Monday June 4 2012 - Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

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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.com

Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the week's
agenda, and what is next

George Lekatis
President of the IARCP

Dear Member,

Today we can start from No. 10 of the list, where we discuss
cyber-attacks. According to Mark G. Clancy, Managing Director and
Corporate Information Security Officer, The Depository Trust & Clearing
Corporation:

“Cyber-attacks on the financial services sector represent a significant risk
not just to industry participants but to the stability and integrity of the
global financial system itself.”

“The global financial system is an enormous, interconnected system of
systems.

In other words, while individual institutions operate different parts of the
critical infrastructure, the financial system itself is a product of the
interactions of all these discrete actions.”

It is an interesting speech, you must read it.

Welcome to the Top 10 list.

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International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

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The Relevance of Audits and the Needs of Investors
May 31, 2012
James R. Doty, Chairman, 31st Annual SEC and
Financial Reporting Institute Conference, Pasadena, CA

May 30, 2012
The Federal Reserve Board announced the
approval of a final rule outlining the procedures
for securities holding companies (SHCs) to elect
to be supervised by the Federal Reserve.
An SHC is a nonbank company that owns at least one registered broker or
dealer.

Last year, the UK financial services industry faced
regulatory change on a sweeping scale.
At the national level the last UK government
introduced the Financial Services Act 2010, which
resulted in a number of changes.

Interview with Gabriel Bernardino, Chairman of
EIOPA, conducted by Jan Wagner,
Versicherungsmagazin (Germany)

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Hearing on the ESRB before
the Committee on Economic
and Monetary Affairs of the
European Parliament
Introductory statement by Mario Draghi, Chair of the ESRB
Brussels, 31 May 2012

Meeting of the Financial Stability Board in Hong
Kong on 29-30 May

At its meeting in Hong Kong, the Financial Stability Board (FSB)
discussed vulnerabilities currently affecting the global financial system
and the progress in authorities’ ongoing work to strengthen global
financial regulation.

Publication of the first regulatory technical
standards on credit rating agencies (CRAs) -
30/05/2012

Four European Commission Delegated
Regulations establishing regulatory technical standards for credit rating
agencies have been published in the Official Journal of the European
Union.

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Commodity Futures Trading Commission
(CFTC)

“Smart Regulatory Reform and the Perils of
High-Frequency Regulation” –
Remarks by Commissioner Scott D. O’Malia
May 31, 2012

Commodity Futures Trading Commission
(CFTC)

Statement Regarding Public Roundtable to
Discuss the Proposed Volcker Rule,
Chairman Gary Gensler,
May 31, 2012

Hearing entitled “Cyber Threats to
Capital Markets and Corporate
Accounts”

Friday, June 1, 2012

House Committee on Financial Services, Subcommittee on Capital
Markets and Government Sponsored Enterprises Hearing on “Cyber
Threats to Capital Markets and Corporate Accounts”
Mark G. Clancy, Managing Director and Corporate Information Security
Officer, The Depository Trust & Clearing Corporation

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NUMBER 1

The Relevance of Audits and the Needs of Investors
May 31, 2012

James R. Doty, Chairman, 31st Annual SEC and Financial
Reporting Institute Conference, Pasadena, CA

Good Afternoon,

I am pleased to be back this year to join you in this conference again. I
must tell you that the views I express today are my own and do not
necessarily reflect the views of the Board, any other Board member, or the
staff of the PCAOB.

This is a special year in many respects. We have our own concerns at
home. But those of us who find our work on financial terrain have our
sights trained east, toward Europe, and west, toward China, more than in
past years.

In the broader population, there is new apprehension for effects we don't
know but must nevertheless judge.

Will European states muster a defense to the behavioral contagion of
financial panic?

Will they find a way to use their inter-dependence to make Europe
financially stronger?

Or will they find that too many divergent interests must agree to save the
European experiment?
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How will the U.S. be affected?

Looking toward China, many say that that nation's economic growth
cannot continue without structural changes.

Can China instill its new, investing middle-class with confidence that
financial markets will provide for its future?

From our larger companies to our smaller entrepreneurs, we are doing
business in China.

Can we have confidence that China isn't the latest iteration of — pick
your era — the Tulip Scandal, the silver-mine frauds of the Old West, the
S&L bust? And how should we deal with these risks in a global economy?

These are questions that require that admirable quality we often call
vision. When we speak of vision, we speak of visionaries.

That is, people who have stepped out from the crowd and revealed
something that the rest of us could not see.

There are false visionaries, who inspire us to act based on what we or they
wish might be. But the true ones give us honesty, and invaluable
leadership.

I. Ken Leventhal Exemplified the Expertise and Integrity that is
Needed to Make Accounting and Auditing Relevant to the 21st
Century.

Earlier this month, the University of Southern California, the accounting
profession and the public more generally lost a true visionary.

I refer to the passing from our scene of Kenneth Leventhal earlier this
month, at the age of 90.

Ken Leventhal, throughout his career, gave us clear ideas about how the
practice of accounting can and should give society the tools necessary to
reduce complicated circumstances to simple, actionable facts.
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And he was a good Trojan. Although a graduate of UCLA, he became an
active and generous USC supporter after UCLA ended its accounting
major.

He believed in the future of the accounting profession.

He wanted to train the new generation of accountants to use the tools he
had developed in practice to help the profession thrive as a vital force for
social good.

He helped build and maintain a first-rate accounting program at USC,
which among other things brings the faculty, policy-makers in
accounting, auditing and securities regulation, as well as leaders in the
profession together each year at this first-rate conference.

Beyond his work here at USC, his professional life leaves a great a legacy
and, if we heed his lessons, perhaps a chance to see our confusing
financial world with his clarity.

He was born in 1921.

As he told his own story, he got the idea for his career when he was a
paper boy for the Herald-Express newspaper.

His boss was planning to take a correspondence accounting course and
go into business for himself, because — as many faculty members will
likely recall Mr. Leventhal recounting — "all it took to get started in
accounting was a pencil."

Mr. Leventhal said that "for a nickel," he figured he could be his own
boss, and he never changed his mind.

Mr. Leventhal's plan was interrupted in 1939, after high school, by WWII.

When he returned from the war, he enrolled at UCLA on the GI Bill.

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That is where he met his wife and future business partner, Elaine Otter
Leventhal. After they finished school in 1949, they started the accounting
firm Kenneth Leventhal & Co. in Los Angeles.

They focused on real estate accounting, and grew the firm into the
premier real estate specialty firm in the country, at one point the ninth
largest firm in the country.

Their clients included the top real estate developers in the post-war
period — Ray Watt, Trammell Crow, Donald Trump, and Donald Bren to
name a few. Mr. Leventhal made his mark guiding those clients "through
times of expansion and financial distress."

To give you a sense of that mark, let me read a passage from a
Washington Post article in 1990.

It said, "When Donald J. Trump, the flamboyant real estate tycoon, found
his business empire in disarray, he could have called on any of Wall
Street's top investment bankers to help him out of his troubles.

Instead, he turned to an accountant in Los Angeles," Kenneth Leventhal.

The Post called him "no run-of-the-mill" accountant. Rather, it reported,
"[a]t a time when the world of accountants and their firms is undergoing
wrenching changes, besieged by government lawsuits and cutthroat
competition for clients" — sound familiar? — "the 70-year-old Leventhal
is running ahead of the pack and, so far, ahead of his profession's
problems."

The Post went on to explain the source of his worth: his skill and integrity.
As one person put it at the time, "If Trump said his properties were worth
such and such, the bankers might not believe him. But if Ken Leventhal
says they were worth it, nobody would challenge his word."

For decades, the firm had enjoyed high regard in accounting and real
estate circles. Forbes magazine noted in a 1979 article on the firm that,
through its expertise, "Leventhal . . . made a name for itself by helping
over a score of troubled real estate companies keep out of the courts.
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The Leventhal firm specialized and trained its professionals in being able
to discern, in simple terms, the economics of transactions.

In putting together a debt-restructuring plan, for example, the firm "first
had to cut through what Leventhal call[ed] ‘the accounting hogwash.'"

