Basel iii News December 2012

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

Dear Member,

Today we will start with an interesting assessment:

Basel III Experts vs. Risk Management Experts

It is interesting to feel the market.

Do you make more money as a risk

manager, or a risk manager with Basel iii knowledge? What do you believe?

Source: IT Jobs Watch, that provides a unique perspective on today's information technology job market.

http://www.itjobswatch.co.uk/jobs/uk/basel%20iii.do Note: This is not an advertisement. We have no affiliation or any other relationship with IT Jobs Watch.

http://www.basel-iii-association.com/


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Basel III Top 30 Related IT Skills in UK

Basel III Jobs, Salary Trend in UK


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Risk Management Jobs, Salary Trend in UK

Basel III Salary Histogram in UK


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Risk Management Salary Histogram in UK

Basel III, Top 9 Job Locations in UK


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Risk Management, Top Job Locations in UK


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Basel 3 – The Timing Dilemma Last month the United States (US) regulatory authorities announced that

they did not expect their rules implementing Basel 3 would become effective on 1 January 2013, although they are working as “expeditiously as possible” to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between the European Commission, the European Parliament and the Council of Ministers to agree the text of Capital Requirements Directive IV (CRD IV, the EU version of Basel 3 is still ongoing and, even if a political

agreement can be reached by year-end (which still appears to be the intention), it is recognised in the EU that there will not be sufficient time for CRD IV to be codified as legislation and put into effect on 1 January 2013.

So, does it necessarily follow that we should delay Basel 3 implementation in Hong Kong because the US and the EU cannot meet the internationally agreed timeline?

Or should we follow the timeline set by the Basel Committee on Banking Supervision and begin the first phase of Basel 3 implementation from 1 January 2013?

Our Basel 3 rules (the Banking (Capital) (Amendment) Rules 2012) are currently tabled at LegCo and notwithstanding the expected delays in the US and the EU, the Basel Committee’s timeline remains unchanged.

Its gradual phase-in of the new capital standards over six years begins from January 2013 and extends until 2019.

In resolving the timing dilemma, it might first be instructive to remind ourselves that Basel 3 is being introduced to rectify weaknesses made all too starkly apparent in the recent global financial crisis.


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Or, put another way, Basel 3 is considered good for financial stability.

The Basel 3 capital standards are designed to strengthen banks’ resilience by requiring more and better quality capital and by addressing and capturing risks not adequately recognised previously.

The aim is to ensure that banks can weather future financial storms without disruption to their lending. This should in turn make them less likely to create or amplify problems in

other areas of the economy and facilitate their contribution to long-term sustainable economic growth. The roller-coaster of excessive leverage pre-crisis and excessive

deleveraging post-crisis is not conducive to sustainable growth. Regulation is all about balance.

If regulation is too lax, excessive risk-taking may result with devastating effects. If regulation is too tight, it may suppress beneficial financial activity and

reduce growth. In our view, Basel 3 represents an appropriate balance in bolstering resilience whilst at the same time (with its extended phase-in) not unduly

hampering lending to business and households today and ensuring banks can continue to lend in any downturn tomorrow. For this reason we propose to begin implementing Basel 3 from 1 January

2013. We are not alone in this.

Our regional peers, Mainland China, Japan, Singapore and Australia have all published their final rules for Basel 3 implementation next year.


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As has Switzerland, another important financial centre.

But notwithstanding the intrinsic benefits of Basel 3, should we nevertheless be swayed by the argument put to us that Asia is taking the “medicine” designed for the countries worst affected by the crisis, whilst the intended “patients” defer and thereby give their banks significant

“competitive advantages” over our own? This competitive advantage argument would seem to be based on two assumptions.

First that US and EU global banks (i.e. those banks that could realistically compete with our own) are currently holding much lower levels of capital than required by Basel 3 (and hence will have a genuine cost advantage);

and second that our banks will, come 1 January 2013, have to hold more capital than they currently hold (and hence will incur additional cost).

Are these assumptions correct? Well even though adoption of Basel 3 is delayed in the US and the EU, this certainly does not mean that banks in these regions remain at their

pre-crisis capital levels. There has been significant re-capitalisation.

