Basel III News, September 2012

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Basel iii Compliance Professionals Association (BiiiCPA)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 Web: www.basel-iii-association.com

Dear Member,

The Basel Committee on Banking
Supervision has completed its review of the
October 2006 Core principles for effective
banking supervision and the associated
Core principles methodology.
The revised Core Principles were endorsed by banking supervisors at the
17th International Conference of Banking Supervisors held in Istanbul,
Turkey, on 13-14 September 2012.
Both the existing Core Principles and the
associated assessment methodology have
served their purpose well in terms of helping
countries to assess their supervisory systems
and identify areas for improvement.
While conscious efforts were made to
maintain continuity and comparability to the
extent possible, the revised document
combines the Core Principles and the
assessment methodology into a single
comprehensive document

www.basel-iii-association.com

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Bank for International Settlements
BIS, Core principles for effective banking supervision
September 2012
The revised set of twenty-nine Core Principles has also been reorganised
to foster their implementation through a more logical structure,
highlighting the difference between what supervisors do and what they
expect banks to do:
Principles 1 to 13 address supervisory powers, responsibilities and
functions, focusing on effective risk-based supervision, and the need for
early intervention and timely supervisory actions.
Principles 14 to 29 cover supervisory expectations of banks, emphasising
the importance of good corporate governance and risk management, as
well as compliance with supervisory standards.
Important enhancements have been introduced into the individual Core
Principles, particularly in those areas that are necessary to strengthen
supervisory practices and risk management.
As a result, certain "additional criteria" have been upgraded to "essential
criteria", while new assessment criteria were warranted in other
instances.
Close attention was given to addressing many of the significant risk
management weaknesses and other vulnerabilities highlighted in the
financial crisis.
In addition, the review has taken account of several key trends and
developments that emerged during the last few years of market turmoil:
- the need for greater supervisory intensity and adequate resources to
deal effectively with systemically important banks;
- the importance of applying a system-wide, macro perspective to the
microprudential supervision of banks to assist in identifying,
analysing and taking pre-emptive action to address systemic risk;
and


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- the increasing focus on effective crisis management, recovery and
resolution measures in reducing both the probability and impact of a
bank failure.
The Committee has sought to give appropriate emphasis to these
emerging issues by embedding them into the Core Principles, as
appropriate, and including specific references under each relevant
Principle.
In addition, sound corporate governance underpins effective risk
management and public confidence in individual banks and the banking
system.
Given fundamental deficiencies in banks' corporate governance that were
exposed during the crisis, a new Core Principle on corporate governance
has been added by bringing together existing corporate governance
criteria in the assessment methodology and giving greater emphasis to
sound corporate governance practices.
Similarly, the Committee reiterated the key role of robust market
discipline in fostering a safe and sound banking system by expanding an
existing Core Principle into two new ones dedicated respectively to
greater public disclosure and transparency, and enhanced financial
reporting and external audit.
As a result of the Committee's review, the number of Core Principles has
increased from 25 to 29.
There are a total of 39 new assessment criteria, comprising 34 new
essential criteria and 5 new additional criteria.
In addition, 34 additional criteria from the existing assessment
methodology have been upgraded to essential criteria that represent
minimum baseline requirements for all countries.
A consultative version of the revised Core Principles was issued for public
consultation in December 2011.


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The Committee appreciates the constructive comments received and
thanks those who have taken the time and effort to express their views on
the consultative document.

Core Principles for Effective Banking Supervision (The Basel
Core Principles)
Executive summary

1. The Core Principles for Effective Banking Supervision (Core
Principles) are the de facto minimum standard for sound prudential
regulation and supervision of banks and banking systems.

Originally issued by the Basel Committee on Banking Supervision (the
Committee) in 1997, they are used by countries as a benchmark for
assessing the quality of their supervisory systems and for identifying
future work to achieve a baseline level of sound supervisory practices.

The Core Principles are also used by the International Monetary Fund
(IMF) and the World Bank, in the context of the Financial Sector
Assessment Programme (FSAP), to assess the effectiveness of countries’
banking supervisory systems and practices.

2. The Core Principles were last revised by the Committee in October
2006 in cooperation with supervisors around the world.

In its October 2010 Report to the G20 on response to the financial crisis,
the Committee announced its plan to review the Core Principles as part of
its ongoing work to strengthen supervisory practices worldwide.

3. In March 2011, the Core Principles Group was mandated by the
Committee to review and update the Core Principles.

The Committee’s mandate was to conduct the review taking into account
significant developments in the global financial markets and regulatory


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landscape since October 2006, including post-crisis lessons for promoting
sound supervisory systems.

The intent was to ensure the continued relevance of the Core Principles
for promoting effective banking supervision in all countries over time and
changing environments.
4. In conducting the review, the Committee has sought to achieve the
right balance in raising the bar for sound supervision while retaining the
Core Principles as a flexible, globally applicable standard.
By reinforcing the proportionality concept, the revised Core Principles
and their assessment criteria accommodate a diverse range of banking
systems.
The proportionate approach also allows assessments of compliance with
the Core Principles that are commensurate with the risk profile and
systemic importance of a broad spectrum of banks (from large
internationally active banks to small, non-complex deposit-taking
institutions).
5. Both the existing Core Principles and the associated Core Principles
Methodology (assessment methodology) have served their purpose well
in terms of helping countries to assess their supervisory systems and
identify areas for improvement.

While conscious efforts were made to maintain continuity and
comparability as far as possible, the Committee has merged the Core
Principles and the assessment methodology into a single comprehensive
document.

The revised set of twenty-nine Core Principles have also been reorganised
to foster their implementation through a more logical structure starting
with supervisory powers, responsibilities and functions, and followed by
supervisory expectations of banks, emphasising the importance of good
corporate governance and risk management, as well as compliance with
supervisory standards.


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6. Important enhancements have been introduced into the individual
Core Principles, particularly in those areas that are necessary to
strengthen supervisory practices and risk management.

Various additional criteria have been upgraded to essential criteria as a
result, while new assessment criteria were warranted in other instances.

Close attention was given to addressing many of the significant risk
management weaknesses and other vulnerabilities highlighted in the last
crisis.

In addition, the review has taken account of several key trends and
developments that emerged during the last few years of market turmoil:

- the need for greater intensity and resources to deal effectively with
systemically important banks;
- the importance of applying a system-wide, macro perspective to the
microprudential supervision of banks to assist in identifying,
analysing and taking pre-emptive action to address systemic risk;
- and the increasing focus on effective crisis management, recovery
and resolution measures in reducing both the probability and impact
of a bank failure.

The Committee has sought to give appropriate emphasis to these
emerging issues by embedding them into the Core Principles, as
appropriate, and including specific references under each relevant
Principle.

7. In addition, sound corporate governance underpins effective risk
management and public confidence in individual banks and the banking
system.

Given fundamental deficiencies in banks’ corporate governance that were
exposed in the last crisis, a new Core Principle on corporate governance
has been added in this review by bringing together existing corporate


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governance criteria in the assessment methodology and giving greater
emphasis to sound corporate governance practices.

Similarly, the Committee reiterated the key role of robust market
discipline in fostering a safe and sound banking system by expanding an
existing Core Principle into two new ones dedicated respectively to
greater public disclosure and transparency, and enhanced financial
reporting and external audit.
8. At present, the grading of compliance with the Core Principles is based
solely on the essential criteria.
To provide incentives to jurisdictions, particularly those that are
important financial centres, to lead the way in the adoption of the highest
supervisory standards, the revised Core Principles will allow countries the
additional option of voluntarily choosing to be assessed and graded
against the essential and additional criteria.
In the same spirit of promoting full and robust implementation, the
Committee has retained the existing four-grade scale of assessing
compliance with the Core Principles.
This includes the current “materially non-compliant” grading that helps
provide a strong signalling effect to relevant authorities on remedial
measures needed for addressing supervisory and regulatory shortcomings
in their countries.
9. As a result of this review, the number of Core Principles has increased
from 25 to 29.

There are a total of 39 new assessment criteria, comprising 34 new
essential criteria and 5 new additional criteria.

In addition, 34 additional criteria from the existing assessment
methodology have been upgraded to essential criteria that represent
minimum baseline requirements for all countries.