As a long-time partner explained it: "What we do is analyze the
underlying real estate in terms of a range of values, under different
economic circumstances. And we look at the probable streams of cash
flow."

In other words, he eschewed over-reliance on manuals and complex
programs that tried to anticipate everything, but, in the end, could be
used to excuse a failure to find the proverbial needle in a haystack.

This is not to say that the global audit firm can do without structure and
manuals, or that our economy can dispense with the global audit firm.

But Mr. Leventhal's career exemplifies confidence in a guiding principle
— one that encourages staff to simplify, to understand the economics of a
transaction before attempting to apply the accounting requirements.

Doing so requires a deep understanding of the prevailing circumstances,
awareness of trends, acute sensitivity to the fact that even the best
managements have an inherent bias toward self-protection.

As he said, it can be done with a pencil, and the will to be skeptical of false
visions. That is, the will to get it right.

The approach an accountant chooses makes an enormous difference, to
the investors that rely on his work, to his firm's integrity and reputation,
and even his own career.

One of the most exciting things about a career in the accounting
profession is that, no matter where you are in the country, your work —
and your choices in how to perform that work — can make an immense
difference to an enormous number of people. That's also, of course, a
daunting responsibility.
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II. An Audit Establishes Its Relevance on a Foundation of
Skeptical Inquiry.

An audit that is merely confirmatory, that supports management's vision
without sufficiently testing it, promotes commoditization of the audit,
and it does worse.

From the halls of the great marble buildings in Washington, from the
skyscrapers of Manhattan, from the sunny gardens here in Pasadena, one
hears the same refrain: the complexity of financial reporting makes it
difficult for management to report, auditors to audit, and investors to
understand the economic substance of a transaction or event.

This tropism — our inexorable tendency toward the complex — threatens
to crush auditor, preparer and investor alike.

But the truth is that, by their conduct, auditors may encourage
complexity by failing to simplify transactions to their economics, by
approaching their task as steps in a corroboration, by failing to speak to
the realities and relying on the formalities.

Leventhal's accountants saw this first hand in a classic instance of Mr.
Leventhal's so-called "hogwash."

This example started out in a little known savings and loan association in
Irvine, California, which was acquired by a hungry and ambitious real
estate investor in Phoenix.

It burst onto the public stage when the Leventhal firm's work was pitted
against the work of three major accounting firms.

Leventhal had been engaged by the federal government to examine
transactions in which thrift regulators paid certain bankers to take on
ailing institutions in exchange for more than $50 billion in federal
subsidies.

The firm helped the government determine which transactions should
have been reopened or renegotiated to win better terms for taxpayers.
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In July 1989, the firm produced a report for the Federal Home Loan Bank
Board of San Francisco on Irvine-based Lincoln Savings and Loan
Association.

The Leventhal report studied 15 transactions undertaken by Lincoln in
1986 and 1987.

The report stated that —

The transactions . . . analyzed were accounting-driven "deals" created for
the appearance of profits.

In economic reality the transactions provided no profit, but instead
exposed the Association to huge economic losses from other linked
transactions or side deals, which the Association entered into for no
apparent reason other than to induce purchases of its real estate at prices
far in excess of appraised value.

The report concluded, ''Lincoln was manufacturing profits by giving its
money away.''

The report ignited a political and public firestorm.

It was the basis for federal regulators' decision to put Lincoln into
receivership in August 1989, costing taxpayers more than $2 billion — still
a large sum today.

It was also submitted to the House Banking Committee, which had
commenced an investigation of Lincoln, its parent American Continental,
and Charles Keating, who headed them.

At the Banking Committee's hearing on the matter, representatives from
one of the three national accounting firms that had audited and signed off
on Lincoln's accounts in recent years challenged the conclusions of the
Leventhal report —

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These matters were complex, and judgmental decisions were sometimes
necessary to determine which accounting rules applied and how to apply
them.

We strongly disagree with Kenneth Leventhal's sweeping generalization
that we elevated form over substance. In its review of just 15 Lincoln and
American Continental transactions, out of hundreds of transactions,
Kenneth Leventhal has made some serious mistakes.

The Leventhal representative responded that "by properly reversing [the
fifteen transactions they studied], over half of Lincoln's reported profits
since Mr. Keating acquired the association disappeared."

Many of the deals included related party transactions, in which Lincoln or
its parent, American Continental, provided the needed cash down
payment to purchasers of Lincoln real estate either through a circuitous
loan or by buying other real estate from the purchaser.

The arrangements allowed Lincoln to report taxable income that
exceeded the consolidated taxable income of the parent, allowing Lincoln
to make cash payments to the parent, American Continental, in the guise
of the subsidiary's portion of American Continental's tax obligation.

To keep all this going, Keating exerted extreme pressure on Lincoln's and
American Continental's auditors, the banking regulators, and even the
Congress, which produced its own scandal in the Keating Five.

Meanwhile, Lincoln, the regulated savings and loan, was drained.

Contrast the paradigm offered by the Lincoln auditor —complexities and
the need for "judgmental decisions" — with the Leventhal approach:
relevance achieved not by accepting complexity but by pursuing clarity,
for its unwillingness to accept form over substance.

The Leventhal approach made accountants' work useful for clients,
pertinent to the economic environment, and beneficial to the public.

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Based on what the Leventhal firm had uncovered, in 1989 the Chairman of
the FDIC said that the government should have moved three years sooner
to take disciplinary action against Lincoln.

III. Indications of Future Challenges and a Path Forward

Until his death, Ken Leventhal exhorted the profession to excel in quality,
integrity and expertise.

He believed those are the ingredients that, if championed, will make the
profession vibrant and successful in the 21st century.

In 2010, after the most recent financial crisis, he said, "The thing that
bothers me nowadays is reading about all these accounting problems and
‘irregularities.' I'm worried about the standards of our profession that
would allow all these ‘irregularities' to occur.

I think we need to teach accounting students and younger staff a greater
obligation to integrity."

A. Inspections Continue to Reveal an Unacceptable Number of
Deficiencies.

Ken Leventhal was right to recognize that, notwithstanding his optimism
for the new generation of accountants and his belief in the importance of
accountants' work to the success of our capital markets, there is
unfinished business to resolve the contradiction between the audit as a
confirming exercise and the audit as an inquiry to arrive at the truth — the
contradiction between the corporate client the auditor sees (and whose
view may determine the success of the individual's career) and the
investor client (whose view determines the success and continued
relevance of the profession as a whole).

The PCAOB has conducted annual inspections of the largest firms for the
last nine years. We also conduct inspections at least once every three
years of other firms that audit, or play a substantial role in auditing,
companies that are considered issuers in the United States.

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This includes some very large non-U.S. firms that are affiliated with the
large U.S. firms, as well as many smaller firms, both U.S. and non-U.S.

Each year, we have deepened our understanding of the firms' issuer audit
practices. From the beginning, inspectors have identified numerous
deficiencies.

These are situations where inspectors believe, after considerable dialogue
with the firm to agree on the facts, that the firm has failed to obtain
sufficient audit evidence to provide a basis for an audit opinion.

In such cases, the financial statements may well be fairly presented in
conformity with GAAP, but the audit work was not sufficient to obtain
reasonable assurance that they are.

I believe the rigor of inspections has improved the quality of auditing.
Our inspectors have noted some significant improvements, such as more
care in certain areas and clearer thought-processes as reflected in audit
plans and audit conclusion memos.

Yet, in recent years, we have seen an equally significant spike in
deficiencies.

Year in, year out, inspectors find deference to management in key
reporting areas.

For example, in the critical area of fair value reporting of financial
instruments, instead of skeptically testing the reasonableness of
managements' assumptions and resulting assertions, one firm's method
involved obtaining valuations from a number of external parties and
picking the one that is, "closest to the pin" — the pin being
management's claimed value.

The work and expense to obtain the various outside valuations may have
created an appearance of rigor.

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But the explicit acknowledgement that the test was designed to support
management's number — the "pin" — calls into question whether the
auditor approached the audit with appropriate skepticism.

What about evaluating management's estimate in light of the
environment and prevailing trends? What about looking for the value that
is probable in light of those trends?