The Dodd Frank Wall Street Reform and Consumer Protection Act in the US already requires the regulatory agencies to conduct stress-testing programmes to ensure banks and other systemically important financial institutions have enough capital to weather severe financial conditions

and, even before the passage of the Dodd Frank Act, the US Federal Reserve Board put some of the largest US bank holding companies through stress-tests, the results of which have led to significant increases in capital.


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By 2012, the 19 bank holding companies subject to the Fed’s Comprehensive Capital Analysis and Review had increased their

aggregate tier 1 common capital to US$803 billion in the second quarter of the year from US$420 billion in the first quarter of 2009, with their tier 1 common capital ratio (which compares high quality capital to assets weighted according to their riskiness) doubling to a weighted average of

10.9% from 5.4%. In the EU, under a recapitalisation exercise in 2011 that covered 71 of the EU’s major banks, the European Banking Authority (EBA) required most

to attain a “core tier 1 ratio” of not less than 9% by the end of June 2012. In October 2012, the EBA indicated that it will focus on capital conservation to “support a smooth convergence to the CRD IV…..

regulatory requirements” and require the banks to maintain an absolute amount of core tier 1 capital corresponding to the level of the 9% core tier 1 ratio.

So even absent formal adoption of Basel 3, the capital levels of the largest banks in the US and the EU have increased significantly post-crisis to levels comparable with, or even in excess of, those required under Basel 3 and so the prospect of such banks “competing” by being allowed to

maintain much lower capital levels than Basel 3 banks would seem more apparent than real. Turning to the second “competitive” assumption, will the first phase of

Basel 3, which starts next year, require local banks to hold significantly more capital than they do at present, to the extent that they may become constrained in their ability to lend and compelled to pass on the costs of the extra capital to borrowers?

Well, the results of the HKMA’s quantitative impact studies tell us that our local banks are already very well-placed to meet the new Basel 3 capital ratios.


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Their capital levels are already in excess of the standard taking effect on 1 January 2013 and the issuance of ordinary shares (common equity)

already accounts for a very significant proportion of their capital base, positioning them well for Basel 3’s new focus on common equity as the highest quality capital for the purpose of loss absorption.

In summary then, irrespective of any delay in formal implementation of Basel 3, major banks in the US and EU are inexorably moving to higher levels of capital.

This, together with the benefits offered by Basel 3 and the relative ease with which local banks can comply, serves to underpin our view that we should proceed to implement the first phase of Basel 3 in line with the Basel Committee’s timeline.

Generally speaking, jurisdictions in Asia have in the past tended to adopt regulations that are in some respects higher than the Basel Committee’s minimum standards.

This may have helped Asia weather the global financial crisis relatively unscathed when compared with the jurisdictions worst affected.

There would, therefore, seem little to be gained from seeking to engage in, or indeed prompt, a “race-to-the-bottom” in regulatory terms by deliberately delaying the introduction of Basel 3 at this point in time.

In implementing on 1 January 2013, we will be fulfilling our commitment both as an international financial centre which customarily adopts best international standards and as a member of the Basel Committee on Banking Supervision.

Karen Kemp Executive Director (Banking Policy)


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Governor Daniel K. Tarullo At the Yale School of Management Leaders Forum,

New Haven, Connecticut

Regulation of Foreign Banking Organizations

In the aftermath of the financial crisis, regulators around the world continue to implement reforms designed to limit the incidence and severity of future crises.

My subject today pertains to an area in which reforms have yet to be

made--the regulation of the U.S. operations of large foreign banks.

Applicable regulation has changed relatively little in the last decade,

despite a significant and rapid transformation of those operations, as foreign banks moved beyond their traditional lending activities to engage in substantial, and often complex, capital market activities.

The crisis revealed the resulting risks to U.S. financial stability.

In taking a fresh look at regulation of foreign banks in the United States, I by no means want to imply that the United States should revoke its

welcome to foreign banks.

On the contrary, this reconsideration reflects the important role foreign

banks have played.

The presence of foreign banks can bring particular competitive and

countercyclical benefits because foreign banks often expand lending in the United States when U.S. banking firms labor under common domestic strains.

