Basel 3 News July 2011

8/6/2019 Basel 3 News July 2011

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Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

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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

Basel III News, July 2011

Dear Member, Is it true that investors will lose money because of Basel III?

It is true. This is the price we pay because the banking system becomesmore resilient. More risks, more profits - do you remember the principle?

You cannot make much money in a "deep, liquid and transparent"market where you take limited risks.

Is it that simple? Less profit because of fewer risks?

There is a second reason.

The objective of the Basel III reforms is to reduce the probability andseverity of future crises. So, we will face fewer risks. But this involvescosts arising from stronger regulatory capital and liquidity requirementsand more intense and intrusive supervision.

We will do have "benefits to the society that will well exceed the costs toindividual institutions", but investors will pay the cost.

According to the Bank for International Settlements (BIS), banks mayneed to scale back their profit expectations.

According to the annual report of the BIS, we could have lower, morestable returns on equity (ROEs), a key measure of profitability, sincebank balance sheets will be less risky.




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There is a third reason also.

Basel III makes regulatory arbitrage harder.

Basel II allowed banks to play more games. Basel II mispriced the risk inherent in securitizations and let banks load up on off-balance-sheetinstruments and collateralized debt obligations. Basel III adds a leverageratio, and capital has to be at least 3% of total assets (TOTAL assets, notrisk weighted assets).

Yes, Basel III introduces a simple leverage ratio that provides a backstopto the risk-based regime.

The supplementary ratio, which is a measure of a bank’s Tier 1 capital as

a percentage of its assets plus off-balance sheet exposures andderivatives, will serve as an additional safeguard against attempts to“game” the risk -based requirements, and will mitigate model risk.

The packaging and selling of loans is no longer the great way to avoidcapital requirements.

Banks must consolidate positions from all their trading desks and maketheir trading book compatible with their banking book (a read IT anddata management challenge).

Another opportunity lost - it will not be that simple for banks to transferassets out of their banking book into the trading book to get better capitaltreatment.

Oh, yes, this is going to be a real challenge for US banks that are notcurrently under the Basel II framework.

The moral of the story: Forget bank returns that are at the range of 20 percent.




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I was surprised to read that Deutsche Bank AG is targeting a pretaxinvestment bank return of 20 to 25 percent after 2013 (down from 28

percent in 2010).

Deutsche Bank AG may have to raise additional capital for anotherreason: Regulators have agreed to make as many as 30 of the world’slargest and systemically important banks hold as much as 2.5 percentmore capital than the 7 percent core Tier 1 capital required.

This adds to the problem that banks cannot use hybrid capitalinstruments that are using now, such as contingent convertible bonds, tomeet the target.

HSBC Holdings Plc (HSBA), Bank of America Corp. (BAC), Citigroup,

Deutsche Bank, BNP Paribas, JPMorgan Chase & Co. (JPM), BarclaysPlc (BARC) and Royal Bank of Scotland Group Plc may be subject to thesurcharge of the 2.5 percent.

UBS AG, Credit Suisse, Goldman Sachs Group Inc. and Societe Generalemay be subject to a lower charge of 2 percent.

The size of the potential market for contingent convertible bonds(CoCos) in the UK has already shrunk by two thirds, as banks cannotcount the instruments as capital cushions, according to an analysis by

Bank of America/Merrill Lynch.

The U.K.’s Financial Services Authority has asked banks to prepare a“flight path” to put them in compliance with the Basel III capital rules,taking into account dividends, bonuses and stress testing (they must takeinto account the possibility of another economic recession).

Paul Tucker, Deputy Governor of the Bank of England, challenges banksand asks them to build up capital ahead of the Basel III requirements(rather than using strong earnings to make payouts to staff and investors).




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In the States, although major banks try to keep a brave face, they havealready challenged Fed Chairman Ben S. Bernanke on whether regulatorshave gone too far and are slowing economic growth.

According to Mario Draghi, incoming European Central Bank president,banks already claim that opposing jurisdictions seek to water down Basel,and at the same time these banks have tried to weaken Basel III withintheir respective jurisdictions.

Important parts of the 81st Annual Report of the BIS

In the 81st Annual Report of the BIS we read that the Basel III rules needto be implemented in a timely and globally consistent manner.

All member countries of the Basel Committee must now translate theBasel III texts into national regulations and legislation in time to meet the2013 deadline.

The Committee and its oversight body of Governors and Heads of Supervision have consistently stated that the new standards will beintroduced in a manner that does not impede the economic recovery.

Thus, they have chosen a staggered timeline for implementation.

For example, the July 2009 enhancements that strengthen regulatorycapital and disclosure requirements are due to take effect no later than theend of 2011.