It is the rare case in which an auditor knowingly acknowledges or
documents the conflict between maintaining objectivity and maintaining
a good client relationship.

Indeed, the auditors who explicitly aimed for the number closest to
management's claimed value may not have consciously sought to obscure
valuation errors.

Nor am I suggesting that Lincoln's auditors colluded with management
to mislead. But they did allow themselves to be mere corroborators of a
story that became thinner with each transaction.

Lincoln stands as a vivid reminder that auditors who merely confirm
managements' estimates and don't challenge them with the basic tools at
their disposal may have squandered a chance to avert later investor ruin:
they run the risk that the company's estimate was unreasonable when
made.

Auditors have clients to keep and practices to grow. Recall the pitches
some auditors have made to win audit clients.

For example, commitments by the engagement team to "support the
desired outcome" when matters need to be vetted with the firm's
National Office. Or to offer "a reduced footprint in the organization,
lessening audit fatigue."

Recall, also, the troubling notes in some auditors' personnel files, in
which the reviewed auditors claim to have advanced cross-selling of
non-audit services, raising the question whether firms' cultures still
impliedly encourage auditors to sell services to their audit clients and, if
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so, legal or illegal, whether such goals undermine the appropriate state of
mind for auditors.

This is the unfinished business that occupies the PCAOB, and occupies
audit regulators around the world who have also identified a gap between
the purpose of the audit and its fulfillment.

These concerns have been expressed by regulators in Canada, Germany,
the U.K., the Netherlands, Australia and elsewhere.

The gap threatens the future relevance of the profession's work, as well as
public confidence in its credibility.

B. The PCAOB's Initiatives Aim to Help the Profession Realize
Its Potential by Enhancing the Relevance, Credibility and
Transparency of the Audit for the Sake of Investor Protection.

The PCAOB is deeply engaged in examining ways to enhance the
relevance, credibility and transparency of the audit to better serve
investors.

Our projects include improvements in basic auditing areas, such as what
to look for in transactions involving related parties, including corporate
executives.

The PCAOB proposed a new auditing standard on related party
transactions on February 28. Comments are requested by today.

This standard describes basic tools that good auditors have used for years
to identify financial reporting risks.

Among other things, it requires auditors to understand management's
compensation as a way to understand management's motivations.

Indeed, changes in performance metrics may well be an important clue to
understand areas where management's story is weak.

They offer the auditor insights that may not be gleaned otherwise.
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The PCAOB has also recently proposed, for a second exposure, a new
auditing standard on what the auditor should communicate to audit
committees in order to protect the public's interest in keeping audit
committees informed of important audit matters.

In addition to receiving written comment, the Board has held a
productive public roundtable discussion on auditors' responsibilities to
audit committees.

I expect the Board soon to adopt a final standard that reflects the public
advice and comment.

The PCAOB standards-setting work also includes more broad-ranging
projects, commenced not with concrete proposals but with concept
releases, to examine ways to enhance the relevance, reliability and
independence of audits in today's world, and in light of lessons both
auditors and investors have learned in the recent financial crisis, not to
mention past crises that like Banquo's ghost haunt us still.

These projects involve consideration of changes to the form and content
of the standard audit report, as well as a deep examination of the
behavioral patterns that the current audit model imposes.

I am not here today to tell you where the PCAOB should come out on the
question of what is the most relevant information auditors should provide
the investing public. But I do believe that the investing public can and
should benefit from the wisdom of auditors like Ken Leventhal.

I am interested in a better, more transparent reporting model, that will
align auditors with investors, that will make the audit more relevant,
de-commoditized, and that will function to more consistently require
auditors to demonstrate the requisite skepticism and provide true insight.

The project on independence invites discussion on ways to relieve
auditors of the pressure both to foster and maintain a long-term
relationship with the audit client when making tough decisions on an
audit — to relieve auditors of the tie between their engagements and their
careers.
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In this regard, as with the revisions of the auditor's reporting model, the
focus of the European Union and its member states becomes a factor in
our own process.

There, the perception grows that something is likely to change.

The EU and its member states are engaged in a process that, I suspect,
will take them through 2013 and into 2014.

What we are learning through roundtables and public meetings on our
concept releases is highly relevant to their process.

How we internalize, how we digest, what we hear in our debate, will
inform the debate and process of policy development in Europe.

This is not an easy subject. Some form of term limits may or may not
provide more independence: but I believe we must explore the possibility
that they would help and the feasibility of the range of approaches
available to free the auditor to think and act more independently.

C. The Global Nature of Auditing Today Requires Enhanced
Attention to Address Risks to Investor Protection.

I could not close a discussion on the future of auditing without reflecting
on some other aspects of the international dimension.

All of the challenges and initiatives I have described must be understood
against the backdrop that auditing today is a global endeavor.

Firms large and small have chased, and then fled, the plethora of potential
Chinese and other non-U.S. clients seeking to draw from the wellspring of
U.S. capital markets.

There are lessons that could be learned, that should have been learned,
from the S&L crisis and the internet bubble.

Auditors' choices are the same, but the outcome could be even worse.

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In the S&L crisis, the U.S. government turned to the profession to sort out
the facts and provide reliable valuations of assets.

Who will be the Ken Leventhals of today?

Last week, faced with a similar task, the Spanish government announced
that it had chosen a different path.

It has eschewed the work of auditors in favor of a different kind of analyst.

The financial statements the government questioned were audited. Is the
auditor's work not relevant today?

The only thing worse for the profession than being involved in the next
banking crisis may be not being involved in it.

Through their networks, audit firms reach everywhere. Local
environments and trends are within their long reach. Engagement
partners supervise audits that span continents and oceans.

But the reader of an audit report may not know how much of the actual
work was done by the firm signing the report.

Participating audit firms practice in markets that exhibit markedly
different business cultures, with divergent patterns of transparency.

Small U.S. firms around the country are also engaged in audits of foreign
private issuers, or U.S. companies that operate, in Asia, Latin America,
Africa and elsewhere.

The PCAOB is focusing on the effect of these various business models on
the protection of investors.

In any given week, PCAOB inspectors are working in numerous
countries, often side-by-side with local audit oversight authorities in joint
inspections.

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We are drawing as broad and as clear a picture as we can about how
auditors meet the challenges of understanding different environments
and coordinating with other auditors to obtain a full grasp of a company's
true results and financial position.

We have identified a number of deficiencies in multi-national
engagements.

Some of the auditing issues have been related to particular areas such as
revenue and fair value.

Others seem to be attributed to a failure to adhere to the instructions
provided by the principal auditor.

The director of our inspection force is here today to discuss them.

I am also concerned that the public knows little about how audits are
conducted.

In this regard, the PCAOB proposed last fall new requirements to disclose
to investors how a multi-firm audit was accomplished.

I expect to ask the Board to act on it in the near future.

With sunlight on how the audits are done, they may improve in
coordination and quality as well.

If darkness persists, I fear some auditors will find themselves on the
wrong side of the debate when the lights go on and they are called to
account for how a fraud could have eluded a vast network of soldiers in
what is supposed to be a fight for truth.

These are choices we make today, but will need to explain tomorrow.

* * *

I want to thank the Leventhal School for inviting me again. The
educational opportunities you provide to students, and the conferences
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like this one that you provide professionals, will make a difference as to
the choices your progeny make.

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NUMBER 2

May 30, 2012
The Federal Reserve Board on Wednesday announced the approval of a
final rule outlining the procedures for securities holding companies
(SHCs) to elect to be supervised by the Federal Reserve.
An SHC is a nonbank company that owns at least one registered broker or
dealer.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
eliminated the previous supervision framework that applied to SHCs
under the Securities and Exchange Commission and permitted SHCs to
be supervised by the Federal Reserve.
An SHC may seek supervision by the Federal Reserve to meet
requirements by a regulator in another country that the firm be subject to
comprehensive, consolidated supervision in the United States in order to
operate in the country.

