies that could substantially reduce the employment gapeven if they run the risk of a modest, transitory rise in inflation thatremains within a reasonable tolerance range of our target.I believe such actions, such as the 7/3 threshold policy I have beenadvocating, would produce smaller net losses relative to our dual mandategoals than would current policy.Conclusion: The Need for a Vibrant Economy to Cushion RisksFinding a way to deliver more accommodation — whether it is monetaryor fiscal — is particularly important now because delays in reducingunemployment are costly.An unusually large percentage of the unemployed have been withoutwork for quite an extended period of time; their skills can become lesscurrent or even deteriorate, leaving affected workers with permanent scarson their lifetime earnings. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  50. 50. And any resulting lower aggregate productivity also weighs on potentialoutput, wages and profits for the economy as a whole.The damage intensifies the longer that unemployment remains high.Failure to act aggressively now could lower the capacity of the economyfor many years to come.Such potential costs would come with the continuation of a subpar paceof economic recovery.The significant risks I discussed earlier – financial disruption from aworsening of the situation in Europe or a messy resolution of U.S. fiscalpolicy – raise the specter of an even more worrisome outcome.At the moment economic growth is not much above stall speed.Another negative shock could send the economy into recession.And if a recessionary dynamic takes hold, it would be especially difficultto regain momentum.I have outlined some policy actions that I think can take us in thedirection of a more vibrant and resilient economy.Given the risks we face, I think it is vital that we make such moves today.I don’t think we should be in a mode where we are waiting to see what thenext few data releases bring.We are well past the threshold for additional action; we should take thataction now.Thank you.NoteCharles L. Evans is the ninth president and chief executive officer of theFederal Reserve Bank of Chicago. In that capacity, he serves on theFederal Open Market Committee (FOMC), the Federal Reserve Systemsmonetary policy-making body. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  51. 51. The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banksacross the country. These 12 banks — along with the Board of Governorsin Washington, D.C. — make up our nations central bank.As head of the Chicago Fed, Evans oversees the work of roughly 1400employees in Chicago and Detroit who conduct economic research,supervise financial institutions, and provide payment services tocommercial banks and the U.S. government.Before becoming president in September of 2007, Evans served asdirector of research and senior vice president, supervising the Banksresearch on monetary policy, banking, financial markets and regionaleconomic conditions. Prior to that, Evans was a vice president and senioreconomist with responsibility for the macroeconomics research group.His personal research has focused on measuring the effects of monetarypolicy on U.S. economic activity, inflation and financial market prices. Ithas been published in the Journal of Political Economy, AmericanEconomic Review, Journal of Monetary Economics, Quarterly Journal ofEconomics, and the Handbook of Macroeconomics.Evans is active in the civic community. He is a board member at ChicagoMetropolis 2020 and the Metro Chicago Information Center, and a trusteeat Rush University Medical Center.Evans has taught at the University of Chicago, the University of Michiganand the University of South Carolina. He received a bachelors degree ineconomics from the University of Virginia and a doctorate in economicsfrom Carnegie-Mellon University in Pittsburgh. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  52. 52. EBA, EIOPA and ESMAJoint Consultation Paper on Draft Regulatory Technical Standards on theuniform conditions of application of the calculation methods underArticle 6.2 of the Financial Conglomerates Directive (JC/CP/2012/02)I. Responding to this ConsultationEBA, EIOPA and ESMA (the ESAs) invite comments on all matters inthis paper and in particular on the specific questions stated in theattached document “Overview of questions for Consultation” at the endof this paper.Comments are most helpful if they:- respond to the question stated;- indicate the specific question to which the comment relates;- contain a clear rationale;- provide evidence to support the views expressed/ rationale proposed; and- describe any alternative regulatory choices EBA should consider.II. Executive SummaryThe CRR/CRD IV proposals (the so-called Capital RequirementsRegulation - henceforth ‘CRR’- and the so-called Capital RequirementsDirective – henceforth ‘CRD’) set out prudential requirements for banks _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  53. 