But just as we are adapting our regulatory approach to U.S. banks, so we

need to incorporate important lessons learned from the crisis into our oversight program for foreign banks.

The question of how best to regulate foreign banks is hardly a new one,

either here or in other countries.


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Debates over the relative merits of territorial versus global or mutual recognition approaches, the difficulties in achieving strictly equal terms

of competition between banks with different home regulatory systems, and the degree to which harmonization of international standards and supervisory consultations can mitigate the resulting inconsistencies and frictions are all familiar topics to academics, banking lawyers, and

supervisory authorities.

While I do not aim to resolve this afternoon the complicated interaction

among these perspectives and considerations, I will try to outline a practical and reasonable way forward.

To be effective, a new approach must address the vulnerabilities that have been created by the shift in foreign bank activities, in keeping with sound prudential policy and congressional mandates in the Dodd-Frank Wall

Street Reform and Consumer Protection Act.

At the same time, a modified regulatory system should maintain the

principle of national treatment and allow foreign banks to continue to operate here on an equal competitive footing, to the benefit of the U.S. banking system and the U.S. economy generally.

Foreign Bank Regulation in the United States

Regulating the U.S. operations of foreign banks presents unique challenges.

Although U.S. supervisors have full authority over the local operations of foreign banks, we see only a portion of a foreign bank's worldwide

activities, and regular access to information on its global activities can be limited.

Foreign banks operate under a wide variety of business models and

structures that reflect the legal, regulatory, and business climates in the home and host jurisdictions in which they operate.

Despite these difficulties, the United States has traditionally accorded foreign banks the same national treatment as domestic banks, and U.S.

regulators generally have allowed foreign banks to choose among


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structures that they believe promote maximum efficiency at the consolidated level.

Under the statutory scheme established by Congress, permissible U.S. structures include cross-border branching and direct and indirect

subsidiaries, provided that they operate in a safe and sound manner.

U.S. law also allows well-managed and well-capitalized foreign banks to

conduct a wide range of bank and nonbank activities in the United States under conditions comparable to those applied to U.S. banking organizations.

Still, it is worth noting that even as there has been continuity in this basic

policy, U.S. regulation of foreign banks has evolved over the years in response to changes in the extent and nature of foreign bank activities. Let me mention two examples.

Before 1978, foreign bank branches in the United States were licensed and regulated by individual states, with little in the way of federal regulation or restrictions.

They were not subject to the full panoply of limitations on interstate

banking, equity investments, or affiliations with securities firms that were applicable to domestic banks.

The rapid growth of foreign banking in the 1970s, particularly branching,

prompted an end to this lighter regulatory regime.

The International Banking Act of 1978 gave the Federal Reserve Board regulatory authority over the domestic operations of foreign banks and significantly equalized regulatory treatment of foreign and domestic

firms.

Congress maintained this approach of basic competitive equality in the

1999 Gramm-Leach-Bliley Act.

That law substantially removed restrictions on affiliations between

commercial banks and other kinds of financial firms for both domestic and foreign institutions operating in the United States.


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Moreover, in light of provisions in Gramm-Leach-Bliley that permitted a foreign bank to be a financial holding company (FHC), the Federal

Reserve announced in 2001 that a bank holding company (BHC) in the United States that was owned and controlled by a well -capitalized and well-managed foreign bank generally would not be required to meet the Board's capital requirements normally applicable to BHCs.

My second example relates to the massive fraud uncovered at the Bank of Credit and Commerce International (BCCI) and its subsequent collapse

in 1991, which highlighted the need for more effective supervision of banks operating in multiple countries.

The Foreign Bank Supervision Enhancement Act of 1991 (FBSEA) required foreign banks to receive approval from the Board before establishing a branch or agency in the United States.

The law required the Federal Reserve, in turn, to determine that the

foreign bank is subject to "comprehensive supervision or regulation on a consolidated basis" in its home country before approving an application either to open a branch or to acquire a U.S. subsidiary bank.

It is further worth noting that changes in U.S. law and regulatory practice affecting foreign banking organizations have often corresponded to changes in international regulatory agreements.