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The final rule specifies the information that an SHC will need to provide
to the Board as part of registration for supervision, including information
related to organizational structure, capital, and financial condition.
Under the final rule, an SHC's registration becomes effective no later than
45 days from the date the Board receives all required information.
The final rule provides that upon an effective registration, an SHC would
be supervised and regulated as if it were a bank holding company.
However, consistent with the Dodd-Frank Act, the restrictions on
nonbanking activities in the Bank Holding Company Act would not apply
to a supervised SHC.
FEDERAL RESERVE SYSTEM
12 CFR Part 241
Regulation OO; Docket No. R-1430
RIN 7100 –AD 81
Supervised Securities Holding Company Registration

AGENCY: Board of Governors of the Federal Reserve System (“Board”).

ACTION: Final Rule

SUMMARY: The Board is adopting this final rule to implement section
618 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(“Dodd-Frank Act” or “Act”), which permits nonbank companies that
own at least one registered securities broker or dealer, and that are
required by a foreign regulator or provision of foreign law to be subject to
comprehensive consolidated supervision, to register with the Board and
subject themselves to supervision by the Board.

The final rule outlines the requirements that a securities holding
company must satisfy to make an effective election, including filing the
appropriate form with the responsible Reserve Bank, providing all
additional required information, and satisfying the statutory waiting
period of 45 days or such shorter period the Board determines
appropriate.

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DATES: The rule is effective [30 days after date of publication in the
Federal Register].

Important parts

SUPPLEMENTARY INFORMATION:
I. Background

Section 618 of the Dodd-Frank Act permits a company that owns at least
one registered securities broker or dealer (a “nonbank securities
company”), and that is required by a foreign regulator or provision of
foreign law to be subject to comprehensive consolidated supervision, to
register with the Board as a securities holding company and become
subject to supervision and regulation by the Board.

A securities holding company that registers with the Board under section
618 is subject to the full examination, supervision, and enforcement
regime applicable to a registered bank holding company, including
capital requirements set by the Board (although the statute allows the
Board to modify its capital rules to account for differences in activities
and structure of securities holding companies and bank holding
companies).

The primary difference in regulatory frameworks between securities
holding companies and bank holding companies is that the restrictions
on nonbanking activities that apply to bank holding companies do not
apply to securities holding companies.

Under section 618 of the Act, a securities holding company that elects to
be subject to supervision by the Board must submit a registration form
that includes all such information and documents the Board, by
regulation, deems necessary or appropriate.

The statute also specifies that registration as a supervised securities
holding company becomes effective 45 days after the date the Board
receives all required information, or within such shorter period as the
Board, by rule or order, may determine.

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Section 618 makes a registered securities holding company subject to all
of the provisions of the Bank Holding Company Act of 1956 (12 U.S.C.
1841 et seq.) (“BHC Act”) in the same manner as a bank holding
company, other than the restrictions on nonbanking activities contained
in section 4 of the BHC Act.

Consistent with the Dodd-Frank Act, the Board anticipates applying the
same supervisory program, including examination procedures, reporting
requirements, supervisory guidance, and capital standards, to supervised
securities holding companies that the Board currently applies to bank
holding companies.

However, the Board may, based on experience gained during the
supervision of supervised securities holding companies, modify these
requirements as appropriate and consistent with section 618.

II. Notice of Proposed Rulemaking: Summary of Comments.
On September 2, 2011, the Board invited public comment on a proposed
rule implementing the registration requirements and procedures for
securities holding companies pursuant to section 618 of the Act.

The Board received three comments, none of which addressed any
substantive aspect of the proposed rule.

One commenter expressed the view that firms should not elect to be
supervised by the Federal Reserve because of a “lack of leadership at the
FED Districts.”

Another commenter included the phrase “supervised securities holding
companies registration” in the subject line of the comment letter but
provided no comment.

The third commenter mistakenly believed that section 618 of the
Dodd-Frank Act and the Board’s proposed Regulation OO apply to
foreign companies that own national banks in the United States.

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This commenter argued that such foreign companies should be subject to
supervision by the Board as supervised securities holding companies if
they wish to operate in the United States by owning national banks.

The Board is finalizing the rule with only technical modifications.

III. Description of Final Rule.
The final rule permits securities holding companies to elect to become
supervised securities holding companies by registering with the Board.

The final rule outlines the requirements that a securities holding
company must satisfy to make an effective registration, including filing
the appropriate form with the responsible Reserve Bank, providing all
additional information requested by the Board, and satisfying the
statutory waiting period of 45 days or such shorter period the Board
determines appropriate.

Section 241.1 of the final rule outlines the authority under which the Board
is issuing the rule.

Section 241.2 of the final rule changes the proposed definition of the term
“securities holding company” in order to more closely reflect the
statutory language.

The revised definition contains additional language, which makes clear
that to become a securities holding company, a company must, among
other things, be “required by a foreign regulator or a provision of foreign
law to be subject to comprehensive consolidated supervision.”

Under the Dodd-Frank Act and final rule, a company that is currently
subject to comprehensive consolidated supervision by a foreign regulator,
a nonbank financial company supervised by the Board, a bank holding
company, a savings and loan holding company, an insured bank, a
savings association, or a foreign banking organization with U.S. banking
operations would not qualify for registration as a supervised securities
holding company.

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Under the final rule, terms such as “affiliate,” “bank,” “bank holding
company,” “control,” and “subsidiary” are defined to have the same
meaning as in section 225.2 of the Board’s Regulation Y.

Section 241.3 of the final rule requires a securities holding company that
elects to register to become a supervised securities holding company to
file the proper form with the responsible Reserve Bank.

The Board is creating a new form for this purpose.

The form, which is similar to the Board’s current form Application for a
Foreign Organization to Acquire a U.S. Bank or Bank Holding Company
(FR Y-3F; OMB No. 7100-0119), used by a company registering to
become a bank holding company, includes a number of questions
relating to the organizational structure of the securities holding company,
its capital structure, and its financial condition.

Specifically, the form requires a securities holding company electing to be
supervised to submit:

1. An organization chart for the securities holding company showing all
subsidiaries.

2. The name, asset size, general activities, place of incorporation, and
ownership share held by the securities holding company for each of the
securities holding company’s direct and indirect subsidiaries that
comprise 1 percent or more of the securities holding company’s
worldwide consolidated assets.

3. A list of all persons (natural as well as legal) in the upstream chain of
ownership of the securities holding company who, directly or indirectly,
own 5 percent or more of the voting shares of the securities holding
company.

In addition, the Board would request information concerning any voting
agreements or other mechanisms that exist among shareholders for the
exercise of control over the securities holding company.

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4. For the senior officers and directors with decision-making authority for
the securities holding company, the biographical information requested
in the Interagency Biographical and Financial Report FR 2081c (the
Financial Report need not be provided).

5. Copies of the most recent quarterly and annual reports prepared for
shareholders, if any, for the securities holding company and certain
subsidiaries.

6. Income statements, balance sheets, and audited GAAP statements, as
well as any other financial statements submitted to the securities holding
company’s current consolidated supervisor, if any, each on a parent-only
and consolidated basis, showing separately each principal source of
revenue and expense, through the end of the most recent fiscal quarter
and for the past two (2) fiscal years.

7. A description of the methods used by the securities holding company to
monitor and control its operations, including those of its domestic and
foreign subsidiaries and offices (e.g., through internal reports and
internal audits).

8. A description of the bank regulatory system that exists in the home
country of any of the securities holding company’s foreign bank
subsidiaries.

The description also should include a discussion of each of the following:

a. The scope and frequency of on-site examinations by the home country
supervisor;

b. Off-site monitoring by the home country supervisor;

c. The role of external auditors;

d. Transactions with affiliates;

e. Other applicable prudential requirements;

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f. Remedial authority of the home country supervisor;

g. Prior approval requirements; and,

h. Any applicable regulatory capital framework.

9. A description of any other regulatory capital framework to which the
securities holding company is subject.

The final rule further provides that the Board may at any time request
additional information that it believes is necessary to complete the
registration.

Under the rule, the registration is considered filed when all information
required by the Board is received.

Section 241.3 of the final rule also states that a registration filed by a
securities holding company becomes effective and supervision by the
Board begins on the 45th calendar day after the date that a complete filing
is received.