The Basel III requirements themselves begin to take effect from thebeginning of 2013 and will be phased in by 2019.

This time frame includes an observation period to review the implicationsof the liquidity standards for individual banks, the banking sector and




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financial markets, with a view to addressing any unintendedconsequences.

Similarly, the Committee will assess the impact of the leverage ratio onbusiness models during the transition period in order to ensure that itachieves its objectives.

Like all Basel Committee standards, Basel III sets out minimumrequirements, and the transitional arrangements are the deadlines foradopting the new standards.

Countries should move faster if their banks are profitable and are able toapply the standards without having to restrict credit.

Banks should not be permitted to increase their capital distributionssimply because the deadline for achieving the minimum standards is stillsome way off, particularly if there are signs of growing macroeconomicrisks and imbalances.

Therefore, banks, for their part, must also begin to plan and to prepare.

Basel III is the core regulatory response to problems revealed by thefinancial crisis.

Delay or weakening of the agreements would jeopardise financial stabilityand the robustness of the recovery over the long term.

The full, timely and consistent implementation of all relevant standardsby banks, along with rigorous enforcement by supervisors, is critical.

Ultimately, both the official and the private sector will reap the benefits of a more stable financial system. The severity of the crisis owed much tothe fact that the banking sector in many countries had taken on too muchrisk without a commensurate increase in capital.




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Furthermore, this inadequate level of capital was of insufficient quality, asthe latter had gradually eroded.

Basel III tightens capital requirements, encompasses a broader array of risks, and explicitly addresses macroprudential aspects of bankingsystem stability.

Basel III substantially raises the quality as well as the quantity of capital, with a much greater emphasis on common equity.

During the crisis, losses reduced banks’ common equity. However, somebanks maintained deceptively high ratios of Tier 1 capital torisk-weighted assets through the inclusion of other forms of financialinstruments in the capital base.

Moreover, non-common Tier 1 capital instruments often did not share inbanks’ losses through reduced coupon or principal payments and so didnot contribute to maintaining the institutions as going concerns in anymeaningful way.

The artificially high Tier 1 risk-based ratios also meant that banks werebuilding up high levels of leverage. Basel III therefore also introduces asimple leverage ratio that provides a backstop to the risk-based regime.

The supplementary ratio, which is a measure of a bank’s Tier 1 capital asa percentage of its assets plus off-balance sheet exposures andderivatives, will serve as an additional safeguard against attempts to“game” the risk -based requirements, and will mitigate model risk.

The Basel Committee has also improved the risk coverage of theregulatory capital framework for capital market activities – a salientfeature of the recent crisis, where trading exposures accounted for muchof the build-up of leverage and were an important source of losses.




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Weak capital, excessive leverage and inadequate risk coverage preventedthe banking system from fully absorbing systemic trading and creditlosses. Nor could it cope with the reintermediation of large off-balancesheet exposures that had built up in the shadow banking system.

Under Basel III, banks will have to hold more capital against their lessliquid, credit-sensitive assets whose holding periods are much longerthan traditional trading positions.

Trading activities will also be The Basel Committee has also improvedthe risk coverage of the regulatory capital framework for capital marketactivities – a salient feature of the recent crisis, where trading exposuresaccounted for much of the build-up of leverage and were an importantsource of losses.

Weak capital, excessive leverage and inadequate risk coverage preventedthe banking system from fully absorbing systemic trading and creditlosses.

Nor could it cope with the reintermediation of large off-balance sheetexposures that had built up in the shadow banking system.

Under Basel III, banks will have to hold more capital against their lessliquid, credit-sensitive assets whose holding periods are much longer

than traditional trading positions.

Measures for global systemically important banks agreed by theGroup of Governors and Heads of Supervision - 25 June 2011

At its 25 June 2011 meeting, the Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee onBanking Supervision (BCBS), agreed on a consultative document setting

out measures for global systemically important banks (G-SIBs).




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These measures include the methodology for assessing systemicimportance, the additional required capital and the arrangements by

which they will be phased in. These measures will strengthen theresilience of G-SIBs and create strong incentives for them to reduce theirsystemic importance over time.

This package of measures will be issued for consultation around the endof July 2011.

The assessment methodology for G-SIBs is based on an indicator-basedapproach and comprises five broad categories:

1. Size

2. Interconnectedness

3. Lack of substitutability

4. Global (cross-jurisdictional) activity and

5. Complexity.

The additional loss absorbency requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital requirement ranging

from 1% to 2.5%, depending on a bank's systemic importance.

To provide a disincentive for banks facing the highest charge to increasematerially their global systemic importance in the future, an additional1% surcharge would be applied in such circumstances.