53. and other financial institutions which are expected to apply from 1January 2013.In anticipation of the finalisation of the legislative texts for theCRR/CRD IV, the EBA, EIOPA and ESMA (hereafter the ESAs) throughthe Joint Committee, have developed the draft RTS in accordance withthe mandate contained in Article 46(4) of the CRR and Article 139 ofCRDIV (amending Article 21 a (2a) of the Directive 2002/87/EC) on thebasis of the European Commission’s proposals.This Article provides the ESAs through the Joint Committee, to developdraft Regulatory Technical Standards (RTS) with regard to the conditionsof the application of the Article 6(2) of the Directive 2002/87/EC(hereafter the Directive).Further the ESAs have developed the draft RTS having regard to Article230 in connection with Articles 220 and 228 of the Directive2009/138/EC2.To the extent that the texts may change before their adoption, the ESAsshall adapt its draft RTS accordingly to reflect any developments.The RTS included in this consultation have to be submitted to the EUCommission by 1 January 2013.Please note that the ESAs have developed the present draft RTS based onthe European Commission’s legislative proposals for the CRR/CRD IV.They have also taken into account major changes subsequently proposedby the revised texts produced by the Council of the EU and the EuropeanParliament, during the ordinary legislative procedure (co-decisionprocess).Following the end of the consultation period, and to the extent that thefinal text of the CRR/CRD IV changes before the adoption of the RTS,the ESAs will adapt the draft RTS accordingly to reflect anydevelopments. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  54. 54. Main features of the RTSThis consultation paper puts forward draft RTS in order to ensure thatinstitutions that are part of a financial conglomerate apply the appropriatecalculation methods for the determination of required capital at the levelof the conglomerate.They are based in particular on the following elements:General Principleso Elimination of multiple gearing;o Elimination of intra-group creation of own funds;o Transferability and availability of own funds; ando Coverage of deficit at financial conglomerate level having regard todefinition of cross-sector capital.Technical calculation methods1. Method 1: “Accounting consolidation method”:The FICOD provides in relation to Method 1 that the own funds arecalculated on the basis of the consolidated position of the group.According to this general provision, the calculation of own funds shouldbe based on the relevant accounting framework for the consolidatedaccounts of the conglomerate applicable to the scope of the Directive.The use of “consolidated accounts” eliminates all own funds’ intra-groupitems, in order to avoid double counting of capital instruments.According to the Directive provisions, the eligibility rules are thoseincluded in sectoral provisions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  55. 55. 2. Method 2: “Deduction and aggregation method”.This method calculates the supplementary capital adequacyrequirements of a conglomerate based on the accounts of solo entities.It aggregates the own funds, deducts the book value of the participationsin other entities of the group and specifies treatment of the proportionalshare applicable to own funds and solvency requirements.All intra-group creation of own funds shall be eliminated.3. Method 3: “Combination of methods 1 and 2”.The use of combination of accounting consolidation method 1 anddeduction and aggregation method 2 is limited to the cases where the useof either method 1 or method 2 would not be appropriate and is subject tothe permission by the competent authorities.III. Background and rationaleThe supplementary supervision of financial entities in a financialconglomerate is covered by the Financial Conglomerates Directive2002/87/EC, hereafter known as the Directive.This Directive provides for competent authorities to be able to assess at agroup-wide level the financial situation of credit institutions, insuranceundertakings and investment firms which are part of a financialconglomerate, in particular as regards solvency (including the eliminationof multiple gearing of own funds instruments).The nature of RTS under EU lawDraft RTS are produced in accordance with Article 10 of the ESAsregulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  56. 56. According to Article 10(4) of the ESAs regulation, they shall be adoptedby means of Regulations or Decisions.According to EU law, EU regulations are binding in their entirety anddirectly applicable in all Member States.This means that, on the date of their entry into force, they become part ofthe national law of the Member States and that their implementation intonational law is not only unnecessary but also prohibited by EU law,except in so far as this is expressly required by them.Shaping these rules in the form of a Regulation would ensure alevel-playing field and would facilitate the cross-border provision ofservices.Background and regulatory approach followed in the draft RTSThese draft RTS are produced in accordance with CRD IV/CRRproposals, which provide that the EBA, ESMA and EIOPA (hereafter theESAs), through the Joint Committee, shall develop draft regulatorytechnical standards with regard to the conditions of the application of thecalculation methods with regard to Article 6(2) of the Directive and shallsubmit those draft regulatory technical standards to the Commission by 1January 2013.The proposed draft RTS covers the uniform conditions for the use of themethods for the determination of capital adequacy of a financialconglomerate under the Directive.They elaborate on Technical principles applying to all of the threemethods provided for by Directive; and also contain an Annex providingfurther detail for Method 2.The requirements contained in the draft RTS are mainly directed atinstitutions, although some of them are directed at competent authorities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  57. 