For example, FBSEA was enacted at the same time as the Basel

Committee on Banking Supervision was working to address the problems revealed by BCCI--an effort that bore fruit the next year in changes to the so-called Basel Concordat, which established minimum standards for the supervision of international banking groups.

Another instance was the substantial reduction or removal of remaining

asset-pledge and asset-maintenance requirements for most U.S. branches of foreign banks, prompted in part by implementation of the new international capital standards included in the 1988 Basel Accord.


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The Shift in Foreign Bank Activities

Although foreign banks expanded steadily in the United States during the

1970s, 1980s, and 1990s, their activities here posed limited risks to overall U.S. financial stability.

Throughout this period, the U.S. operations of foreign banks were largely net recipients of funding from their parents and generally engaged in

traditional lending to home-country and U.S. clients.

U.S. branches and agencies of foreign banks held large amounts of cash

during the 1980s and '90s, in part to meet asset-maintenance and asset-pledge requirements put in place by regulators.

Their cash-to-third-party liability ratio from the mid-1980s through the late 1990s generally ranged between 25 percent and 30 percent.

The U.S. branches and agencies of foreign banks that borrowed from their parents and lent those funds in the United States ("lending

branches") held roughly 60 percent of all foreign bank branch and agency assets in the United States during the 1980s and '90s.

Commercial and industrial lending continued to account for a large part

of foreign bank branch and agency balance sheets through the 1990s.

This profile of foreign bank operations in the United States changed in the run-up to the financial crisis.

Reliance on less stable, short-term wholesale funding increased significantly.

Many foreign banks shifted from the "lending branch" model to a

"funding branch" model, in which U.S. branches of foreign banks were borrowing large amounts of U.S. dollars to upstream to their parents.

These "funding branches" went from holding 40 percent of foreign bank

branch assets in the mid-1990s to holding 75 percent of foreign bank branch assets by 2009.


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Foreign banks as a group moved from a position of receiving funding from their parents on a net basis in 1999 to providing significant funding

to non-U.S. affiliates by the mid-2000s--more than $700 billion on a net basis by 2008.

A good bit of this short-term funding was used to finance long-term, U.S.

dollar-denominated project and trade finance around the world.

There is also evidence that a significant portion of the dollars raised by European banks in the pre-crisis period ultimately returned to the United States in the form of investments in U.S. securities.

Indeed, the amount of U.S. dollar-denominated asset-backed securities

and other securities held by Europeans increased significantly between 2003 and 2007, much of it financed by the short-term, dollar-denominated liabilities of European banks.

Meanwhile, commercial and industrial lending originated by U.S. branches and agencies as a share of their third-party liabilities fell significantly after 2003.

In contrast, U.S. broker-dealer assets of the top-10 foreign banks

increased rapidly during the past 15 years, rising from 13 percent of all foreign bank third-party assets in 1995 to 50 percent in 2011.

Lessons from the Recent Financial Crisis

The 2007–2008 financial crisis and the continuing financial stress in

Europe have revealed financial stability risks associated with the foreign banking model as it has evolved in the United States.

To some extent the concerns associated with foreign banking operations track the more general shortcomings of pre-crisis financial regulation.

Internationally agreed minimum capital levels were too low, the quality standards for required capital were too weak, the risk weights assigned to

certain asset classes did not reflect their actual risk, and the potential for liquidity strains was seriously underappreciated.


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But some risks are more closely tied to the specifically international character of certain global banks, both here and in some other parts of the

world.

The location of capital and liquidity proved critical in the resolution of

some firms that failed during the financial crisis.

Capital and liquidity were in some cases trapped at the home entity, as in

the case of the Icelandic banks and, in our own country, Lehman Brothers.

Actions by home-country authorities during this period showed that while a foreign bank regulatory regime designed to accommodate centralized

management of capital and liquidity can promote efficiency during good times, it also increases the chances of ring-fencing by home and host jurisdictions at the moment of a crisis, as local operations come under severe strain and repayment of local creditors is called into question.

Resolution regimes and powers remain nationally based, complicating the resolution of firms with large cross-border operations.