The higher loss absorbency requirements will be introduced in parallel with the Basel III capital conservation and countercyclical buffers, iebetween 1 January 2016 and year end 2018 becoming fully effective on 1

January 2019.




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The GHOS and BCBS will continue to review contingent capital, andsupport the use of contingent capital to meet higher national lossabsorbency requirements than the global minimum, as high-triggercontingent capital could help absorb losses on a going concern basis.

Mr Jean-Claude Trichet, President of the European Central Bank andChairman of the Group of Governors and Heads of Supervision, said that"the agreements reached today will help address the negativeexternalities and moral hazard posed by global systemically importantbanks."

Mr Nout Wellink, Chairman of the Basel Committee on BankingSupervision and President of the Netherlands Bank, added that "the

proposed measures will increase the going-concern loss absorbency of

G-SIBs. This will contribute to enhancing the resiliency of the bankingsystem and help mitigate the wider spill-over risks of global systemicallyimportant banks".

More about the G-SIBs and the new Basel III rules from the FSB

From the Report of the Financial Stability Board (FSB) to G20 FinanceMinisters and Central Bank Governors (10 April 2011)

Following the endorsement by the G20 Leaders of the Basel III packageof capital and liquidity reforms at the November Seoul Summit, and theissuance by the Basel Committee of the Basel III rules text in December2010, all members will now put in place the necessary regulations and/orlegislation to implement the Basel III framework on 1 January 2013, suchthat it can be fully phased in by 1 January 2019.

Some issues have been raised pertaining to the new liquidityrequirements. These revolve around the calibration of the ratios, ratherthan the conceptual basis of the liquidity framework.




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The Basel Committee will use the observation period to review theimplications of the standards for individual banks, the banking sector,and financial markets, addressing any unintended consequences asnecessary.

The Committee is focused on ensuring that the calibration of the liquidityframework is appropriate.

Certain aspects of the calibration will be examined and this will involveregular data collection from banks.

Adjustments will be based on additional information and rigorousanalyses.

In February 2011, the Basel Committee issued revisions to the Basel IImarket risk framework, updated to reflect the adjustments to theframework announced by the Basel Committee in its June 2010 pressrelease and the stress testing guidance for the correlation trading

portfolio.

Addressing systemically important financial institutions (SIFIs)

At the November 2010 Summit, the G20 Leaders endorsed the policyframework, work processes and timelines set out in the October 2010 FSB

report “Reducing the moral hazard posed by systemically importantfinancial institutions”.

At their February 2011 meeting, the G20 Finance Ministers and CentralBank Governors asked the FSB to deliver to the November 2011 Summitthe recommendations that had been scheduled for end-2011 in theOctober 2010 report.

The FSB and its members have agreed an accelerated timetable in orderto meet that request.




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G-SIFI determination and loss absorbency

The Basel Committee (BCBS) has broadly agreed a methodology to assistthe FSB and national authorities in assessing the systemic importance of financial institutions at a global level.

This methodology incorporates revisions based on feedback from theGroup of Governors and Heads of Supervision (the Committee’soversight body) and from the FSB.

The revised methodology is based on quantitative indicators for fivecategories: global activity, size, interconnectedness, substitutability, andcomplexity.

The BCBS’s methodology will be used as input to the determination bythe FSB and national authorities, in consultation with standard-setters, of the banking institutions to which the FSB global SIFI (G-SIFI)recommendations will initially apply.

The International Association of Insurance Supervisors (IAIS) isdeveloping a provisional methodology and set of indicators for assessingthe global systemic importance of insurers as input to the initialdetermination by the FSB and national authorities of G-SIFIs.

A status report on the development of the methodology was provided tothe FSB in March and the IAIS expects to finalise its methodology inSeptember 2011.

In Seoul, the G20 Leaders endorsed a requirement that SIFIs and initiallyin particular GSIFIs should have higher loss absorbency capacity toreflect the greater risks that these firms pose to the global financialsystem.

Depending on national circumstances, this greater capacity could be

drawn from a menu of viable alternatives and could be achieved by a




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combination of a capital surcharge, a quantitative requirement forcontingent capital instruments and a share of debt instruments or otherliabilities.

As requested by the FSB, the BCBS expects to complete by June 2011 itsstudy of the magnitude of additional loss absorbency along with anassessment of the extent of going concern loss absorbency which couldbe provided by the various proposed instruments.

As noted in the next section, the FSB Bail-in Working Group, working oncontractual and statutory bail-in, also expects to finalise its proposals bymid-2011.

Drawing on these analyses, the FSB, in consultation with the BCBS, will

recommend by the G20 Summit an additional degree of loss absorbencyfor globally systemic banks and the instruments by which this can be met.