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10. The revised Core Principles will continue to provide a comprehensive
standard for establishing a sound foundation for the regulation,
supervision, governance and risk management of the banking sector.
Given the importance of consistent and effective standards
implementation, the Committee stands ready to encourage work at the
national level to implement the revised Core Principles in conjunction
with other supervisory bodies and interested parties.

I. Foreword to the review

11. The Basel Committee on Banking Supervision (the Committee) has
revised the Core Principles for Effective Banking Supervision (Core
Principles).

In conducting its review, the Committee has sought to balance the
objectives of raising the bar for banking supervision (incorporating the
lessons learned from the crisis and other significant regulatory
developments since the Core Principles were last revised in 2006) against
the need to maintain the universal applicability of the Core Principles and
the need for continuity and comparability.

By raising the bar, the practical application of the Core Principles should
improve banking supervision worldwide.

12. The revised Core Principles strengthen the requirements for
supervisors, the approaches to supervision and supervisors’ expectations
of banks.

This is achieved through a greater focus on effective risk-based
supervision and the need for early intervention and timely supervisory
actions.


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Supervisors should assess the risk profile of banks, in terms of the risks
they run, the efficacy of their risk management and the risks they pose to
the banking and financial systems.

This risk-based process targets supervisory resources where they can be
utilised to the best effect, focusing on outcomes as well as processes,
moving beyond passive assessment of compliance with rules.

13. The Core Principles set out the powers that supervisors should have in
order to address safety and soundness concerns.

It is equally crucial that supervisors use these powers once weaknesses or
deficiencies are identified.

Adopting a forward-looking approach to supervision through early
intervention can prevent an identified weakness from developing into a
threat to safety and soundness.

This is particularly true for highly complex and bank-specific issues (eg
liquidity risk) where effective supervisory actions must be tailored to a
bank’s individual circumstances.

14. In its efforts to strengthen, reinforce and refocus the Core Principles,
the Committee has nonetheless remained mindful of their underlying
purpose and use.

The Committee’s intention is to ensure the continued relevance of the
Core Principles in providing a benchmark for supervisory practices that
will withstand the test of time and changing environments.

For this reason, this revision of the Core Principles builds upon the
preceding versions to ensure continuity and comparability as far as
possible.

15. In recognition of the universal applicability of the Core Principles, the
Committee conducted its review in close cooperation with members of


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the Basel Consultative Group which comprises representatives from both
Committee and non-Committee member countries and regional groups
of banking supervisors, as well as the IMF, the World Bank and the
Islamic Financial Services Board.

The Committee consulted the industry and public before finalising the
text.

General approach

16. The first Core Principle sets out the promotion of safety and
soundness of banks and the banking system as the primary objective for
banking supervision.

Jurisdictions may assign other responsibilities to the banking supervisor
provided they do not conflict with this primary objective.

6 It should not be an objective of banking supervision to prevent bank
failures.

However, supervision should aim to reduce the probability and impact of
a bank failure, including by working with resolution authorities, so that
when failure occurs, it is in an orderly manner.

17. To fulfil their purpose, the Core Principles must be capable of
application to a wide range of jurisdictions whose banking sectors will
inevitably include a broad spectrum of banks (from large internationally
active banks to small, non-complex deposit-taking institutions).

Banking systems may also offer a wide range of products or services and
the Core Principles are aligned with the general aim of catering to
different financial needs.

To accommodate this breadth of application, a proportionate approach is
adopted, both in terms of the expectations on supervisors for the


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discharge of their own functions and in terms of the standards that
supervisors impose on banks.

Consequently, the Core Principles acknowledge that supervisors typically
use a risk-based approach in which more time and resources are devoted
to larger, more complex or riskier banks.

In the context of the standards imposed by supervisors on banks, the
proportionality concept is reflected in those Principles focused on
supervisors’ assessment of banks’ risk management, where the Principles
prescribe a level of supervisory expectation commensurate with a bank’s
risk profile and systemic importance.

18. Successive revisions to existing Committee standards and guidance,
and any new standards and guidance will be designed to strengthen the
regulatory regime.

Supervisors are encouraged to move towards the adoption of updated and
new international supervisory standards as they are issued.

Approach toward emerging trends and developments

(i) Systemically important banks (SIBs)

19. In the aftermath of the crisis, much attention has been focused on
SIBs, and the regulations and supervisory powers needed to deal with
them effectively.

Consideration was given by the Committee to including a new Core
Principle to cover SIBs.

However, it was concluded that SIBs, which require greater intensity of
supervision and hence resources, represent one end of the supervisory
spectrum of banks.


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Each Core Principle applies to the supervision of all banks.

The expectations on, and of, supervisors will need to be of a higher order
for SIBs, commensurate with the risk profile and systemic importance of
these banks.

Therefore, it is unnecessary to include a specific stand-alone Core
Principle for SIBs.

(ii) Macroprudential issues and systemic risks

20. The recent crisis highlighted the interface between, and the
complementary nature of, the macroprudential and microprudential
elements of effective supervision.

In their application of a risk-based supervisory approach, supervisors and
other authorities need to assess risk in a broader context than that of the
balance sheet of individual banks.

For example, the prevailing macroeconomic environment, business
trends, and the build-up and concentration of risk across the banking
sector and, indeed, outside of it, inevitably impact the risk exposure of
individual banks.

Bank-specific supervision should therefore consider this macro
perspective.

Individual bank data, where appropriate, data at sector level and
aggregate trend data collected by supervisors should be incorporated into
the deliberations of authorities relevant for financial stability purposes
(whether part of, or separate from, the supervisor) to assist in
identification and analysis of systemic risk.

The relevant authorities should have the ability to take pre-emptive action
to address systemic risks.


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Supervisors should have access to relevant financial stability analyses or
assessments conducted by other authorities that affect the banking
system.

21. This broad financial system perspective is integral to many of the Core
Principles. For this reason, the Committee has not included a specific
stand-alone Core Principle on macroprudential issues.

22. In supervising an individual bank which is part of a corporate group, it
is essential that supervisors consider the bank and its risk profile from a
number of perspectives: on a solo basis (but with both a micro and macro
focus as discussed above); on a consolidated basis (in the sense of
supervising the bank as a unit together with the other entities within the
“banking group”) and on a group-wide basis (taking into account the
potential risks to the bank posed by other group entities outside of the
banking group).

Group entities (whether within or outside the banking group) may be a
source of strength but they may also be a source of weakness capable of
adversely affecting the financial condition, reputation and overall safety
and soundness of the bank.

The Core Principles include a specific Core Principle on the consolidated
supervision of banking groups, but they also note the importance of
parent companies and other non-banking group entities in any
assessment of the risks run by a bank or banking group.

This supervisory “risk perimeter” extends beyond accounting
consolidation concepts.

In the discharge of their functions, supervisors must observe a broad
canvas of risk, whether arising from within an individual bank, from its
associated entities or from the prevailing macro financial environment.


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23. Supervisors should also remain alert to the movement, or build-up, of
financial activities outside the regulated banking sector (the development
of “shadow banking” structures) and the potential risks this may create.

Data or information on this should also be shared with any other
authorities relevant for financial stability purposes.

(iii) Crisis management, recovery and resolution

24. Although it is not a supervisor’s role to prevent bank failures,
supervisory oversight is designed to reduce both the probability and
impact of such failures.

Banks will, from time to time, run into difficulties, and to minimise the
adverse impact both on the troubled bank and on the banking and
financial sectors as a whole, effective crisis preparation and management,
and orderly resolution frameworks and measures are required.

25. Such measures may be viewed from two perspectives:

(i) The measures to be adopted by supervisory and other authorities
(including developing resolution plans and in terms of information
sharing and cooperation with other authorities, both domestic and
cross-border, to coordinate an orderly restructuring or resolution of a
troubled bank); and

(ii) Those to be adopted by banks (including contingency funding plans
and recovery plans) which should be subject to critical assessment by
supervisors as part of their ongoing supervision.

26. To reflect, and to emphasise, the importance of crisis management,
recovery and resolution measures, certain Core Principles include specific
reference to the maintenance and assessment of contingency
arrangements.


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The existing Core Principle on home-host relationships has also been
strengthened to require cooperation and coordination between home and
host supervisors on crisis management and resolution for cross-border
banks.