The large intra-firm, cross-border flows that grew rapidly in the years

leading up to the crisis also created vulnerabilities.

To be fair, the ability to move liquidity freely throughout a banking group

may have provided some financial stability benefits during the crisis by enabling banks to respond to localized balance-sheet shocks and dysfunctional markets in some areas (such as the interbank and foreign

exchange swap markets) and by transferring resources from healthier parts of the group.

Nevertheless, this model also created a degree of cross-currency funding

risk and heavy reliance on swap markets that proved destabilizing.

Moreover, foreign banks that relied heavily on short-term, U.S. dollar liabilities were forced to sell U.S. dollar assets and reduce lending rapidly when that funding source evaporated, thereby compounding risks to U.S.

financial stability.


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Although the United States did not suffer a destabilizing failure of foreign banks, many rode out the crisis only with the help of extraordinary

support from home- and host-country regulators.

Following national treatment practice, the Federal Reserve itself provided

substantial discount window access to U.S. branches and the opportunity to participate in the Primary Dealer Credit Facility to U.S. primary-dealer subsidiaries of foreign banks.

Moreover, the potential for funding disruptions did not disappear with the waning of the global financial crisis.

In 2011, for example, as concerns about the euro zone rose, U.S. money

market funds suddenly pulled back their lending to large euro area banks, reducing lending to these firms by roughly $200 billion over just four months.

While there has been some reduction in operations and some change in funding patterns by foreign banking organizations in the United States since the crisis, particularly by European firms reacting to euro zone

financial stress, the basic circumstances have not changed.

The proportion of foreign banking assets to total U.S. banking assets has

remained at about one-fifth since the end of the 1990s.

But the concentration and complexity of those assets have changed

noticeably from earlier decades, and have not reversed in recent years despite the global financial crisis and subsequent events.

Ten foreign banks now account for more than two-thirds of foreign bank third-party assets held in the United States, up from 40 percent in 1995.

And while the largest U.S. operations of foreign banks do not approach

the size of our largest domestic financial institutions, it is striking that there are 23 foreign banks with at least $50 billion in assets in the United States--the threshold established by the Dodd-Frank Act for special prudential measures for domestic firms--compared with 25 U.S. firms.


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Most notably, perhaps, five of the top-10 U.S. broker-dealers are owned by foreign banks.

Like their U.S.-owned counterparts, large foreign-owned U.S. broker-dealers were highly leveraged in the years leading up to the crisis.

Their reliance on short-term funding also increased, with much of the

expansion of both U.S.-owned and foreign-owned U.S. broker-dealer activities attributable to the growth in secured funding markets during the past 15 years.

Finally, we should note that one of the fundamental elements of the current approach--our ability, as host supervisors, to rely on the foreign

bank to act as a source of strength to its U.S. operations--has come into question in the wake of the crisis.

The likelihood that some home-country governments of significant

international firms will backstop their banks' foreign operations in a crisis appears to have diminished.

It also appears that constraints have been placed on the ability of the home offices of some large international banks to provide support to their

foreign operations.

The motivations behind these actions are not hard to understand and

appreciate, but they do affect the supervisory terrain for host countries such as the United States.

International and Domestic Regulatory Response

Since the crisis, important changes have been made to strengthen

international regulatory standards.

The Basel III capital and liquidity frameworks are big improvements, and

the proposed capital surcharges for systemically important firms will be another important step forward.


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But these reforms are primarily directed at the consolidated level , with little attention to vulnerabilities posed by internationally active banks in

host markets.

The risks associated with large intra-group funding flows have remained

largely unaddressed.

Managing international regulatory initiatives also has become more

difficult, as the number of complex items on the agenda has increased.

And despite continued work by the Financial Stability Board, challenges

to cross-border resolution are likely to remain significant.

For the foreseeable future, then, our regulatory system must recognize that while internationally active banks live globally, they may well die locally.

Quite apart from the need to act pragmatically under the circumstances,

it is not clear that we should aim toward extensive harmonization of national regulatory practices related to foreign banking organizations.

The nature and extent of foreign banking activities vary substantially

across national markets, suggesting that regulatory responses might best vary as well.