Public consultations will take place during the second half of 2011 on theidentification methodology, amounts and instruments of added lossabsorbency and implementation horizon, before the recommendationsare finalised and delivered to the November Summit.

Resolution tools and regimes

Work towards the implementation of the recommendations on resolutionset out in the FSB’s October 2010 SIFI report is progressing.

The FSB has established a Steering Group responsible for delivering theoverall work programme on resolution and for developing the Key

Attributes of Effective Resolution Regimes which will identify theessential features that national resolution regimes for financialinstitutions, including non-bank financial institutions, should have.




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To make resolution possible in a cross-border context, the Steering Groupis also considering the essential elements for institution-specificcooperation agreements.

These should serve as a benchmark and point of reference to nationalauthorities as they negotiate these agreements (which are to be drawn upby end-2011).

The FSB will discuss the set of draft proposals at its Plenary meeting in July.

The FSB Cross-border Crisis Management Group (CBCM) is monitoringthe development of G-SIFIs recovery and resolution plans in closecooperation with the institution-specific Crisis Management Groups.

To assist this process the CBCM is developing Essential Elements of Effective Recovery and Resolution Plans as well as a framework for theassessment of resolvability of individual SIFIs, including by drawing onthe group’s technical analysis of obstacles to effective resolution arisingfrom internal interconnectedness, global payments operations andinformation systems.

The FSB also has work underway on the technical aspects and financialstability implications of both contractual and statutory bail-in

instruments and mechanisms to provide for higher loss absorbency andimprove resolvability of SIFIs.

The FSB Bail-in Working Group will report in mid-2011 on thecharacteristics that contractual and statutory bail-in should have to beeffective.

The BCBS Cross-border Bank Resolution Group (CBRG) conducted acomprehensive survey in the first quarter of 2011 to take stock of existingnational resolution regimes and tools.




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The CBRG will be reporting on its findings from the survey aroundmid-2011.

The FSB will draw on the CBRG’s findings as one of the inputs for theelaboration of the Key Attributes.

A public consultation will take place during the second half of 2011 on themeasures that the FSB will propose to improve resolution tools andregimes, before the recommendations are finalised and delivered to theNovember Summit.

Supervisory intensity and effectiveness

National supervisors and standard setters continue to address the

recommendations set out in the FSB’s November 2010 report on“Intensity and Effectiveness of SIFI Supervision”.

National supervisors are to submit in June their self-assessments againstthe Basel Core Principles (BCPs) covering mandates, powers, resourcesand independence, which create the foundation for effective supervision.

IAIS members will submit their self assessments against the revisedInsurance Core Principles (ICPs) covering mandates, powers, resources,independence and group wide and consolidated supervision by March

2012.

In addition, based on a survey of its members, the BCBS will provide adraft report to the FSB Supervisory Intensity and Effectiveness (SIE)group in June on the changes national supervisors are making to improvetheir methods and techniques.

Standard setters are tightening their core principles, implementationstandards and assessment methodologies and criteria.




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The IAIS’s proposed changes to its ICPs are currently out for publicconsultation and are expected to be finalised in October 2011.

The BCBS intends to issue a consultative paper on revised BCPs inDecember 2011.

The IMF and World Bank, in conjunction with the BCBS and IAIS, areconsidering the FSB recommendation that more weight be given to theBCP “additional criteria” and the IAIS “advanced criteria” whenassessing against core principles and expect to provide draft revisions tothe assessment methodologies to the FSB in September 2011.

The FSB will review by November 2011 a status report on whether furthersteps should be taken to implement or complement the recommendations

set out in the November 2010 report.

Shadow Banking

At the November 2010 Summit, the G20 Leaders requested that the FSB,in collaboration with international standard-setting bodies, developrecommendations to strengthen the regulation and oversight of the“shadow banking system” by mid-2011.

The FSB has formed a task force to develop initial recommendations for

discussion that would:

1. Clarify what is meant by “the shadow banking system”;

2. Set out potential approaches for monitoring the shadow bankingsystem; and

3. Explore possible regulatory measures to address the systemic risk andregulatory arbitrage concerns posed by the shadow banking system.




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The FSB will consider initial draft recommendations at its July Plenarymeeting and thereafter further develop the recommendations to besubmitted to the G20 in the autumn.

The FSB this month is publishing a short background note on this project, setting out current thinking and inviting public comments ontaking the work forward.

The note proposes that monitoring and responses be guided by atwo-stage approach:

Firstly, casting the net wide, looking at all nonbank credit intermediationto ensure that data gathering and surveillance cover all the activities

within which shadow banking-related risks might arise; and

Second, then narrowing the focus, concentrating on the subset of non-bank credit intermediation where maturity/liquidity transformationand/or flawed credit risk transfer and/or leverage create important risks.