57. IV. Draft Regulatory Technical Standards on the uniformconditions of application of the calculation methods underArticle 6.2 of the Financial Conglomerates DirectiveCommission Delegated Regulation (EU) No XX/2012supplementing Directive xx/XX/EU [CRD] of the European Parliamentand of the Council of [date], Regulation (..) No xx/XXXX [CRR] of theEuropean Parliament and of the Council of [date] and Directive2002/87/EC [Financial Conglomerates Directive] of the EuropeanParliament and of the Council of [date] with regard to regulatorytechnical standards for the uniform conditions of application of thecalculation methods under Article 6.2 of the Financial ConglomeratesDirective of XX Month 2012THE EUROPEAN COMMISSION,Having regard to the Treaty on the Functioning of the European Union,Having regard to the [proposal for a] Regulation (...) No xx/xxxx of theEuropean Parliament and of the Council of dd mm yyyy on prudentialrequirements for credit institutions and investment firms Regulationxx/xxxx [CRR] and in particular Article 46 (4) thereof.Having regard to the [proposal for a] Directive (...) No xx/xxxx of theEuropean Parliament and of the Council of dd mm yyyy on the access tothe activity of credit institutions and the prudential supervision of creditinstitutions and investment firms [CRDIV] and in particular Article 139thereof.Having regard to the Directive 2002/87/EC, as amended, of theEuropean Parliament and of the Council on the supplementarysupervision of credit institutions, insurance undertakings and investmentfirms in a financial conglomerate (hereinafter “the Directive”) and inparticular to Article 6(2) and Annex 1 thereof.Whereas: _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  58. 58. (1) Directive 2002/87/EC provides in Chapter II, Section 2, rules oncapital adequacy of financial conglomerates, such that the elements ofown funds are available at the level of a Financial Conglomerates arealways at least equal to the capital adequacy requirements as calculated inaccordance with Annex I of the Directive.(2) Regulation (...) No xx/xxx (‘CRR’) provides in Article 46, within PartII, Chapter 2, Section 3, Sub-Section 2 and in the context of commonequityTier I rules, requirements for deduction where consolidation orsupplementary supervision are applied.This section of the CRR provides empowerments to the EuropeanCommission to adopt delegated acts (regulatory technical standards) inaccordance with articles 10-14 of the Regulation (EU) No 1093/2010establishing the European Banking Authority (‘EBA’), Articles 10-14 ofthe Regulation (EU) No 1094/2010 establishing the European Insuranceand Occupational Pensions Authority (‘EIOPA), and Articles 10-14 of theRegulation (EU) No 1095/2010 (‘ESMA), establishing the EuropeanSecurities and Markets Authority.These acts will complete the EU single rulebook for institutions in thearea of own funds.(3) Directive (...) No xx/xxx (‘CRDIV’) provides in Article 139 that theDirective 2002/87/EC shall be amended, such that the EBA, EIOPA andESMA through the Joint Committee, to develop draft RegulatoryTechnical Standards (RTS) with regard to the conditions of theapplication of the Article 6(2) of the Directive.(4) For effective supervision of Financial Conglomerates, supplementarysupervision should be applied to all such conglomerates, thecross-sectoral financial activities of which are significant, which is thecase when certain thresholds are reached, no matter how they arestructured. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  59. 59. Supplementary supervision should cover all financial activities identifiedby the sectoral financial legislation and all entities principally engaged insuch activities should be included in the scope of the supplementarysupervision, including asset management companies and alternativeinvestment fund management companies.(5) Without prejudice to sectoral rules, supplementary supervision of thecapital adequacy rules is necessary to bring more convergence in theapplication of the calculation methods listed in Annex 1 of the Directive.(6) For financial conglomerates which include significant banking orinvestment business and insurance business, multiple use of elementseligible for the calculation of own funds at the level of the financialconglomerate (multiple gearing) as well as any inappropriate intra-groupcreation of own funds must be eliminated.(7) The financial conglomerate should seek an acceptable timeframe forthe transferability of funds across entities within the financialconglomerate, which shall depend on whether the specific entity issubject to the Directive 2009/138/EC or the CRDIV/CRR.Moreover for an entity subject to the CRD IV/CRR this timeframe shouldbe expediated based on the fact that due to the nature of their activities,they are more vulnerable to a rapid deterioration in confidence and/orsudden resolution situation.(8) In addition any non-sector-specific own funds, in excess of sectoralrequirements, need to originate from entities which are not subject totransferability/availability impediments.(9) It is important to ensure that own funds are only included atconglomerate level if there are no impediments to the transfer of assets orrepayment of liabilities across different conglomerate entities, includingacross sectors. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  60. 60. (10) If there is a deficit of own funds at the level of the financialconglomerate, the financial conglomerate should inform the coordinatoron the measures taken to cover this deficit.(11) Further convergence in the way that financial conglomerates applythese rules shall ensure the robust and consistent application of themethods of calculation.