Under the final rule, the Board also reserves the right to shorten the
45-day waiting period and begin consolidated supervision at such earlier
date as the Board specifies to the securities holding company in writing.

The final rule provides that, upon an effective registration, a supervised
securities holding company would be supervised and regulated as if it
were a bank holding company, and that the nonbanking restrictions
contained in section 4 of the BHC Act will not apply to a supervised
securities holding company.

This treatment will generally mean that supervised securities holding
companies will, among other things, be required to submit the same
reports and be subject to the same examination procedures, supervisory
guidance, and capital standards that currently apply to bank holding
companies.

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The final rule provides the Board with flexibility to adjust these
requirements as appropriate to ensure that securities holding companies
operate in a manner that is consistent with safety and soundness and that
addresses the risks they pose to financial stability.

IV. Administrative Law Matters
A. Paperwork Reduction Act Analysis
In accordance with the requirements of the Paperwork Reduction Act of
1995 (44 U.S.C. 3501 et seq.) (“PRA”), the Board may not conduct or
sponsor, and the respondent is not required to respond to, an information
collection unless it displays a currently valid Office of Management and
Budget (OMB) control number.

The OMB control numbers for the existing information collections are
provided below.

The OMB control number will be assigned for the new information
collection related to registrations described below.

The Board reviewed the final rule under the authority delegated to the
Board by OMB.

Title of Existing Information Collections:

 The Annual Report of Bank Holding Companies (FR Y-6),
 The Report of Foreign Banking Organizations (FR Y-7),
 The Consolidated Financial Statements for Bank Holding
Companies (FR Y-9C),
 The Parent Company Only Financial Statements for Large Bank
Holding Companies (FRY-9LP),
 The Parent Company Only Financial Statements for Small Bank
Holding Companies (FRY-9SP),
 The Financial Statements for Employee Stock Ownership Plan
Bank Holding Companies (FR Y-9ES),

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 The Supplement to the Consolidated Financial Statements for Bank
Holding Companies (FR Y-9CS),
 The Financial Statements of U.S. Nonbank Subsidiaries of U.S.
Bank Holding Companies (FR Y-11 and FR Y-11S),
 The Financial Statements of Foreign Subsidiaries of U.S. Banking
Organizations (FR2314 and FR 2314S),
 The Bank Holding Company Report of Insured Depository
Institutions’ Section 23A Transactions with Affiliates (FR Y-8),
 The Consolidated Bank Holding Company Report of Equity
Investments in Nonfinancial Companies (FR Y-12) and the Annual
Report of Merchant Banking Investments Held for an Extended
Period (FR Y-12A), and
 The Capital and Asset Report of Foreign Banking Organizations
(FR Y-7Q), and the Financial Statements of U.S. Nonbank
Subsidiaries Held by Foreign Banking Organizations (FR Y-7N
and FR Y-7NS).

Frequency of Response: Annually, semi-annually, quarterly,
event-generated.
Affected Public: Nonbank companies.

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NUMBER 3

Introduction

Last year, the UK financial services industry faced regulatory change on a
sweeping scale.

At the national level the last UK government introduced the Financial
Services Act 2010, which resulted in a number of changes to our
objectives, powers and duties, in particular giving us a new financial
stability objective and additional enforcement powers.

In June 2010, the current UK coalition government announced that the
FSA will be split up.

The prudential supervision of banks and insurers will be moved to a new
operationally independent subsidiary of the Bank of England: the
Prudential Regulation Authority (PRA).

The FSA will be renamed the Financial Conduct Authority (FCA) and will
focus on consumer protection and markets oversight.

The government also established a new committee of the Bank of
England with responsibility for delivering financial stability: the Financial
Policy Committee (FPC).
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The European Union (EU), meanwhile, created three pan-European
agencies to address the risk of regulatory arbitrage and improve the
quality of national supervision of banks, securities markets and the
insurance industry.

The EU also created a new advisory body, the European Systemic Risk
Board (ESRB), to identify systemic risks and make recommendations for
mitigating them.

Europe’s new regulatory architecture became operational in January 2011
and will fundamentally change the way in which national supervisory
authorities operate.

A significant majority of regulatory requirements will be determined
solely at the EU level and national supervisors will play a key role in
negotiating and agreeing these, but their role as decision makers will
centre on their function as supervisors of firms and markets.

The Financial Services Act 2010

The Financial Services Act 2010 (the Act), which received royal assent on
8 April 2010, resulted in a number of changes:

Consumer protection

The Act removed the FSA’s public awareness objective and required us to
set up an independent body to take forward consumer education work.

The Act also provides for more funding to be made available for
consumer education work.

The Act gave us additional powers for the FSA to require consumer
redress.

This allows us to make sure that consumers receive redress in cases
involving large-scale consumer mis-selling or other failures.

Financial stability
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The Act gave us a new financial stability objective to contribute to
protecting and enhancing UK financial stability.

We are required to cooperate appropriately with the Treasury, the Bank of
England and other relevant bodies in pursuing this objective.

The Act requires us to have and keep under review a financial stability
strategy.

It enables us to gather information from entities, including unregulated
entities for financial stability purposes.

It also requires us to consider the impact that international events and
circumstances could have on financial stability in the UK.

Enhanced powers

The Act extends the scope of our key regulatory powers to make rules and
to alter authorised firms’ regulatory permissions, so we may use the
powers in pursuit of any of our regulatory objectives, including the new
financial stability objective.

We have new rule-making powers for:

• Remuneration: we now have the power to specify that remuneration
agreements in breach of our rules are void;

• Recovery and resolution plans;

• Short selling; and

• Consumer redress schemes.

We have new enforcement powers to:
• restrict or suspend the carrying on of regulated activities for up to 12
months;

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• suspend or impose restrictions on an approved person for up to two
years;

• impose a financial penalty at the same time as cancelling a firm’s
permission;

• penalise any person who performs a controlled function4 without
approval; and

• issue a warning notice against an individual three years from the time
we first became aware of the misconduct (increased from two years).

Financial Services Compensation Scheme (FSCS)

The Act contains provisions that will enable the FSCS to act as a single
point of contact and to pay redress to consumers where redress is due to
them under other schemes, such as schemes established outside the UK.

UK regulatory reform

Over the past nine months, the FSA has begun the process of aligning the
organisation to ensure it is ready to cut over to the new regulatory
structure.

As a result, we incurred approximately £1m of direct costs last financial
year:

• Programme management support £0.33m;

• Regulatory design £0.10m;

• IT design £0.33m; and

• Other (e.g. HR and other central functions) £0.24m.
Shortly after the end of our financial year in April 2011, we replaced our
Risk and Supervision business units with two new ones: the Conduct
Business Unit, which broadly aligns with the regulatory activities to be
undertaken by the FCA, other than enforcement; and the Prudential
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Business Unit, which broadly aligns with the regulatory activities of the
PRA, other than enforcement. Central services will continue for the
lifetime of the FSA to be structured on an unitary basis.

We are confident that our programme remains on track and further
progress will be made during 2011/12.

A new European supervisory structure
European Supervisory Authorities (ESAs) and the European
Systemic Risk Board (ESRB)

The creation of ESRB and the three new ESAs marks a significant change
to the way in which financial services regulation will be developed and
delivered across Europe.

The ESRB will undertake macro-prudential analysis at EU level to
identify risks to EU financial stability and will make recommendations to
address these risks.

European Supervisory Authorities (ESAs)

The ESAs became operational in January 2011.
They are:

• The European Banking Authority (EBA);

• The European Insurance and Occupational Pensions Authority
(EIOPA); and

• The European Securities and Markets Authority (ESMA).

They replace:

• The Committee of European Banking Supervisors (CEBS);

• The Committee of European Insurance and Occupational Pensions
Supervisors (CEIOPS); and
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• The Committee of European Securities Regulators (CESR).

The ESAs are responsible for developing a large proportion of the rules
that apply to the financial services sector in the UK.

These will be issued as EU regulations, so will be directly applicable
across the EU.