(iv) Corporate governance, disclosure and transparency

27. Corporate governance shortcomings in banks, examples of which
were observed during the crisis, can have potentially serious
consequences both for the bank concerned and, in some cases, for the
financial system as a whole.

A new Core Principle, focused on effective corporate governance as an
essential element in the safe and sound functioning of banks, has
therefore been included in this revision.

The new Principle brings together existing corporate governance criteria
in the assessment methodology and gives greater emphasis to sound
corporate governance practices.

28. Similarly, the crisis served to underline the importance of disclosure
and transparency in maintaining confidence in banks by allowing market
participants to understand better a bank’s risk profile and thereby reduce
market uncertainties about the bank’s financial strength.

In recognition of this, a new Core Principle has been added to provide
more direction on supervisory practices in this area.

Structure and assessment of Core Principles
Structure

29. The preceding versions of the Core Principles were accompanied by a
separate assessment methodology that set out the criteria to be used to
gauge compliance with the Core Principles.


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In this revision, the assessment methodology has been merged into a
single document with the Core Principles reflecting the essential
interdependence of Core Principles and Assessment Criteria and their
common usage.

The Core Principles have also been reorganised: Principles 1-13 address
supervisory powers, responsibilities and functions, and Principles 14-29
cover supervisory expectations of banks, emphasising the importance of
good corporate governance and risk management, as well as compliance
with supervisory standards.

This re-ordering highlights the difference between what supervisors do
themselves and what they expect banks to do. For comparability with the
preceding version, a mapping table is provided in Annex 1.

Assessment

30. The Core Principles establish a level of sound supervisory practice
that can be used as a benchmark by supervisors to assess the quality of
their supervisory systems.

They are also used by the IMF and the World Bank, in the context of the
Financial Sector Assessment Programme (FSAP), to assess the
effectiveness of countries’ banking supervisory systems and practices.

31. This revision of the Core Principles retains the previous practice of
including both essential criteria and additional criteria as part of the
assessment methodology.

Essential criteria set out minimum baseline requirements for sound
supervisory practices and are of universal applicability to all countries.

An assessment of a country against the essential criteria must, however,
recognise that its supervisory practices should be commensurate with the
risk profile and systemic importance of the banks being supervised.


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In other words, the assessment must consider the context in which the
supervisory practices are applied.

The concept of proportionality underpins all assessment criteria even if it
is not always directly referenced.

32. Effective banking supervisory practices are not static.

They evolve over time as lessons are learned and banking business
continues to develop and expand.

Supervisors are often swift to encourage banks to adopt “best practice”
and supervisors should demonstrably “practice what they preach” in
terms of seeking to move continually towards the highest supervisory
standards.

To reinforce this aspiration, the additional criteria in the Core Principles
set out supervisory practices that exceed current baseline expectations
but which will contribute to the robustness of individual supervisory
frameworks.

As supervisory practices evolve, it is expected that upon each revision of
the Core Principles, a number of additional criteria will migrate to
become essential criteria as expectations on baseline standards change.

The use of essential criteria and additional criteria will, in this sense,
contribute to the continuing relevance of the Core Principles over time.

33. In the past, countries were graded only against the essential criteria,
although they could volunteer to be assessed against the additional
criteria too and benefit from assessors’ commentary on how supervisory
practices could be enhanced.

In future, countries undergoing assessments by the IMF and/or the
World Bank can elect to be graded against the essential and additional
criteria.


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It is anticipated that this will provide incentives to jurisdictions,
particularly those that are important financial centres, to lead the way in
the adoption of the highest supervisory standards.

As with the essential criteria, any assessment against additional criteria
should recognise the concept of proportionality as discussed above.

34. Moreover, it is important to bear in mind that some tasks, such as a
correct assessment of the macroeconomic environment and the detection
of the build-up of dangerous trends, do not lend themselves to a rigid
compliant/non-compliant structure.

Although these tasks may be difficult to assess, supervisors should make
assessments that are as accurate as possible given the information
available at the time and take reasonable actions to address and mitigate
such risks.

35. While the publication of the assessments of jurisdictions affords
transparency, an assessment of one jurisdiction will not be directly
comparable to that of another.

First, assessments will have to reflect proportionality.

Thus, a jurisdiction that is home to many SIBs will naturally have a higher
hurdle to obtain a “Compliant” grading10 versus a jurisdiction which only
has small, non-complex deposit-taking institutions.

Second, with this version of the Core Principles, jurisdictions can elect to
be graded against essential criteria only or against both essential criteria
and additional criteria.

Third, assessments will inevitably be country-specific and time -
dependent to varying degrees.

Therefore, the description provided for each Core Principle and the
qualitative commentary accompanying the grading for each Core


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Principle should be reviewed in order to gain an understanding of a
jurisdiction’s approach to the specific aspect under consideration and the
need for any improvements. Seeking to compare countries by a simple
reference to the number of “Compliant” versus “Non-Compliant” grades
they receive is unlikely to be informative.

36. From a broader perspective, effective banking supervision is
dependent on a number of external elements, or preconditions, which
may not be within the direct jurisdiction of supervisors.

Thus, in respect of grading, the assessment of preconditions will remain
qualitative and distinct from the assessment (and grading) of compliance
with the Core Principles.

37. Core Principle 29 dealing with the Abuse of Financial Services
includes, among other things, supervision of banks’ anti-money
laundering/combating the financing of terrorism (AML/CFT) controls.

The Committee recognises that assessments against this Core Principle
will inevitably, for some countries, involve a degree of duplication with
the mutual evaluation process of the Financial Action Task Force
(FATF).

To address this, where an evaluation has recently been conducted by the
FATF on a given country, FSAP assessors may rely on that evaluation and
focus their own review on the actions taken by supervisors to address any
shortcomings identified by the FATF.

In the absence of any recent FATF evaluation, FSAP assessors will
continue to assess countries’ supervision of banks’ AML/CFT controls.

Consistency and implementation

38. The banking sector is only a part, albeit an important part, of a
financial system and in conducting this review of its Core Principles, the
Committee has sought to maintain consistency, where possible, with the


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corresponding standards for securities and insurance (which have
themselves been the subject of recent reviews), as well as those for
anti-money laundering and transparency.

Differences will, however, inevitably remain as key risk areas and
supervisory priorities differ from sector to sector. In implementing the
Core Principles, supervisors should take into account the role of the
banking sector in supporting and facilitating productive activities for the
real economy.

II. The Core Principles

39. The Core Principles are a framework of minimum standards for sound
supervisory practices and are considered universally applicable.

The Committee issued the Core Principles as its contribution to
strengthening the global financial system.

Weaknesses in the banking system of a country, whether developing or
developed, can threaten financial stability both within that country and
internationally.

The Committee believes that implementation of the Core Principles by all
countries would be a significant step towards improving financial
stability domestically and internationally, and provide a good basis for
further development of effective supervisory systems.

The vast majority of countries have endorsed the Core Principles and
have implemented them.

40. The revised Core Principles define 29 principles that are needed for a
supervisory system to be effective.

Those principles are broadly categorised into two groups: the first group
(Principles 1 to 13) focus on powers, responsibilities and functions of


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supervisors, while the second group (Principles 14 to 29) focus on
prudential regulations and requirements for banks.

The original Principle 1 has been divided into three separate Principles,
while new Principles related to corporate governance, and disclosure and
transparency, have been added.

This accounts for the increase from 25 to 29 Principles.

41. The 29 Core Principles are:

Supervisory powers, responsibilities and functions
• Principle 1 – Responsibilities, objectives and powers:

An effective system of banking supervision has clear responsibilities and
objectives for each authority involved in the supervision of banks and
banking groups.

A suitable legal framework for banking supervision is in place to provide
each responsible authority with the necessary legal powers to authorise
banks, conduct ongoing supervision, address compliance with laws and
undertake timely corrective actions to address safety and soundness
concerns.

• Principle 2 – Independence, accountability, resourcing and
legal protection for supervisors:

The supervisor possesses operational independence, transparent
processes, sound governance, budgetary processes that do not undermine
autonomy and adequate resources, and is accountable for the discharge
of its duties and use of its resources.

The legal framework for banking supervision includes legal protection for
the supervisor.