Improving the OTC and commodity derivatives markets

In its October 2010 report on Implementing OTC Derivatives MarketReforms, the FSB made 21 recommendations addressing practical issuesthat authorities may encounter in implementing the G-20 Leaders’

commitments concerning standardisation, central clearing, exchange orelectronic platform trading, and reporting of transactions to traderepositories by end-2012.

The FSB has surveyed the actions being taken to implement therecommendations and is publishing a separate, more detailed report on

progress, based on the analysis of its OTC derivatives working group.

The following paragraphs give a brief summary.




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Major implementation projects are underway in the largest OTCderivatives markets, and international policy development is proceedingaccording to the timetable set out in the October report, including thefollowing steps:

1. The Committee on Payment and Settlement Systems (CPSS) and theInternational Organization of Securities Commissions (IOSCO)

published in March a consultative report on harmonised principles forfinancial market infrastructures, covering payment systems, centralsecurities depositories, securities settlement systems, and centralcounterparties (CCPs), and including guidance on trade repositories.

2. IOSCO published in February a study evaluating the benefits andchallenges associated with the implementation of measures aimed at

increasing exchange and electronic trading. It will conduct furtheranalysis on the current market use of multi or single-dealer platforms.

3. The largest derivatives dealers and other major market participantsdelivered in March a letter to the OTC Derivatives Supervisors Group,setting out broad objectives, specific initiatives and supportingcommitments in this letter as the foundation of a roadmap forimplementation of G20 objectives.

4. The CGFS, CPSS, and IOSCO held a forum in January 2011 and are

organizing follow-up work to promote expanding access to centralclearing to a broader set of participants, and links between CCPs, withoutsacrificing the rigour of CCP risk controls.

Nevertheless, although implementation is still in its early stages, the FSBis concerned that many jurisdictions may not meet the end-2012 deadline,and believes that in order for this target to be achieved, jurisdictions needto take substantial, concrete steps toward implementation immediately.

Differences in approaches are emerging that could weaken the

effectiveness of reforms in these markets, create potential opportunities




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for regulatory arbitrage, or subject market participants and infrastructuresto conflicting regulatory requirements.

Divergent approaches to requirements for the reporting of transactiondata to trade repositories may lead to difficulties in cross-border sharingof data or aggregating data on a global basis unless steps are taken toensure consistency.

Potential emerging inconsistencies may also be seen in the developmentand future application of clearing requirements and strengthenedmargining/collateralisation practices across asset classes, products andmarket participants, and requirements for trading on multi-dealer versussingle dealer platforms.

In this context, the FSB has requested that IOSCO undertake furtheranalysis on market use of multi- or single-dealer platforms.

More generally, the FSB will continue to monitor developments asimplementation progresses and flag emerging inconsistencies that itidentifies.

The FSB’s next report on progress in implementing OTC derivativesreforms will be delivered by October 2011.

The FSB expects that this later report will provide greater insight as to whether progress is on track and greater detail on implementation byasset class (covering interest rate, credit, equity, commodity, and foreignexchange).

With respect to the commodity derivatives markets, steps are being takento improve transparency, mitigate systemic risk, and protect againstmarket abuse. In the first place, all these objectives should be furtheredthrough implementation of the recommendations in the FSB’s October2010 report on OTC derivatives market reforms, which apply equally to

commodity derivatives as to other asset classes.




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In addition, the March 2011 report of the IOSCO Task Force onCommodity Futures Markets proposes future work to address these goals,including, by October 2011, updating standards of best practice set out inthe 1997 Tokyo Communiqué and producing a joint report with theInternational Energy Agency, International Energy Forum and OPEC onthe impact of price reporting agencies, and working towards the creationof a trade repository for the financial oil market by the first quarter of 2012.

The FSB will consider next steps following the Task Force’s report to it in September 2011

Breaking NewsBIS invites new members, 26 June 2011

The Board of Directors of the Bank for International Settlements (BIS)announced its decision to invite 4 central banks to become BIS members:

1. Colombia2. Luxembourg3. Peru and4. The United Arab Emirates to become BIS members.

These central banks were selected in accordance with Article 8.3 of the

BIS Statutes.