As well as developing binding rules, the ESAs have powers to:

• impose a temporary ban on financial activities;

• investigate alleged breaches of EU rules;

• take binding decisions in emergencies;

• arbitrate in disputes between national supervisors;

• play a coordinating role within colleges of supervisors;

• undertake peer review;

• directly supervise credit rating agencies (ESMA only); and

• require information to be passed to them that is necessary for
discharging their responsibilities.

In 2010/11, we devoted significant resource during the negotiation of the
ESA legislation to ensure that the ESA package as a whole secured the
key objectives of:

• protecting the single market;

• addressing the risks arising from regulatory arbitrage;

• raising standards of supervision among national supervisors; while

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• retaining responsibility for day-to-day supervision at the national level.

Once the ESA legislative package was agreed in the Autumn of 2010, our
focus shifted to preparing for the new European order. During 2010/11,
we:

• influenced the ESAs regulatory framework and operating model;

• adapted our operating model to work effectively with the ESAs;

• enhanced our secondments strategy and identified training
requirements; and

• developed systems to handle ESA data requests.

Financial stability
Introduction

During 2010/11 the FSA’s mandate was significantly extended.

From April 2010, we were given a new statutory objective, which made
more explicit the responsibilities for promoting financial stability that we
had been exercising under the ‘market confidence’ objective mandated
under FSMA.

At the same time, our supervisory approach continued to progress toward
intensive supervision and proactive challenge, laying the groundwork for
the preventative interaction framework that will guide the PRA.

We continued to embed the organisational and cultural change needed to
implement intensive supervision, moving our regulatory approach from
retrospective intervention to proactive challenge.

Our supervisors made judgements on firms’ business models; intervening
early if they anticipated any risks that might arise from firms’ business
strategies and approaches to funding and capital.

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This approach has demanded quality staff, industry knowledge and the
will to challenge the industry robustly where potential threats were
identified.

We contributed significantly to the development of a robust policy reform
programme, driven by the initiatives and issues identified in The Turner
Review and the wider policy agenda mandated by the EU.

And the FSA continued to play a leading role in influencing regulatory
reform on the global stage, while ensuring that the UK arrangements on,
for example, key issues of capital and liquidity were consistent with the
direction of international standards.

This section describes the work we accomplished in these areas, under
these headings:

• The Financial Services Act – our new financial stability objective;

• FSA supervision – a major intensification of approach;

• Progress on reforming the international and European regulatory
framework – policy and practice; and

• Specific measures to strengthen firms’ resilience.

We also include the principal metrics we use to assess our supervisory
effectiveness in relation to our financial stability objective and to gauge
financial stability generally.

These are:
Supervisory effectiveness
Chart 1: Supervisory issues closed

Chart 2: Firm feedback on the quality of FSA supervisory risk assessments

Measures of financial stability

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Chart 3: Cost of credit

Chart 4: FSA firm cancellations

Chart 5: Major UK banks – CDS spreads, five-year senior debt

A central tool in supervision is identifying the risk mitigation actions
firms must take.

Looking at the quantity identified and speed which with these are closed
gives a perspective on the intensity and effectiveness of our supervision.

The number of issues closed in Q4 2010/11 is 439 (from 303 in Q3
2010/11); this represents 17% (12% in Q3 2010/11) of the population of
open issues.

This shows an absolute and proportional increase in the number of issues
closed than previously reported.
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The proportion of high-risk issues closed was slightly higher than other
issues at 18%, reflecting us prioritising issues with the most risk.

Also, about 40% of the issues (recorded and closed) were in respect of
high-impact firms, reflecting the enhanced focus of our risk assessment
and mitigation work on these firms.

From our regulated firms’ perspective, the quality of our risk assessment
in the last six months has reduced slightly from 5.2 down to 4.9, with the
most significant reductions in our Major Retail Groups Division and
Retail Division.

Risk mitigation is scored more positively at 5.3, but again this represents
a fall against the 5.6 recorded for the six months to June.
However, scores remain positive in the context of a 1-7 scoring system,
where 4 is neutral.
The deterioration may have been driven by the amount and pace of
regulatory change, which has continued to put pressure on both sides of
the firm-supervisory relationship.

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The current cost of interbank borrowing (measured by the Libor-OIS
spread) – in a context and relative to the extremes of 2008 – is not
excessive.

However, spreads have recently entered a slightly more volatile period,
driven by movement in the OIS swap rate.

In part, this reflects uncertainty about the short-term outlook for the bank
rate, amid persistent above target inflation and variable information about
the performance of the economy.

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This chart shows the number of authorised firms this year that have
cancelled their authorisation with the FSA.

Not all cancellations are necessarily failures and not all failures are
regulatory failures.

Nevertheless, this chart gives some indication of the level of distress in
the system.

During 2010/11, there was a significant reduction in the
cancellation rate among significant impact firms.

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UK banks’ credit default swaps (CDS) spreads are a measure of how
investors perceive the default risk posed by these firms.

UK banks’ CDS spreads rose in November, as the Irish sovereign crisis
pushed up CDS spreads for Eurozone sovereigns.

Spreads for some of the banks fell back after the EU and IMF bailout was
announced.

HSBC and Standard Chartered have seen swap rates rise in early 2011 due
to concerns in the aftermath of the Japanese earthquake.

Nevertheless, using absolute CDS as an indicator, they remain the banks
with the lowest perceived credit risk, driven in part by their strength in
emerging market economies.

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Solvency II

As we said in our Business Plan for 2010/11, Solvency II is a fundamental
change of the prudential regime for the European insurance industry.

It aims to establish a revised set of EU-wide risk management standards
and capital requirements that will replace and harmonise the current
arrangements.

Policy in this area continues to be developed in Europe.

There have been delays to the timeline that have affected our own
consultation and shortened the window for implementation.

As a result, we are looking for ways to manage this uncertainty.

At the same time, we have continued to contribute to the development of
the Directive, such as through our involvement in the work of European
Insurance and Occupational Pensions Authority (EIOPA).

We continue to lead some of the working groups, and Hector Sants was
appointed to the EIOPA Management Board in January 2011.

Our work with the UK industry

We have maintained close contact with the UK insurance industry on
both policy and implementation issues.

We continued in 2010 to engage with firms to understand how the
developing requirements affect them and inform our contributions to
EIOPA.

We also had ongoing discussions with firms about how prepared they are
for the new regime.

The fifth quantitative impact study (QIS5) helped us increase our
dialogue with firms on both fronts.

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We gave briefings and ran workshops to educate firms about the
importance of taking part in QIS5.

We encouraged firms of all sizes and types to participate in the exercise to
provide a robust evidence base to inform the ongoing development of the
Solvency II landscape.

During the exercise, we answered over 600 queries, and the UK report to
EIOPA was compiled with submissions from 267 solo firms and 35
groups, representing over 70% of the market.

We also had discussions with firms about the practical implications for
them and we will continue to do so in the run up to implementation.

We have continued to make progress with the internal model approval
process (IMAP).

We published an update in April 2010 setting out the pre-application
process for firms, and the findings of the thematic review in February
2011.

At the end of March 2011, started the next phase of IMAP as we endeavour
to give as many firms as possible a decision on their model for day one.

We further detailed our approach at our Solvency II Conference in April
2011 – more information about this is available on the dedicated
Solvency II pages of the FSA website.

As stated above, we had started to prepare our consultations; however, the
publication of the Omnibus II proposals to amend the Solvency II
Directive to bring it in line with the new European regulatory structure
and allow for transitional provisions has meant that our consultation
timetable has been affected.

Our consultation process will relate to the transposition of the level 1 text
of the Directive and consequential changes to the Handbook.

We expect to publish the first Consultation Paper later this year.
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We will review the European policy timelines regularly, and publish our
own consultation timeline on our website in due course.

Internally, we developed and delivered technical training for supervisors
and other specialists working on Solvency II.

At the end of March, we had trained over 450 people.

To deliver Solvency II we have increased our resources significantly, with
recruitment ongoing to provide the skills and processes to support and
deliver the implementation of the Directive.

Most recently, we shared our current thinking on the policy issues and
implementation approach, with approximately 550 people from the UK
insurance industry at our Solvency II Conference on 18 April 2011.

• We outlined our two-tier approach to the way we would allocate
resources to firms in the pre-application phase of IMAP.