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• Principle 3 – Cooperation and collaboration:

Laws, regulations or other arrangements provide a framework for
cooperation and collaboration with relevant domestic authorities and
foreign supervisors.

These arrangements reflect the need to protect confidential information.

• Principle 4 – Permissible activities:

The permissible activities of institutions that are licensed and subject to
supervision as banks are clearly defined and the use of the word “bank” in
names is controlled.

• Principle 5 – Licensing criteria:

The licensing authority has the power to set criteria and reject
applications for establishments that do not meet the criteria.

At a minimum, the licensing process consists of an assessment of the
ownership structure and governance (including the fitness and propriety
of Board members and senior management) of the bank and its wider
group, and its strategic and operating plan, internal controls, risk
management and projected financial condition (including capital base).
Where the proposed owner or parent organisation is a foreign bank, the
prior consent of its home supervisor is obtained.

• Principle 6 – Transfer of significant ownership:

The supervisor has the power to review, reject and impose prudential
conditions on any proposals to transfer significant ownership or
controlling interests held directly or indirectly in existing banks to other
parties.


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• Principle 7 – Major acquisitions:

The supervisor has the power to approve or reject (or recommend to the
responsible authority the approval or rejection of), and impose prudential
conditions on, major acquisitions or investments by a bank, against
prescribed criteria, including the establishment of cross-border
operations, and to determine that corporate affiliations or structures do
not expose the bank to undue risks or hinder effective supervision.

• Principle 8 – Supervisory approach:

An effective system of banking supervision requires the supervisor to
develop and maintain a forward-looking assessment of the risk profile of
individual banks and banking groups, proportionate to their systemic
importance; identify, assess and address risks emanating from banks and
the banking system as a whole; have a framework in place for early
intervention; and have plans in place, in partnership with other relevant
authorities, to take action to resolve banks in an orderly manner if they
become non-viable.

• Principle 9 – Supervisory techniques and tools:

The supervisor uses an appropriate range of techniques and tools to
implement the supervisory approach and deploys supervisory resources
on a proportionate basis, taking into account the risk profile and systemic
importance of banks.

• Principle 10 – Supervisory reporting:

The supervisor collects, reviews and analyses prudential reports and
statistical returns from banks on both a solo and a consolidated basis, and
independently verifies these reports through either on-site examinations
or use of external experts.


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• Principle 11 – Corrective and sanctioning powers of
supervisors:

The supervisor acts at an early stage to address unsafe and unsound
practices or activities that could pose risks to banks or to the banking
system.

The supervisor has at its disposal an adequate range of supervisory tools
to bring about timely corrective actions.

This includes the ability to revoke the banking licence or to recommend
its revocation.

• Principle 12 – Consolidated supervision:

An essential element of banking supervision is that the supervisor
supervises the banking group on a consolidated basis, adequately
monitoring and, as appropriate, applying prudential standards to all
aspects of the business conducted by the banking group worldwide.

• Principle 13 – Home-host relationships:

Home and host supervisors of cross-border banking groups share
information and cooperate for effective supervision of the group and
group entities, and effective handling of crisis situations. Supervisors
require the local operations of foreign banks to be conducted to the same
standards as those required of domestic banks.

Prudential regulations and requirements

• Principle 14 – Corporate governance:


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The supervisor determines that banks and banking groups have robust
corporate governance policies and processes covering, for example,
strategic direction, group and organisational structure, control
environment, responsibilities of the banks’ Boards and senior
management, and compensation.

These policies and processes are commensurate with the risk profile and
systemic importance of the bank.

• Principle 15 – Risk management process:

The supervisor determines that banks have a comprehensive risk
management process (including effective Board and senior management
oversight) to identify, measure, evaluate, monitor, report and control or
mitigate all material risks on a timely basis and to assess the adequacy of
their capital and liquidity in relation to their risk profile and market and
macroeconomic conditions.

This extends to development and review of contingency arrangements
(incuding robust and credible recovery plans where warranted) that take
into account the specific circumstances of the bank.

The risk management process is commensurate with the risk profile and
systemic importance of the bank.

• Principle 16 – Capital adequacy:

The supervisor sets prudent and appropriate capital adequacy
requirements for banks that reflect the risks undertaken by, and presented
by, a bank in the context of the markets and macroeconomic conditions
in which it operates.


26

The supervisor defines the components of capital, bearing in mind their
ability to absorb losses.

At least for internationally active banks, capital requirements are not less
than the applicable Basel standards.

• Principle 17 – Credit risk:

The supervisor determines that banks have an adequate credit risk
management process that takes into account their risk appetite, risk
profile and market and macroeconomic conditions.

This includes prudent policies and processes to identify, measure,
evaluate, monitor, report and control or mitigate credit risk (including
counterparty credit risk) on a timely basis.

The full credit lifecycle is covered including credit underwriting, credit
evaluation, and the ongoing management of the bank’s loan and
investment portfolios.

• Principle 18 – Problem assets, provisions and reserves:

The supervisor determines that banks have adequate policies and
processes for the early identification and management of problem assets,
and the maintenance of adequate provisions and reserves.

• Principle 19 – Concentration risk and large exposure limits:

processes to identify, measure, evaluate, monitor, report and control or
mitigate concentrations of risk on a timely basis.


27

Supervisors set prudential limits to restrict bank exposures to single
counterparties or groups of connected counterparties.

• Principle 20 – Transactions with related parties:

In order to prevent abuses arising in transactions with related parties and
to address the risk of conflict of interest, the supervisor requires banks to
enter into any transactions with related parties on an arm’s length basis;
to monitor these transactions; to take appropriate steps to control or
mitigate the risks; and to write off exposures to related parties in
accordance with standard policies and processes.

• Principle 21 – Country and transfer risks:

processes to identify, measure, evaluate, monitor, report and control or
mitigate country risk and transfer risk in their international lending and
investment activities on a timely basis.

• Principle 22 – Market risks:

The supervisor determines that banks have an adequate market risk
management process that takes into account their risk appetite, risk
profile, and market and macroeconomic conditions and the risk of a
significant deterioration in market liquidity.

This includes prudent policies and processes to identify, measure,
evaluate, monitor, report and control or mitigate market risks on a timely
basis.

• Principle 23 – Interest rate risk in the banking book:


28

The supervisor determines that banks have adequate systems to identify,
measure, evaluate, monitor, report and control or mitigate interest rate
risk in the banking book on a timely basis.

These systems take into account the bank’s risk appetite, risk profile and
market and macroeconomic conditions.

• Principle 24 – Liquidity risk:

The supervisor sets prudent and appropriate liquidity requirements
(which can include either quantitative or qualitative requirements or
both) for banks that reflect the liquidity needs of the bank.
The supervisor determines that banks have a strategy that enables
prudent management of liquidity risk and compliance with liquidity
requirements.

The strategy takes into account the bank’s risk profile as well as market
and macroeconomic conditions and includes prudent policies and
processes, consistent with the bank’s risk appetite, to identify, measure,
evaluate, monitor, report and control or mitigate liquidity risk over an
appropriate set of time horizons.

At least for internationally active banks, liquidity requirements are not
lower than the applicable Basel standards.

• Principle 25 – Operational risk:

The supervisor determines that banks have an adequate operational risk
management framework that takes into account their risk appetite, risk
profile and market and macroeconomic conditions.

This includes prudent policies and processes to identify, assess, evaluate,
monitor, report and control or mitigate operational risk on a timely basis.


29

• Principle 26 – Internal control and audit:

The supervisor determines that banks have adequate internal control
frameworks to establish and maintain a properly controlled operating
environment for the conduct of their business taking into account their
risk profile.

These include clear arrangements for delegating authority and
responsibility; separation of the functions that involve committing the
bank, paying away its funds, and accounting for its assets and liabilities;
reconciliation of these processes; safeguarding the bank’s assets; and
appropriate independent internal audit and compliance functions to test
adherence to these controls as well as applicable laws and regulations.

• Principle 27: Financial reporting and external audit:

The supervisor determines that banks and banking groups maintain
adequate and reliable records, prepare financial statements in accordance
with accounting policies and practices that are widely accepted
internationally and annually publish information that fairly reflects their
financial condition and performance and bears an independent external
auditor’s opinion.

The supervisor also determines that banks and parent companies of
banking groups have adequate governance and oversight of the external
audit function.