The invitations to membership constitute a further step in a process thatbegan in 1996 with invitations to nine central banks:

1. Central Bank of Brazil2. People's Bank of China3. Hong Kong Monetary Authority4. Reserve Bank of India

5. Bank of Korea6. Bank of Mexico




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7. Central Bank of the Russian Federation8. Saudi Arabian Monetary Agency and9. Monetary Authority of Singapore

The invitations to membership continued in 1999 with four new members:

1. Central Bank of Argentina2. European Central Bank 3. Central Bank of Malaysia and4. Bank of Thailand.

The invitations to membership continued in 2003 with six new members:

1. Bank of Algeria

2. Central Bank of Chile3. Bank Indonesia4. Bank of Israel5. Reserve Bank of New Zealand and6. Bangko Sentral Pilipinas.

General Manager's speech: Building a lasting foundation forsustainable growth – Speech delivered by Mr Jaime Caruana, General Manager of the BIS, on

the occasion of the Bank's Annual General Meeting, Basel, 26 June 2011.

Good afternoon, ladies and gentlemen.

In a number of crucial respects, the picture today is better than it was a year ago, and much better than it was in June 2009.

While serious vulnerabilities remain and hard work lies ahead, it isimportant that we don't lose sight of how far we have come. Taking the

global economy as a whole, the gap between world demand and




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productive capacity is closing. And the world economy is growing at ahistorically respectable rate of around 4 per cent.

The recovery, although slow and uneven, has raised output to its pre-crisis levels in some of the countries hardest hit.

The resurgence of demand has put concerns about deflation behind us. Accordingly, the need for continued extraordinary monetaryaccommodation has faded. The financial reform agenda has movedforward rapidly with the agreement reached on Basel III.

Banks have already increased their capital base significantly. A macroprudential approach that focuses on systemic risk forms afundamental part of the new framework and internationally agreed

standards.

These are no small achievements, and not one of them was assured a yearago.

After four years, however, the financial crisis and the ensuing policyresponses continue to cast long shadows.

Economies and financial systems are still vulnerable to even modestshocks, and the likelihood of severely adverse developments has not

decreased.

The global recovery remains uneven, and global headline inflation hasrisen a full percentage point, to 3.6 per cent, since April of last year.

In the advanced economies at the centre of the crisis, overalldeleveraging and structural adjustment is still incomplete.

Excess capacity remains in the financial and construction sectors.

The repair of private balance sheets still has some way to go.




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And the threats posed by public sector debt have materialised, reaching acrisis point in some countries.

There are still substantial risks of contagion between sovereign andfinancial sector fragilities.

Some emerging market economies exhibit the all-too-familiar signs of rising financial vulnerabilities, as domestic credit and asset prices surge.

Sizeable current account imbalances are very much with us, and grosscapital flows pose risks even to economies running current accountsurpluses.

As these developments unfold, global monetary and financial conditions

remain unusually accommodative.

In the remainder of my remarks, I will describe these legacies of thecrisis, and then turn to the policies - fiscal, monetary, structural and

prudential - that can contribute to the lasting foundation for robust, stableand sustainable growth.

Those policies, in turn, need to be part of a broader, integrated framework in which policymakers act promptly both with a long-term perspective -

paying modest costs today to avoid larger costs tomorrow - and with

attention to the global repercussions of their policies.

In the end, cooperation will make everyone better off.

Challenges and policies for stable and sustainable growth

As we leave the crisis behind us, it is important to understand theunderlying source of the challenges it has left.

We experienced the bust of a global financial cycle.




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During the preceding boom, there was a tendency not only tounderestimate financial risk, but to overestimate the economy's potentialgrowth rate and its capacity to generate sustainable tax revenue.

And associated with this was a failure to recognise emerging structuralimbalances that would ultimately damage the foundations of sustainablelong-run growth.

I will highlight four challenges that were left by the crisis: fiscalreckoning; inflation; excess capacity together with the unfinishedadjustment of private sector balance sheets; and financial vulnerabilities.

Fiscal reckoning

The economic downturn, the tax cuts and expenditure increases inresponse to the crisis, and the cost of recapitalising the financial sectorhave all brought forward the fiscal reckoning.

In countries that experienced credit booms, policymakers have come torecognise the significant hole left by the collapse in tax revenues that hadbeen only temporarily boosted by the boom.

The aftermath is a sovereign debt crisis. In many cases, recent eventssimply brought forward an approaching problem. Without corrective

measures, the fiscal trajectories of some of the world's largest advancedeconomies are unsustainable.

This is not news. Rising dependency ratios, expensive publicly funded programmes for retirement and health care and the like put futurecommitments well in excess of future revenues.

Financial market participants can ignore such looming problems for along time until, suddenly, they enforce changes that are swift and painful.

Thus, the need for fiscal consolidation is even more urgent than when Ispoke a year ago. According to the OECD, the average OECD country




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must improve its primary balance by nearly 7 per cent of GDP just tostabilise its debt-to-GDP ratio by 2026.

We will not have lasting macroeconomic and financial stability until wehave taken decisive measures to put public finances on a sound andcredible path.