• We discussed the main policy uncertainties, which we also set out in the
accompanying conference document Delivering Solvency II, April 2011.

• We outlined the key dates, including our assumptions that full
implementation will be on 1 January 2013, and that we would be open to
receive applications on the provisions of the Directive that require our
approval.

• We underlined the importance of the UK industry’s continued
involvement in developing the approach to implementation in Europe
and the UK.

We will do this through a number of different fora, including the existing
Insurance Standing Group and its sub-groups, which has over 100 people
registered to receive information.

We will also create new ones as needed.

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We published an overall update on Solvency II in June 2010 on all pillars
of the Directive to inform and motivate firms to take action as needed.

We have tailored our information for smaller insurers through our events
and our website, including things for firms to consider when creating
their implementation plans.

We also gave briefings to market analysts and ratings agencies (February
2011), and to non-executive directors of insurance and reinsurance firms
(January and April 2011) as part of our educational programme.

2011/12 is critical in our preparations for implementing Solvency II, in
Europe and the UK.

We are confident that our implementation approach will help us deliver
our Solvency II programme and carry out our obligations fully.

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NUMBER 4

Interview with Gabriel Bernardino,
Chairman of EIOPA, conducted by Jan
Wagner, Versicherungsmagazin
(Germany)
The EU’s new regulatory regime for insurers,
known as Solvency II, will take effect from 2014.

Although hailed by EU regulators as an
innovation, the regime has come under sharp
criticism from smaller insurers, including several
in Germany.

They complain that the scheme favors bigger
insurers who have the resources to easily adjust
to the new regime.

Wrong says Gabriel Bernardino, who as chairman of the EU insurance
and pension regulator EIOPA will be Solvency II’s chief enforcer.

Versicherungsmagazin spoke to him at length.

Why is Solvency II needed? Has not Solvency I ensured for a
well (functioning insurance industry? I know of no cases in
Germany where the insured lost their money when an insurer
went under.

The idea was never that Solvency II would fix the market because
Solvency I failed, or because insurers needed more capital.

The idea was rather a move toward a risk_based system.

The problem is that there is misallocation of capital among companies.

Some have more capital than they need, and some have less.
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This has negative consequences for protection and pricing.

To illustrate this, let us take two insurance firms with the same liabilities
but two different investment strategies.

One is based on shares and the other is based on bonds.

From a market perspective, you would conclude that the firm with a share
driven strategy would need to hold more capital than the one with a bond
driven one.

But the current regime doesn’t require this! The risks on the asset side are
not taken into account, and that’s what Solvency II aims to resolve.

Are European insurers prepared for the transition to Solvency II?

When Solvency II begins in 2014, there will be no ‘Big Bang.’

That’s because some of its elements are already in the system.

In Germany for example, incentives for better risk management and
governance are embedded in MaRisk, which is already in force.

The objective is not to force insurers to have more capital. It is rather to
have capital better aligned with the risks.

You will have companies that have more capital than they need under a
risk based system and others that do have less than they need.

For those who have less, it’s fair to ask them to raise more capital.

But even in the latter situation, Solvency II is accommodating.

You don’t need to apply it immediately from 2014, so you have time to
raise the capital you need.

Another example is the life business where a transition period applies to
calculations of the liabilities according to Solvency II.
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Isn’t it true though that big listed insurers have an advantage
over mutuals, as they will be able to raise the capital they need
under Solvency II more easily?

If you look at mutuals around Europe, they collectively have much more
capital than public companies.

I therefore don’t think Solvency II will be a big burden for them.

Moreover: If they can demonstrate to the regulator that they effectively
manage the risks on their investments, they may deviate from the
standard model with its set of risk charges and use an internal one which
is more flexible.

So smaller insurers have nothing to fear from Solvency II?

I’m not saying that the introduction of Solvency II will have no effect on
the market.

Something like this always does.

One possible consequence of Solvency II is that there will be some
concentration in certain markets. But we’re seeing this already!

Some insurers complain that Solvency II will compel them to
invest in safe, but low yielding instruments like bonds, as they
carry no risk charge.

Clearly that’s not what we have seen and that’s not what we will see.

The US asset manager Black Rock did a survey some months ago in
which it asked European insurers what asset classes they would target
even under Solvency II.

They replied that they would invest more in alternative investments like
hedge funds, venture capital and project finance.
And why?
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P a g e | 52

In a low interest rate environment insurers have to find ways of boosting
returns.

No one is saying that with Solvency II you have to invest more in this or
that asset class.

We’re merely saying that if you have more risk, you should have more
capital.

Given the European debt crisis, does it still make sense to
require no risk charge for sovereign bonds. Greek bonds can
hardly be considered safe instruments…
Although there is a zero risk charge for sovereign bonds, Solvency II deals
with the specificity of the various asset classes in that market valuations
are used.

This is different than in the banking sector.

If sovereign debt in the portfolios of insurers were to be assessed under
Solvency II, it would need to be rated according to the risk that the
markets perceive nowadays.

And that perception has definitely changed with the debt crisis, no
question.

So if say German Bunds decrease in value, this is immediately reflected
on the portfolios of the insurers, and this is the figure you take into
account in order to calculate the difference between your assets and
liabilities.

If therefore an insurer has a 100 percent solvency requirement, but the
markets penalize some bonds on the portfolio, then the assets diminish
value and your solvency diminishes.

So you see, Solvency II does take the risk associated with sovereign bonds
into account.

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P a g e | 53

For assets which are more volatile like shares and real estate, a further risk
charge applies.

Will the reporting requirements under Solvency II be a burden
for smaller insurers?

The requirements are harmonized around Europe, so this makes things
easier for cross border companies.

But this is also good for medium sized ones with business in two or three
countries.

Having one system of reporting provides a huge cost benefit for all
insurers doing cross border business.

The idea is to bring more commonality to supervision.

Secondly, we’ve got the principle of proportionality applied to the
ultimate extent.

There will be of course more complexity for those insurers who are
invested in say structured products or use derivatives.

But if you don’t invest in these kinds of instruments your reporting will be
less complex.

There will be annual reporting, which is more comprehensive, as well as
quarterly reporting on the most important elements.

But for smaller companies whose risk profile doesn’t really change, the
regulators have the option of waiving the quarterly reporting requirement.

Will Solvency II be applied to pension funds?

As I have always said, this is not a copy_paste exercise.

_____________________________________________________________

P a g e | 54

There are elements of Solvency II that make lots of sense for pension
funds, such as governance, transparency and risk management.

These are known as the second and third pillars of Solvency II.

In terms of the capital requirements, or the first pillar of the regime, we
concluded that there is great diversity among pension plans in Europe.

There are plans that are basically insurance type contracts, and in those
you should have a regime like Solvency II.

But there are also employer sponsored plans where the risk is not
transferred to the insured.

This is a different type of system than the insurance type, and it makes
little sense to apply exactly the same capital requirements.

_____________________________________________________________

P a g e | 55

NUMBER 5

Hearing on the ESRB before the Committee on Economic and
Monetary Affairs of the European Parliament
Introductory statement by Mario Draghi, Chair of the ESRB
Brussels, 31 May 2012
Dear Madam Chair,
Dear Honourable Members,

I am very pleased to appear before this Committee today to present the
first annual report on the activities of the European Systemic Risk Board
(ESRB) – of which you have all received a copy and which is being
published as I speak.

In my remarks today, I will refrain from repeating the content of the
report and will instead focus on three key areas of the ESRB’s work over
the past year, which will also keep us busy for the foreseeable future.

These are:

i) The assessment of systemic risks;

ii) The establishment of a sound macro-prudential framework in the EU;
and

iii) Medium-term structural developments in the EU financial system.

I will then be at your disposal for questions.

1. Assessment of systemic risks in the EU financial system
It is less than a year since the ESRB cautioned that the risks to the EU
financial system had become systemic.
_____________________________________________________________

P a g e | 56

After a period of stabilisation on the back of actions by central banks and
other institutions earlier this year, more recently there have been renewed
bouts of volatility and uncertainty, although not at the same levels
reached in November 2011.