• Principle 28 – Disclosure and transparency:

The supervisor determines that banks and banking groups regularly
publish information on a consolidated and, where appropriate, solo basis
that is easily accessible and fairly reflects their financial condition,


30

performance, risk exposures, risk management strategies and corporate
governance policies and processes.

• Principle 29 – Abuse of financial services:

processes, including strict customer due diligence rules to promote high
ethical and professional standards in the financial sector and prevent the
bank from being used, intentionally or unintentionally, for criminal
activities.

42. The Core Principles are neutral with regard to different approaches to
supervision, so long as the overriding goals are achieved.

They are not designed to cover all the needs and circumstances of every
banking system. Instead, specific country circumstances should be more
appropriately considered in the context of the assessments and in the
dialogue between assessors and country authorities.

43. National authorities should apply the Core Principles in the
supervision of all banking organisations within their jurisdictions.
Individual countries, in particular those with advanced markets and
banks, may expand upon the Core Principles in order to achieve best
supervisory practice.

44. A high degree of compliance with the Core Principles should foster
overall financial system stability; however, this will not guarantee it, nor
will it prevent the failure of banks. Banking supervision cannot, and
should not, provide an assurance that banks will not fail. In a market
economy, failures are part of risk-taking.


31

45. The Committee stands ready to encourage work at the national level
to implement the Core Principles in conjunction with other supervisory
bodies and interested parties.

The Committee invites the international financial institutions and donor
agencies to use the Core Principles in assisting individual countries to
strengthen their supervisory arrangements.

The Committee will continue to collaborate closely with the IMF and the
World Bank in their monitoring of the implementation of the
Committee’s prudential standards.

The Committee also remains committed to further enhancing its
interaction with supervisors from non-member countries.


32

Policymaking in an interconnected
world

Luncheon speech by Jaime Caruana
General Manager, Bank for International
Settlements

The Federal Reserve Bank of Kansas
City’s 36th Economic Policy Symposium
on “The changing policy landscape”
Jackson Hole

Let me extend my thanks to President
George and the organisers for the
opportunity to address this gathering – at
an event that is more keenly anticipated by
policymakers and journalists with every passing year.

My question today is: Is there scope for more international cooperation in
monetary policy?

After all, we see international cooperation as essential for financial
regulation.

Why do we reject keeping one’s own house in order as a precept for
financial regulation but accept it for monetary policy?

The question is not a new one. In his famous Critical essays on monetary
theory, Sir John Hicks argued that individual central banks have only
limited influence because:
“… they have been national central banks. Only in a national economy
that is largely self-contained, can a national central bank be a true central
bank; with the development of world markets, and (especially) of world
financial markets, national central banks take a step down, becoming
single banks in a world-wide system …. Thus the problem that was


33

(partially) solved by the institution of national central banks has
reappeared …. on the world level”.

That was in 1967, during the waning days of Bretton-Woods.

And financial integration over the past 45 years has made the problem
that Hicks identified even more intractable.

The burden of my remarks today is that central banks need to take a more
international perspective, recognise their collective influence and take
into account monetary policy spillovers.

Monetary policy that contributes to financial stability needs more of the
cooperation that we already practise in financial regulation.

Let me break my main question into four questions and then turn to each:

1. What was the state of cooperation in
financial regulation and monetary policy
before the crisis?

2. Where does cooperation stand after the
crisis?

3. Why is the scope for international
cooperation in monetary policy often
underestimated?

4. Do we need to improve the institutional
framework for monetary policy
cooperation?


34

Q1. What was the state of international cooperation in financial
regulation and monetary policy before the crisis?

Since the financial liberalisation of the 1970s, the cooperation on
regulatory standards for large international banks as embodied in Basel I
and II extended well beyond any cooperation in monetary policy outside
the euro area.
This cooperation involved:

(i) Exchange of information;

(ii) Information-sharing based on a common understanding of how the
world works;

(iii) Joint decision-making; and

(iv) Standards set by an international committee.

The very first papers circulated to the Basel Committee on Banking
Supervision (BCBS) in 1975 surveyed the “Rules and practices to protect
the banks’ solvency and liquidity”.

It turned out that these varied a great deal.

Subsequently, regulators evolved a common intellectual framework and
came to speak a common language.

In 1988, Basel I went one step further, to joint decision-making. It set
definitions of capital, risk weights for assets, and, crucially, a minimum
ratio of capital to assets.

These formulations were based on consensus, not enshrined in a treaty or
in international law.


35

Instead, the original Basel accord was enacted in national law and
enforced by national regulators.

In fact, market pressure quickly made Basel I the standard even for banks
in countries not represented on the BCBS.

The driving forces for this cooperation are well known.

As countries liberalised their capital accounts and moved to floating
exchange rates, banks seized the opportunity to intermediate
international capital flows.
Soon after, Bankhaus Herstatt and Franklin National collapsed.

These banks were not globally systemically important financial
institutions, in today’s parlance, but their messy failures did help to drive
forward international cooperation on bank regulation.

When, in August 1982, the big banks suddenly stopped lending to Latin
America, Congress increased the IMF’s resources but demanded higher
capital levels for big US banks.

Concerns about competitive neutrality then prompted the Federal
Reserve to pursue joint action in what became Basel I.

Basel III, to be discussed in a moment, has marked an even more explicit
shift towards internalising the externalities imposed by big banks and
banks’ collective behaviour.
By contrast, monetary policy remained mainly national after the
breakdown of Bretton Woods.
Attempts at cooperation were episodic, mainly relating to exchange rates.
This gave monetary cooperation a bad name – especially in countries with
current account surpluses, which came under pressure to expand
demand.


36

At the level of theory, monetary policy shifted from the 1930s focus on
competitive devaluation, first to the post-war treatment of monetary
policy as just one instrument in overall macroeconomic stability policy,
and then in the past 25 years to the guardian of domestic price stability.
Flexible exchange rates, it was thought, would provide buffers against
external shocks while policymakers kept their own house in order.
In fact, the largest economies not only remained relatively closed but also
had banking systems with very low proportions of foreign currency assets.
To be sure, the quality of global monetary policy discussions has
advanced over the past generation, as a common intellectual framework
evolved.

Indeed, one could argue that monetary policymakers shared a more
thoroughly elaborated intellectual framework than did their counterparts
in financial regulation.

Even so, this shared framework could be indifferent (or even hostile) to
cooperation in monetary policy.

Q2. Where does cooperation stand after the financial crisis?

The short answer is that we have agreed to cooperate more deeply on the
regulatory/financial stability front.

But on the monetary policy front, the pre-crisis convergence of views has
become strained.

There is little doubt that, since the crisis, we have had the widest, deepest
and most far-reaching regulatory cooperation in history.

Participation has broadened, coordination has intensified, and
implementation will be peer-reviewed.

Institutionally, all G20 members have joined the BCBS.


37

Similarly, the Financial Stability Board’s membership has become more
inclusive.

Emerging market representatives bring useful macroprudential
experience to the table.

And attention is being paid to vulnerabilities in the shadow banking
system, outside the narrow scope of the regulated sector.

Cooperation has intensified with Basel III’s requirement for more and
better capital, backstopped by a simple leverage ratio and international
oversight of weights and implementation.

Cooperation has also widened with the inclusion of international
standards on liquidity management.

Recognition of potential procyclicality in the operation of capital
standards has led to the adoption of mutual recognition in the new
countercyclical capital requirement, which empowers host country
authorities.

Tougher solvency standards have been set for banks whose failure could
have system-wide effects.

We should not minimise the challenges ahead.

I am acutely aware that, even as intended regulatory cooperation has
reached an all-time high, the risks of fragmenting banking along national
lines have grown.

While there are long-standing differences in the tax treatment of loan-loss
provisions, national bank bonus taxes have been imposed and now
financial transaction taxes are being discussed regionally.


38

While Dodd-Frank is improving the funding model of US-chartered
banks, other banks that rely on wholesale funding have gained markets
share in dollar intermediation.

While important advances have been made, serious obstacles remain in
concerting resolution regimes given different bankruptcy laws.

A particularly troubling source of fragmentation along country lines is the
inclination to put up national barriers against contagion.

As Mario Draghi has said, “even though each of them may be right,
collectively they have been wrong”.