The creditworthiness of the sovereign is a prerequisite for a well-functioning economy.

The default of the sovereign breaks the social contract and underminesthe trust that is essential to the smooth running of both the state and theeconomy.

No economy - no matter how large, rich and powerful - is immune to therisks posed by fiscal incoherence.

Nowhere is the link between fiscal sustainability and financial healthmore apparent than in parts of Europe today.

In some European countries, vulnerabilities in the financial sector weakened the state; in others, public sector weakness has infected thebanks; in all, the resulting fragilities now jeopardise the benefits of economic and financial integration.

There is no easy way out, no shortcut, no painless solution - that is, noalternative to the rigorous implementation of comprehensive country

packages including strict fiscal consolidation and structural reforms.

The design of the euro area's fiscal and competitiveness arrangementsmust lead to predictable, reliable and less discretionary early correctiveaction in good times.

Unfortunately, Europe does not have a monopoly on urgent fiscal

challenges.




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The big economies also need to manage their situations carefully andmake efforts to consolidate fiscal positions quickly, not least because theyhave a big impact on global financial conditions.

Inflation, side-effects and low interest rates

The welcome recovery and absorption of spare resources have brought with them the less welcome spectre of inflation.

As they did in the early 1970s, booming commodity prices may point to amore serious problem.

Prices of food, energy, metals and the like are more sensitive to shifts insupply and demand than are the prices of either manufactured goods or

services.

And, unlike in the past two decades, prices of internationally tradedmanufactured goods look to provide little inflation offset, as wages and

prices are rising in emerging markets.

Despite the apparent persistence of slack in some parts of the world, thereare risks of second-round effects and of rising inflation expectations.

Very accommodative monetary policy conditions in the economic regions

most affected by the turmoil have been transmitted globally through bondand equity markets and bank credit.

Double-digit growth in US dollar loans to non-US residents is just oneexample of how borrowing in major currencies is providing cheap crediteven where central banks have tightened.

Extraordinarily loose financial conditions may have undesirableside-effects.

We are all familiar with the list.




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Low interest rates can delay balance-sheet repair, encourage dangerousrisk-taking in segments of financial markets and, in the process, make theeventual exit from official support more hazardous.

They can intensify investors' eagerness to place funds in boomingemerging market economies, encouraging the build-up of financialimbalances there.

The more active deployment of macroprudential tools in emergingmarket economies is welcome, but cannot substitute for monetarytightening.

The longer that interest rates are low, the more severe these side-effectsand the greater the risk of a disruption when yields inevitably rise.

There is a need to normalise monetary policy.

The prevailing, extraordinarily accommodative policy rates will notdeliver lasting monetary and financial stability.

Real short-term interest rates have actually fallen in the past year, fromminus 0.6 per cent to minus 1.3 per cent globally.

History teaches us that recoveries from financial crises are slower and less

robust than those after ordinary recessions.

After a financial crisis, it takes longer for debt burdens to fall, balancesheets to be repaired, unproductive capital to be scrapped, and labour tobe reallocated.

Policymakers should not hinder this inevitable adjustment.

Normalising policy too late and too slowly may undermineinflation-fighting credibility as well as risk further damage from the delay

of structural and balance-sheet adjustments.




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More normal interest rates lessen the temptation to muddle through, andthey place the focus squarely on the needed adjustments.

Monetary policy tightening can also aid the adjustment in currentaccount imbalances.

By encouraging currency appreciation in countries that are growing morequickly, it will contribute to correcting imbalances there.

It can also complement the structural policies needed to rebalancegrowth patterns globally, moving us away from the unsustainablecombination of leverage-led and export-led growth.

Excess capacity and unfinished balance-sheet adjustments

Excess capacity in finance and real estate points to unfinishedadjustments in the crisis-stricken economies.

The financial industry has built capital buffers, but overall leverage in theeconomy - private and public - remains too high.

The simple mean of household debt-to-GDP for the US, the UK andSpain declined by only 2 percentage points from 2007 to the end of 2010,

while over the same period for the same countries, governmentdebt-to-GDP rose 30 percentage points.

Until losses are revealed and balance sheets repaired, funding problemsand distortions will persist.

This is an important feature of economies after the bust of a credit boom.

In particular, the post-crisis financial system remains large relative to theeconomy as a whole: excess leverage and excess capacity have not beenshed. Policymakers must intensify their efforts to promote the repair of financial sector balance sheets and to set the conditions for banks'

long-term profitability.




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The macroeconomic road is likely to be at least as bumpy next year as ithas been this year. This means making sure that banks are ready whenthe next shock inevitably comes.

Tough stress tests, supported by recapitalisation measures, are essential.