Fundamental challenges persist. In my view, these include:

i) Limiting contagion between Member States across the EU; and

ii) Promoting a macroeconomic strategy that, together with fiscal
consolidation, supports growth and furthers the competiveness
adjustments needed to tackle the economic imbalances within the EU.

Addressing these challenges in a decisive and sustainable manner is a
prerequisite for the success of measures to ensure a more resilient
financial system capable of supplying, on a sustainable basis, the
financial services necessary to support economic activity.

From a macro-prudential point of view, such measures include:

i) Implementing credible mechanisms for the recapitalisation and
restructuring of banks, where needed; and

ii) Improving banking supervision and resolution at the European level.

In the past, the ESRB has underlined the need for all national and
European authorities to act, and to do so in unison, with speed, ambition
and a total commitment to safeguard financial stability.

Today, I reiterate this call, while acknowledging the efforts undertaken so
far.

Within the broader economic and financial context, the financial system
continues to face the challenge of adjustment in order to address
imbalances accumulated in the past.

For banks, progress has already been made on some fronts, but more is
needed. For other financial sectors, it is important that international and
_____________________________________________________________

P a g e | 57

EU reforms, designed to improve their resilience, are fully implemented
and adhered to – an issue that I will return to later.

The ESRB is concerned with two aspects of banks’ adjustment.

First, it should be carried out in an orderly way to support economic
growth to the full extent necessary, without exacerbating market fragility
and the positions of others in the financial system.

Second, the degree of adjustment planned by the EU banking sector over
the coming years must be sufficient to restore confidence in the strength
of banks’ balance sheets.

With regard to the first point, official data and surveys from many
countries across the EU indicate some overall stabilisation in financial
conditions in the early part of this year.

However, the recent turbulence highlights the uncertainty surrounding
the outlook for these financial conditions, given their link to the
soundness of EU banks’ balance sheets and, in turn, the direct or indirect
connections between those balance sheets and sovereign vulnerabilities.

Concerning the second point, close monitoring and a systemic
assessment of the feasibility and nature of the adjustment by banks, as
well as within the financial system more broadly, is crucial.

In this regard, the ESRB has called upon its partners within the European
System of Financial Supervision – supervisory authorities at the national
and EU level – to regularly collect detailed, ex ante information from
banks and other key players in the system, and report it to the ESRB.

The General Board will review the latest developments – and their
implications – at its meeting in June.

2. A sound macro-prudential framework for the EU
Let me now turn to the work undertaken to establish a framework capable
of addressing the deficiencies of the pre-crisis framework in preventing
and mitigating systemic risks in the EU.
_____________________________________________________________

P a g e | 58

While the launch of the ESRB was a first, and necessary, step in this
respect, it is vital to develop a sound and comprehensive
macro-prudential framework for both the EU as a whole and the
individual Member States.

As indicated in the Annual Report, this has been one of the ESRB’s
priorities since its inception.

First, in order to create a solid foundation for pre-emptive action against
systemic risks, it is essential to develop macro-prudential mandates and
tools.

In its recommendation published in January, the ESRB highlighted the
need for well-defined macro-prudential mandates for national authorities
to act either on their own initiative, or in response to the ESRB’s advice.

In accordance with the ESRB’s duty to follow up on its
recommendations, the first reports from the Member States outlining
their progress thus far are expected by the end of June under the ESRB’s
“comply or explain” mechanism.

A key lesson from the past is that financial or systemic stability mandates
must be accompanied by the means to act.

Macro-prudential authorities will need to be equipped with effective
policy tools to respond, in a pre-emptive way, to the complex and
ever-changing variety of systemic risks.

The ESRB is currently working on identifying the minimum set of tools
necessary for conducting macro-prudential policies throughout the EU.

Second, it is crucial to ensure that macro-prudential issues are taken into
consideration when developing EU legislation for the financial sector,
given the impact that such regulations could have on incentives within
the financial system.

In this regard, I would like to touch on a number of important pieces of
EU legislation that the ESRB has been following:
_____________________________________________________________

P a g e | 59

i) A draft directive and regulation on capital requirements for credit
institutions (the “CRD/CRR”);

ii) The proposal for a regulation on OTC derivatives, central
counterparties and trade repositories (“EMIR”); and

iii) The part of the proposal for the Omnibus II directive that concerns the
regulation of the insurance sector.

With regard to the CRD/CRR, I very much welcome the recent progress
made by this Committee, as well as by the EU Council, on advancing the
proposals put forth by the Commission less than a year ago.

Your work together with the Council provides a promising basis for the
establishment of important macro-prudential instruments for addressing
systemic risks in the banking sector.

To assist you, and the Council, in your work on the CRD/CRR, the ESRB
wrote to you in March outlining a number of macro-prudential principles.

I urge you to consider these principles in order to ensure that
macro-prudential authorities, at both the EU and national level, are fully
equipped with a flexible set of policy tools and sufficient scope to act early
and effectively to prevent the build-up of systemic risks in the future.

Obviously, discretion to pursue macro-prudential policies requires
efficient coordination as a safeguard against potential negative
externalities or unintended consequences.

The ESRB is ready to play a central role in this respect, and work is under
way to establish a general framework for the coordination of national
macro-prudential policies by the ESRB, where such policies give rise to
material spillovers across borders.

The agreement on EMIR was also an important step forward in
implementing lessons from the crisis, and it includes a number of useful
elements to safeguard financial stability in the EU.

_____________________________________________________________

P a g e | 60

The ESRB has started preparations for performing the tasks assigned to it
under EMIR.

From a macro-prudential perspective, however, I should point out that, in
the view of the ESRB, EMIR does not address the issues raised by the
possible pro-cyclical effects of either easing or tightening of collateral
eligibility and of requirements for transactions subject to central
counterparty clearing.

In accordance with its responsibilities, the ESRB continues to examine
whether and how collateral requirements could be applied as a
macro-prudential tool at a later stage.

The new regulatory framework for insurance activities is currently being
finalised.

Some important aspects of this framework – such as those related to the
treatment of long-term guarantees – are being discussed over the next few
days as part of the “Omnibus II trialogue” discussions, in which this
Committee is actively involved.

The ESRB is aware that several of the issues at stake are potentially
relevant from a macro-prudential point of view.

In particular, the new regulatory framework (Solvency II) may amplify the
procyclicality of insurers’ balance sheets and, in particular, capital levels.

This has been recognised by the legislator, which is designing several
policy instruments (including some of a macro-prudential nature) to
mitigate procyclicality and other factors.

It is crucial that such instruments are designed to deliver a clear and
credible objective and that their interaction is duly considered to ensure
that the use of these instruments has the intended effect.

3. Structural developments in the EU financial system
Finally, I would like to highlight some medium-term, structural
developments that the ESRB is currently looking at, with a view to
_____________________________________________________________

P a g e | 61

gaining a better understanding of their implications for systemic risk and
to identifying appropriate policy responses for delivering a more resilient
financial system.

The ESRB is devoting particular attention to structural aspects of both
the traditional banking sector and the shadow banking sector.

Before commenting on developments in these sectors, I would like to
briefly say a few words on the whole financial system, which is currently
undergoing a regulatory reform in all its segments.

An important goal of such reforms is to ensure a sustainable supply of
financial services from the system to the rest of the economy.

In Europe, the financial sector has traditionally been centred around
banks.

However, some activities may shift to other – maybe less regulated – parts
of the system in the years to come, perhaps as a direct consequence of the
current crisis or as a result of the overhaul of standards for regulated
activities and entities.

While such developments can, in principle, be of benefit to the system,
they must be monitored closely in order to limit the emergence of new
vulnerabilities, for example those stemming from shifts driven by
regulatory arbitrage.

Turning to the banking sector, the onset of the financial crisis revealed
significant shortcomings in banks’ funding structures – part of the
necessary adjustment I referred to earlier involves a transition to more
sustainable funding structures.

However, banks’ ability to manage this adjustment is being hampered by
conditions in European interbank and unsecured credit markets.

As a result, there has been a rise in banks’ recourse to secured funding
markets and innovative funding instruments.

_____________________________________________________________

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