While regulatory cooperation is the prerequisite for open financial
markets and the free flow of funds, capital controls seem to be gaining
acceptance as a response to the challenge of managing currencies when
yields are zero in most major money markets.

These developments threaten to segment financial markets, not only in
the euro area but around the world.

Nevertheless, I remain hopeful that the movement towards global
consistency and more harmonisation will prevail over the forces working
to fragment international banking regulation and supervision.

On monetary policy cooperation, there were notable steps during the
crisis.

Widespread, and ultimately in some cases, open-ended, cooperation in
foreign-currency funding through central bank swaps had both the
monetary goal of controlling the relevant market rates like Libor and the
financial-stability goal of providing emergency funding.

Such arrangements are temporary.


39

But the willingness of central banks – not least the Federal Reserve – to
act quickly and massively averted what could have been a meltdown.

The global nature of the crisis also saw episodic cooperation in policy rate
setting.

For instance, on 8 October 2008, interest rates were simultaneously cut by
the Bank of Canada, the Bank of England, the ECB, the Federal Reserve,
the Riksbank, the Swiss National Bank and the People’s Bank of China,
in a concerted move that was strongly backed by the Bank of Japan.

But a number of issues have strained the pre-crisis convergence of views
on monetary policy.

What can monetary policy contribute to financial stability? And how does
monetary policy work alongside macroprudential action?

Q3. Why is the scope for international cooperation in monetary
policy often underestimated?

This question raises three more.

First, do flexible exchange rates insulate economies as some theory
suggests?

Second, are bond markets so globally integrated that policies affecting
yields in major countries now have a bigger impact on yields in other
countries than they once did, possibly exerting an even larger effect than
local policies and conditions?

And third, can central banks properly assess the aggregate impact of their
actions on global outcomes, or do they suffer from a fallacy of
composition?


40

Starting with exchange rates, flexible rates do of course help to insulate a
country from inflationary or deflationary shocks coming from abroad. But
they do it imperfectly.

First, since major currencies are used internationally, the policy rates set
by their issuers directly affect monetary conditions elsewhere.

Borrowing in foreign currencies may be rare in the biggest economies,
but it can be significant elsewhere.

And common monetary and risk factors affect the flow of international
bank credit and portfolio capital.

Since the crisis, while credit to US households and businesses has barely
resumed its growth, dollar loans to such borrowers in the rest of the world
has grown at up to 20% and has reached about $7 trillion.

Second, the foreign exchange market’s behaviour does not always satisfy
the textbook interest rate or purchasing power parity conditions.

Exchange rate movements do not merely compensate for interest or
inflation differentials.

Instead, most of the time, currencies with an interest rate advantage
actually appreciate against lower yielding currencies and can do so for
some time, making the domestic industry less competitive.

The depreciation of higher-yielding currencies tends to happen fast
during episodes of stress in global asset markets, and many emerging
market economies have found this destabilising.

Next, there is the issue of international bond markets.

As policy interest rates and official bond purchases affect bond yields,
their effects ripple across globally integrated bond markets.


41

This happens even with independent setting of policy rates and floating
exchange rates.

Large-scale bond purchases can have global effects whether they are part
of an explicit monetary policy or a side-effect of currency intervention.

There is evidence that the large Japanese interventions of 2003–04
lowered global bond yields, as dollars purchased in the foreign exchange
market were invested in bonds.

There is also evidence that the Federal Reserve’s recent large-scale
bond-buying has also reduced global bond yields.

So the integration of global bond markets makes for a global interest in
policies that, intentionally or not, affect bond yields in major markets.

Turning to the possibility of a fallacy of composition, I believe that an
international perspective is essential if we are to correctly assess the
impact of central bank policies on global outcomes.

The price dynamics in commodity markets – which are increasingly
similar to those in financial markets – could be taken as a signal of global
demand pressure rather than being considered by central banks as a
supply shock for each of them.

Similarly, each emerging market central bank might hesitate to raise
interest rates out of concern for capital inflows, given the very low interest
rates prevailing in major currencies.

Indeed, if central banks were to take an international perspective, they
might discover that they would all be better off by raising rates, thereby
setting global average interest rates more appropriately.

These questions are not easy to answer.


42

How can we cope with these spillovers: the interconnections arising from
the behaviour of exchange rates, the globalisation of bond markets, and
the collective impact of policies?

John Hicks knew that the one simple answer to the limitations he
identified – a global central bank – would be totally unrealistic.

National central banks have national mandates, and meeting these is
already difficult enough.

We know less about the workings of international linkages than we do
about domestic linkages.

How interest rates will affect the major centres in other countries depends
in part on those countries’ own policies and institutions.

And it would not be difficult to add to this list.

A number of factors combine to make nation states less than willing to
cooperate on monetary policy.

For instance, monetary policy can be redistributional, shifting wealth and
income between creditors and debtors.

This makes it even more politically charged than regulatory policy – if
that is possible.

Nevertheless, I do not believe that monetary policy can be restricted to
keeping one’s “house in order” at all times.

While such house-keeping is necessary, monetary policy does require
international perspective and cooperation, particularly when it provides
the backing for financial stability.

Q4. Do we need to improve the institutional setting for monetary
cooperation?

43

We hope that the structural trend that deepens interdependence, namely
the globalisation of financial markets, continues.

If it does, there will be periods, in good times and bad, when international
spillovers will be substantial and highly relevant for monetary policy.

If this notion and the underlying analysis are accepted, then the question
arises of how to strengthen cooperation in monetary policy.

This does not necessarily mean monetary policy coordination at the
global level, but it does require central banks to better appreciate,
internalise and share the side effects that arise from individual monetary
policies.

This will require a shift to a more global analytical approach, one that
seeks to factor in collective behaviour, interactions and feedback effects.

This would also help us to better frame international cooperation.

I therefore tend to agree with the recent call from prominent academics
and practitioners for global considerations to play a more explicit role in
monetary policy frameworks.

But I am more sceptical about their proposal to formalise cooperative
arrangements.

The major central banks would not be able to publicly outline the mutual
consistency of their policies.

Drawing attention to areas of inconsistency and dissent would probably
undermine effective cooperation.

Traditionally, the BIS and the various Basel committees have always
sought to complement the domestic analysis at central banks with a more
global perspective.


44

The informal but structured nature of the meetings that take place at the
BIS has often facilitated analysis and discussion of the many international
dimensions of monetary policies.

For example, after providing support to a central bank review of global
liquidity we are working on regular indicators that seek to capture global
financial conditions.

These and other global measures also serve as inputs to vulnerability
analysis and the early warning exercise conducted by the Financial
Stability Board and the IMF.

The IMF is playing a role as well, with its spillover reports and
macroeconomic policies consistency analysis

Let me conclude by saying that much needs to be done.

Moving towards a more cooperative approach makes more sense than
reversing the internationalisation of markets and segmenting those
markets in the hope of protecting them against spillovers.

We need more research on these questions and I hope that some of the
powerful analytic talents represented here at Jackson Hole will be
brought to bear on them.


45

FSA statement regarding CRD IV implementation

The draft European Union legislation to update the
capital requirements framework, known as CRD IV, has
been under discussion between the European Parliament,
European Commission and Council of Ministers.

These discussions originally aimed to finalise an agreed position by end
June 2012 enabling adoption by the European Parliament plenary in early
July 2012.

Following the delay of the Parliament’s plenary vote and the recent
statement by the Rapporteur of the European Parliament and the
discussion of the Council of Economic and Finance Ministers, it is clear
the legislation will not be adopted earlier than autumn 2012.

Following adoption it is necessary for verification, translation and
signature of the EU legislation to take place before it can be published in
the Official Journal of the European Union.

Publication in the Official Journal is a necessary pre-cursor of EU
legislation entering into force.

On this basis it does not appear feasible that the legislation can enter into
force in line with the implementation date of 1 January 2013 as included in
the 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, the
European Banking Authority (EBA) issued a press release on 31 July
setting out the potential need to phase-in or flexibly apply certain
technical standards to ensure a practical approach to implementation.


46

In light of these developments the FSA will keep the situation under
active review and continue to support the European institutions in their
efforts to reach a conclusion on the final version of the legislation.