(12) For bank-led conglomerates it is necessary to apply the most prudentmethod of calculation for the treatment of insurance holdings to avoidregulatory arbitrage.(13) It is important that sector-specific own funds cannot cover risksabove sectoral requirements.The financial conglomerate should first count sector-specific own fundsagainst their requirements (while respecting sectoral rules and limits) foreach relevant entity or group of entities. If there is an excess ofsector-specific own funds, this should not be recognised at conglomeratelevel.(14) When calculating supplementary capital adequacy of a financialconglomerate, in respect to non-regulated financial entities within thefinancial conglomerate, both a notional capital requirement and anotional level of own funds shoud be calculated.(15) Under Solvency II, method 1 is applied on the basis of consolidateddata which are set out at Level 2 and not on the basis of consolidatedaccounts.(16) Further changes to the capital adequacy rules may be addressed inthe European Commission’s review of Directive 2002/87/EC.(17) It is necessary that the new regime for treatment of methods ofconsolidation enters into force the soonest possible following the entryinto force of the CRR/CRD IV and Solvency II. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  61. 61. (18) This Regulation is based on the draft regulatory technical standardssubmitted jointly by the EBA, EIOPA and ESMA to the Commission.(19) The EBA, EIOPA and ESMA have conducted open publicconsultations on the draft regulatory technical standards on which thisRegulation is based, analysed the potential related costs and benefits, inaccordance with Article 10 of Regulation (EU) No 1093/2010, Article 10 ofRegulation (EU) No 1094/2010, Article 10 of Regulation (EU) No1095/2010,and requested the opinion of the Banking Stakeholder Groupestablished in accordance with Article 37 of Regulation (EU) No1093/2010, Insurance Stakeholder Group and the OccupationalStakeholder Group established in accordance with Article 37 ofRegulation (EU) No 1094/2010, and the European Securities and MarketsStakeholder Group established in accordance with Article 37 ofRegulation (EU) No 1095/2010.HAS ADOPTED THIS REGULATION:TITLE ISubject matter and definitionsArticle 1Subject matterThis Regulation lays down rules of the uniform conditions of applicationof the calculation methods under Article 6.2 of the Directive.Article 2Definitions1. Definitions of the CRD IV/CRR, Directive 2002/87/EC and Directive2009/138/EC shall apply to this Regulation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  62. 62. 2. Capital instruments are those capital instruments eligible under CRR(Regulation 2012/…./EC) and those capital instruments referred to as“own funds” in Directive 2009/138/EC.3. Ultimate responsible entity is the entity within the financialconglomerate that is responsible for determining the capital for thefinancial conglomerate having regard to the following minimum criteria:control, the dominant entity from the market’s perspective (market listedentity) and the ability to fulfill specific duties towards its subsidiaries andits supervisor.4. ‘indirect holding’ as defined under definition 17 of Article 22 of CRR [tobe added if not in final CRR text].5. Insurance-led financial conglomerate is a financial conglomeratewhose most important sector is insurance as defined under Article 3(2) ofthe Directive.6. Bank-led financial conglomerate is a financial conglomerate whosemost important sector is banking as defined under Article 3(2) of theDirective.7. Investment firm-led financial conglomerate is a financial conglomeratewhose most important sector is investment services as defined underArticle 3(2) of the Directive.TITLE IITechnical PrinciplesArticle 3Elimination of multiple gearing and the intra-group creation ofown fundsThe ultimate responsible entity shall ensure that own funds, which havebeen created by intra-group transactions, be it direct or indirect, shall be _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com
  63. 63. eliminated for the purpose of determining the required capital on aconsolidated basis.Article 4Transferability and availability of own funds1. For all entities of a financial conglomerate, own funds, in excess ofsectoral solvency requirements, shall be considered available to absorblosses elsewhere in the financial conglomerate provided that all of thefollowing conditions are fulfilled:(a) There are no practical, legal, regulatory, contractual or statutoryimpediments to the transfer of funds or repayment of liabilities acrossconglomerate entities in due course.This is the case when the transfer of own funds from one conglomerateentity to another is not barred by a restriction of any kind and there are noclaims of any kind from third parties on these assets.The ultimate responsible entity of the financial conglomerate shallconfirm to the satisfaction of the coordinator that the conditions set out inthis point are met.(b) For the purpose of assessing the transferability of funds to entitiessubject to 2009/138/EC, “in due course” shall mean no later than 9months;for the purpose of assessing the transferability of funds to entitiessubjected to CRR, “in due course” shall mean no later than, threecalendar days with no impediments on the coordinator requiring a fastertransfer if necessary.2. Own funds, in excess of sectoral solvency requirements, which do notmeet the criteria under point 1 shall be excluded from the conglomerate’sown funds. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.com