Moreover, without a stronger and leaner financial system, it will beimpossible to withdraw the extensive public support that is still in place.

No financial system can operate safely and effectively under conditionsthat are creating both moral hazard and the resource misallocations thatcome with it.

Financial vulnerabilities

Despite efforts to date, sovereign and financial sector risks continue tofeed on each other. Short-term bank funding needs remain high, and therisks of interest rate surprises continue to be elevated.

Elements of global finance are prolonging financial fragilities: theseinclude not only low policy rates and expectations of continued officialsupport, but also high expectations of returns on bank equity.

Investors need to lower their expectations of such returns in accord with

lower bank leverage.

At the same time, there are signs of a return to excessive risk-taking. While encouraging investors to take some risk was part of crisismanagement, there are signs that, in some areas, investors may be goingtoo far again.

Moreover, several of the more vibrant economies of the world areexhibiting signs of an unsustainable credit boom. Credit levels and asset

prices have moved outside their historical ranges, signalling theemergence of financial vulnerabilities.




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History may never actually repeat itself, but it does have a recurringtempo and tone.

These developments portend yet another damaging financial cycle.

We should not underestimate the work required to complete financialreform. Basel III needs full and consistent implementation worldwide.

We need to demand higher standards for systemically important financialinstitutions and credible mechanisms for their orderly resolution.

The risks posed by shadow banking systems must be monitored andreduced. Improvements are needed in the statistics and processes formonitoring systemic risks, nationally and globally.

Where credit booms and output are advancing strongly, authoritiesshould consider imposing the Basel III countercyclical buffer to makebanks more resilient.

And throughout all this, we need to make the arrangements flexibleenough to keep pace with the rapidly evolving financial system and theincentives to arbitrage restrictions away.

To sum up, early action is needed.

The question is not whether to consolidate fiscal policy.

It is not whether to normalise monetary policy. And it is not whether toaccelerate structural adjustment.

It is when and how each of these will happen.

Fiscal trajectories must be put on sustainable paths, monetary conditionsshould be normalised, and adjustments in the real economy and balance

sheets should be accelerated.




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Early action will reduce vulnerabilities, lower repair costs and strengthenresistance to unexpected events.

This is particularly true for the resilience of financial firms.

Where possible, we should build strength now. Instead of taking themaximum time to reach the minimum standards, there is a good case forgoing faster and going further.

Perhaps this time we will see a virtuous race to the top.

Policy frameworks

The more enduring lessons of the crisis, however, are not just about

policy actions, but about policy frameworks.

A lasting foundation for monetary and financial stability requiresregulation and supervision with a strong macroprudential orientation;monetary policy that plays an active role in supporting financial stability;and fiscal policy that amasses the buffers required for effective crisismanagement.

These policies share two features.

One rejects short-termism in favour of a long-term view.

The other frees us from home bias in policymaking, allowing us to domore than just "keep our own house in order".

The first feature requires policymakers to keep an eye on the long-termhorizon if they are to pre-empt the slow build-up of financial imbalancesthat can derail growth, cripple monetary policy and trigger sovereigncrises. The governance of macroprudential policy must encouragedecision-makers to take a long view based on the principles of

independence, clarity and accountability.




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This suggests that central banks should play a key role.

Fiscal policy also needs to take a long-term view. Governments, likefinancial firms, must build up buffers.

Fiscal policy should aim at maintaining a very low level of debt duringnormal times so that governments are ready for the next, inevitableshocks. And policymakers should recognise that the level of revenuecollected in the midst of a credit boom is unsustainable.

The second feature tells policymakers that, in an integrated globaleconomy, keeping their own house in order is not enough. No individualeconomy is safe unless the global economy is safe. The fortunes of individual countries and the adequacy of their policies can be accurately

assessed only as part of the global conditions that, collectively, they helpto shape.

For instance, if every central bank views commodity price movements asoutside its control, then global monetary policy can be too loose.

Just as each big private bank generates systemic effects that it mustinternalise, so too each country's policies create international spilloversthat it must take on board.

Building a lasting foundation for low inflation, robust growth and astable financial system requires early action in the face of uncertainty.

It will require not only good ideas, hard work and difficult adjustmentsbut also collaboration, cooperation and coordination both nationally andinternationally.

Developing a shared understanding of the challenges, and workingtowards common solutions, is what international cooperation is all about.

As it has throughout its history, the BIS will continue to pursue this core

mission.




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The Basel iii Compliance Professionals Association (BiiiCPA) is thelargest association of Basel iii Professionals in the world. It is a businessunit of the Basel ii Compliance Professionals Association (BCPA), whichis also the largest association of Basel ii Professionals in the world

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Basel 3 News July 2011

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