The FSA will continue to undertake all preparatory work that is possible
in the absence of finalised legislative text, in full expectation that the EU
legislation 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 by
Basel III for banking system stability.

In particular the FSA will continue to undertake its supervision of banks
in a manner consistent with the recommendations of the 22 June meeting
of the interim Financial Policy Committee (FPC) of the Bank of England.

The interim FPC recommended that: taking into account each
institution’s risk profile, the FSA works with banks to ensure they build a
sufficient cushion of loss-absorbing capital in order to help to protect
against the currently heightened risk of losses; that cushion may
temporarily be above that implied by the official transition path to Basel
III; and banks should continue to restrain cash dividends and
compensation in order to maximise the ability to build equity through
retained earnings.

The FSA reminds those investment firms that are currently subject to the
Capital Requirements Directive that they will be impacted by the CRD IV
legislation and that they too should prepare accordingly.

The introduction of Common Reporting, which is incorporated into the
requirements in CRD IV, is dependent on delivery of the necessary
technical systems and on implementing technical standards to be drafted
by EBA under CRD IV and adopted by the European Commission.


47

The FSA is proceeding with the necessary preparatory work to be ready to
begin collecting data under Common Reporting for the period beginning
1 July 2013, should the legislation and related standards be finalised by
this date.

In line with the press release issued by EBA, the FSA will take account of
any phase-in plans incorporated into the implementing technical
standards on supervisory reporting.


48

EBA, EIOPA and ESMA
Joint Consultation Paper on Draft Regulatory Technical Standards on the
uniform conditions of application of the calculation methods under
Article 6.2 of the Financial Conglomerates Directive (JC/CP/2012/02)

I. Responding to this Consultation

EBA, EIOPA and ESMA (the ESAs) invite comments on all matters in
this paper and in particular on the specific questions stated in the
attached document “Overview of questions for Consultation” at the end
of 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 Summary

The CRR/CRD IV proposals (the so-called Capital Requirements
Regulation - henceforth ‘CRR’- and the so-called Capital Requirements


49

Directive – henceforth ‘CRD’) set out prudential requirements for banks
and other financial institutions which are expected to apply from 1
January 2013.

In anticipation of the finalisation of the legislative texts for the
CRR/CRD IV, the EBA, EIOPA and ESMA (hereafter the ESAs) through
the Joint Committee, have developed the draft RTS in accordance with
the mandate contained in Article 46(4) of the CRR and Article 139 of
CRDIV (amending Article 21 a (2a) of the Directive 2002/87/EC) on the
basis of the European Commission’s proposals.

This Article provides the ESAs through the Joint Committee, to develop
draft Regulatory Technical Standards (RTS) with regard to the conditions
of 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 Article
230 in connection with Articles 220 and 228 of the Directive
2009/138/EC2.

To the extent that the texts may change before their adoption, the ESAs
shall adapt its draft RTS accordingly to reflect any developments.

The RTS included in this consultation have to be submitted to the EU
Commission by 1 January 2013.

Please note that the ESAs have developed the present draft RTS based on
the European Commission’s legislative proposals for the CRR/CRD IV.

They have also taken into account major changes subsequently proposed
by the revised texts produced by the Council of the EU and the European
Parliament, during the ordinary legislative procedure (co-decision
process).

Following the end of the consultation period, and to the extent that the
final text of the CRR/CRD IV changes before the adoption of the RTS,


50

the ESAs will adapt the draft RTS accordingly to reflect any
developments.

Main features of the RTS

This consultation paper puts forward draft RTS in order to ensure that
institutions that are part of a financial conglomerate apply the appropriate
calculation methods for the determination of required capital at the level
of the conglomerate.

They are based in particular on the following elements:

General Principles

o Elimination of multiple gearing;

o Elimination of intra-group creation of own funds;

o Transferability and availability of own funds; and

o Coverage of deficit at financial conglomerate level having regard to
definition of cross-sector capital.

Technical calculation methods

1. Method 1: “Accounting consolidation method”:
The FICOD provides in relation to Method 1 that the own funds are
calculated on the basis of the consolidated position of the group.

According to this general provision, the calculation of own funds should
be based on the relevant accounting framework for the consolidated
accounts of the conglomerate applicable to the scope of the Directive.


51

The use of “consolidated accounts” eliminates all own funds’ intra-group
items, in order to avoid double counting of capital instruments.

According to the Directive provisions, the eligibility rules are those
included in sectoral provisions.

2. Method 2: “Deduction and aggregation method”.
This method calculates the supplementary capital adequacy
requirements of a conglomerate based on the accounts of solo entities.

It aggregates the own funds, deducts the book value of the participations
in other entities of the group and specifies treatment of the proportional
share 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 and
deduction and aggregation method 2 is limited to the cases where the use
of either method 1 or method 2 would not be appropriate and is subject to
the permission by the competent authorities.

III. Background and rationale

The supplementary supervision of financial entities in a financial
conglomerate is covered by the Financial Conglomerates Directive
2002/87/EC, hereafter known as the Directive.

This Directive provides for competent authorities to be able to assess at a
group-wide level the financial situation of credit institutions, insurance
undertakings and investment firms which are part of a financial
conglomerate, in particular as regards solvency (including the elimination
of multiple gearing of own funds instruments).


52

The nature of RTS under EU law

Draft RTS are produced in accordance with Article 10 of the ESAs
regulation.

According to Article 10(4) of the ESAs regulation, they shall be adopted
by means of Regulations or Decisions.

According to EU law, EU regulations are binding in their entirety and
directly applicable in all Member States.

This means that, on the date of their entry into force, they become part of
the national law of the Member States and that their implementation into
national 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 a
level-playing field and would facilitate the cross-border provision of
services.

Background and regulatory approach followed in the draft RTS

These draft RTS are produced in accordance with CRD IV/CRR
proposals, which provide that the EBA, ESMA and EIOPA (hereafter the
ESAs), through the Joint Committee, shall develop draft regulatory
technical standards with regard to the conditions of the application of the
calculation methods with regard to Article 6(2) of the Directive and shall
submit those draft regulatory technical standards to the Commission by 1
January 2013.

The proposed draft RTS covers the uniform conditions for the use of the
methods for the determination of capital adequacy of a financial
conglomerate under the Directive.


53

They elaborate on Technical principles applying to all of the three
methods provided for by Directive; and also contain an Annex providing
further detail for Method 2.

The requirements contained in the draft RTS are mainly directed at
institutions, although some of them are directed at competent authorities.

IV. Draft Regulatory Technical Standards on the uniform
conditions of application of the calculation methods under
Article 6.2 of the Financial Conglomerates Directive

Commission Delegated Regulation (EU) No XX/2012
supplementing Directive xx/XX/EU [CRD] of the European Parliament
and of the Council of [date], Regulation (..) No xx/XXXX [CRR] of the
European Parliament and of the Council of [date] and Directive
2002/87/EC [Financial Conglomerates Directive] of the European
Parliament and of the Council of [date] with regard to regulatory
technical standards for the uniform conditions of application of the
calculation methods under Article 6.2 of the Financial Conglomerates
Directive of XX Month 2012

THE 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 the
European Parliament and of the Council of dd mm yyyy on prudential
requirements for credit institutions and investment firms Regulation
xx/xxxx [CRR] and in particular Article 46 (4) thereof.

Having regard to the [proposal for a] Directive (...) No xx/xxxx of the
European Parliament and of the Council of dd mm yyyy on the access to
the activity of credit institutions and the prudential supervision of credit
institutions and investment firms [CRDIV] and in particular Article 139
thereof.


54

Having regard to the Directive 2002/87/EC, as amended, of the
European Parliament and of the Council on the supplementary
supervision of credit institutions, insurance undertakings and investment
firms in a financial conglomerate (hereinafter “the Directive”) and in
particular to Article 6(2) and Annex 1 thereof.

Whereas:

(1) Directive 2002/87/EC provides in Chapter II, Section 2, rules on
capital adequacy of financial conglomerates, such that the elements of
own funds are available at the level of a Financial Conglomerates are
always at least equal to the capital adequacy requirements as calculated in
accordance with Annex I of the Directive.

(2) Regulation (...) No xx/xxx (‘CRR’) provides in Article 46, within Part
II, Chapter 2, Section 3, Sub-Section 2 and in the context of common
equity

Tier I rules, requirements for deduction where consolidation or
supplementary supervision are applied.

This section of the CRR provides empowerments to the European
Commission to adopt delegated acts (regulatory technical standards) in
accordance with articles 10-14 of the Regulation (EU) No 1093/2010
establishing the European Banking Authority (‘EBA’), Articles 10-14 of
the Regulation (EU) No 1094/2010 establishing the European Insurance
and Occupational Pensions Authority (‘EIOPA), and Articles 10-14 of the
Regulation (EU) No 1095/2010 (‘ESMA), establishing the European
Securities and Markets Authority.

These acts will complete the EU single rulebook for institutions in the
area of own funds.

(3) Directive (...) No xx/xxx (‘CRDIV’) provides in Article 139 that the
Directive 2002/87/EC shall be amended, such that the EBA, EIOPA and
ESMA through the Joint Committee, to develop draft Regulatory


55

Technical Standards (RTS) with regard to the conditions of the
application of the Article 6(2) of the Directive.

(4) For effective supervision of Financial Conglomerates, supplementary
supervision should be applied to all such conglomerates, the
cross-sectoral financial activities of which are significant, which is the
case when certain thresholds are reached, no matter how they are
structured.

Supplementary supervision should cover all financial activities identified
by the sectoral financial legislation and all entities principally engaged in
such activities should be included in the scope of the supplementary
supervision, including asset management companies and alternative
investment fund management companies.

(5) Without prejudice to sectoral rules, supplementary supervision of the
capital adequacy rules is necessary to bring more convergence in the
application of the calculation methods listed in Annex 1 of the Directive.

(6) For financial conglomerates which include significant banking or
investment business and insurance business, multiple use of elements
eligible for the calculation of own funds at the level of the financial
conglomerate (multiple gearing) as well as any inappropriate intra-group
creation of own funds must be eliminated.

(7) The financial conglomerate should seek an acceptable timeframe for
the transferability of funds across entities within the financial
conglomerate, which shall depend on whether the specific entity is
subject to the Directive 2009/138/EC or the CRDIV/CRR.

Moreover for an entity subject to the CRD IV/CRR this timeframe should
be expediated based on the fact that due to the nature of their activities,
they are more vulnerable to a rapid deterioration in confidence and/or
sudden resolution situation.


56

(8) In addition any non-sector-specific own funds, in excess of sectoral
requirements, need to originate from entities which are not subject to
transferability/availability impediments.

(9) It is important to ensure that own funds are only included at
conglomerate level if there are no impediments to the transfer of assets or
repayment of liabilities across different conglomerate entities, including
across sectors.

(10) If there is a deficit of own funds at the level of the financial
conglomerate, the financial conglomerate should inform the coordinator
on the measures taken to cover this deficit.

(11) Further convergence in the way that financial conglomerates apply
these rules shall ensure the robust and consistent application of the
methods of calculation.

(12) For bank-led conglomerates it is necessary to apply the most prudent
method of calculation for the treatment of insurance holdings to avoid
regulatory arbitrage.

(13) It is important that sector-specific own funds cannot cover risks
above sectoral requirements.

The financial conglomerate should first count sector-specific own funds
against their requirements (while respecting sectoral rules and limits) for
each relevant entity or group of entities. If there is an excess of
sector-specific own funds, this should not be recognised at conglomerate
level.

(14) When calculating supplementary capital adequacy of a financial
conglomerate, in respect to non-regulated financial entities within the
financial conglomerate, both a notional capital requirement and a
notional level of own funds shoud be calculated.


57

(15) Under Solvency II, method 1 is applied on the basis of consolidated
data which are set out at Level 2 and not on the basis of consolidated
accounts.

(16) Further changes to the capital adequacy rules may be addressed in
the European Commission’s review of Directive 2002/87/EC.

(17) It is necessary that the new regime for treatment of methods of
consolidation enters into force the soonest possible following the entry
into force of the CRR/CRD IV and Solvency II.

(18) This Regulation is based on the draft regulatory technical standards
submitted jointly by the EBA, EIOPA and ESMA to the Commission.

(19) The EBA, EIOPA and ESMA have conducted open public
consultations on the draft regulatory technical standards on which this
Regulation is based, analysed the potential related costs and benefits, in
accordance with Article 10 of Regulation (EU) No 1093/2010, Article 10 of
Regulation (EU) No 1094/2010, Article 10 of Regulation (EU) No
1095/2010,and requested the opinion of the Banking Stakeholder Group
established in accordance with Article 37 of Regulation (EU) No
1093/2010, Insurance Stakeholder Group and the Occupational
Stakeholder Group established in accordance with Article 37 of
Regulation (EU) No 1094/2010, and the European Securities and Markets
Stakeholder Group established in accordance with Article 37 of
Regulation (EU) No 1095/2010.

HAS ADOPTED THIS REGULATION:
TITLE I
Subject matter and definitions

Article 1
Subject matter


58

This Regulation lays down rules of the uniform conditions of application
of the calculation methods under Article 6.2 of the Directive.

Article 2
Definitions

1. Definitions of the CRD IV/CRR, Directive 2002/87/EC and Directive
2009/138/EC shall apply to this Regulation.

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 financial
conglomerate that is responsible for determining the capital for the
financial conglomerate having regard to the following minimum criteria:
control, the dominant entity from the market’s perspective (market listed
entity) and the ability to fulfill specific duties towards its subsidiaries and
its supervisor.

4. ‘indirect holding’ as defined under definition 17 of Article 22 of CRR [to
be added if not in final CRR text].

5. Insurance-led financial conglomerate is a financial conglomerate
whose most important sector is insurance as defined under Article 3(2) of
the Directive.

6. Bank-led financial conglomerate is a financial conglomerate whose
most important sector is banking as defined under Article 3(2) of the
Directive.

7. Investment firm-led financial conglomerate is a financial conglomerate
whose most important sector is investment services as defined under
Article 3(2) of the Directive.


59

TITLE II
Technical Principles

Article 3
Elimination of multiple gearing and the intra-group creation of
own funds

The ultimate responsible entity shall ensure that own funds, which have
been created by intra-group transactions, be it direct or indirect, shall be
eliminated for the purpose of determining the required capital on a
consolidated basis.

Article 4
Transferability and availability of own funds

1. For all entities of a financial conglomerate, own funds, in excess of
sectoral solvency requirements, shall be considered available to absorb
losses elsewhere in the financial conglomerate provided that all of the
following conditions are fulfilled:

(a) There are no practical, legal, regulatory, contractual or statutory
impediments to the transfer of funds or repayment of liabilities across
conglomerate entities in due course.

This is the case when the transfer of own funds from one conglomerate
entity to another is not barred by a restriction of any kind and there are no
claims of any kind from third parties on these assets.

The ultimate responsible entity of the financial conglomerate shall
confirm to the satisfaction of the coordinator that the conditions set out in
this point are met.


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(b) For the purpose of assessing the transferability of funds to entities
subject to 2009/138/EC, “in due course” shall mean no later than 9
months;

for the purpose of assessing the transferability of funds to entities
subjected to CRR, “in due course” shall mean no later than, three
calendar days with no impediments on the coordinator requiring a faster
transfer if necessary.

2. Own funds, in excess of sectoral solvency requirements, which do not
meet the criteria under point 1 shall be excluded from the conglomerate’s
own funds.

3. The financial conglomerate shall demonstrate that measures have been
taken to mitigate the risk that transfer of funds would have a material
effect on the transferor’s solvency.

EXPLANATORY TEXT for consultation purposes

This text is consistent with Annex 1 of the Directive which states “when
calculating own funds at the level of the financial conglomerate,
competent authorities shall also take into account the effectiveness of the
transferability and availability of the own funds across the different legal
entities in the group, given the objectives of the capital adequacy rules”.

Point 1(a) aims to ensure that own funds are only included at
conglomerate level if there are not impediments to the transfer of assets or
repayment of liabilities across different conglomerate entities, including
across sectors.

If the conglomerate cannot confirm to the satisfaction of the coordinator
that there are no inherent impediments in relation to a given entity, that
entity’s own funds in excess of its sectoral requirements cannot be
included at conglomerate level.


Basel III News, September 2012

Basel III News, September 2012

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