For instance, the importance of the U.S. dollar in many international transactions can motivate foreign banks to use their U.S. operations to

raise dollar funding for their international operations, potentially creating vulnerabilities.

Such a model is unlikely to prevail in most other host financial markets around the world.

Indeed, in response to financial stability risks highlighted during the crisis, ongoing challenges associated with the resolution of large

cross-border firms, and the limitations of the international reform agenda, several national authorities have already introduced their own policies to fortify the resources of internationally active banks within their geographic boundaries.


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Regulators in the United Kingdom, for example, have recently increased requirements for liquidity to cover local operations of domestic and

foreign banks, set stricter rules around intra-group exposures of U.K. banks to foreign subsidiaries, and moved to ring-fence home-country retail operations.

Meanwhile, Swiss authorities have explicitly prioritized the domestic systemically important operations of their large, internationally active firms in resolution.

Here in the United States, Congress included in the Dodd-Frank Act a

number of changes directed at the financial stability risk posed by foreign banks.

Sections 165 and 166 instruct the Federal Reserve to implement enhanced

prudential standards for large foreign banks as well as for large domestic BHCs and nonbank systemically important financial institutions.

Dodd-Frank also bolstered capital requirements for FHCs, including foreign FHCs, by extending the well-capitalized and well-managed

requirements beyond U.S. bank subsidiaries to the top-tier holding company.

In addition, the so-called Collins Amendment in Dodd-Frank removed the exemption from BHC capital requirements granted by the Federal Reserve's Supervision and Regulation Letter 01-01.

The required phase-out of SR 01-01 was clearly intended to strengthen the

capital regime applied to the U.S. operations of foreign banks; however, the organizational flexibility that the amendment gave to foreign banks in the United States has allowed some large foreign banks to restructure their U.S. operations to minimize the impact of this regulatory change.

As a result, in the absence of additional structural requirements for foreign banks in the United States, the effectiveness of our capital regime

for large foreign banks with both bank and nonbank operations in the United States depends on the foreign bank's own organizational choices.


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A Rebalanced Approach to Foreign Bank Regulation

As has been the case in the past, we need to adjust the regulatory

requirements for foreign banks in response to changes in the nature of their activities in the United States, the risks attendant to those changes, and instructions from Congress in new statutory provisions.

The modified regime should counteract the risks posed to U.S. financial

stability by the activities of foreign banking organizations, as manifested in the years leading up to, and through, the financial crisis.

Special attention must be paid to the risk of runs associated with

significant reliance on short-term funding.

In addition, the regime should reduce the difficulties in resolution of cross-border firms.

Finally, it should take steps to diminish the potential need for ex-post ring-fencing when losses mount or runs develop during a crisis, since

such actions may well be unhelpfully procyclical.

At the same time, in modifying our regulatory regime for foreign banking

organizations, we must remain mindful of the benefits that foreign banks can bring to our economy and of the important policies of national treatment and comparable competitive opportunity.

Thus, we should chart a middle course, not moving to a fully territorial model of foreign bank regulation, but instead making targeted

adjustments to address the risks I have identified.

In basic terms, three such adjustments are desirable.

First, a more uniform structure should be required for the largest U.S.

operations of foreign banks--specifically, that these firms establish a top-tier U.S. intermediate holding company (IHC) over all U.S. bank and nonbank subsidiaries.


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An IHC would make application of enhanced prudential supervision more consistent across foreign banks and reduce the ability of foreign

banks to avoid U.S. consolidated-capital regulations.

Because U.S. branches and agencies are part of the foreign parent bank,

they would not be included in the IHC.

However, they would be subject to the activity restrictions applicable to

branches and agencies today as well as to certain additional measures discussed below.

Second, the same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs.

These rules have been reshaped to counteract the risks to the U.S. financial system revealed by the crisis and should be implemented

consistently across all firms that engage in similar activities.

Similarly, other enhanced prudential standards required by the

Dodd-Frank Act--including stress testing requirements, risk management requirements, single counterparty credit limits, and early remediation requirements--should be applied to the U.S. operations of

large foreign banks in a manner consistent with the Board's domestic proposal.

Third, there should be liquidity standards for large U.S. operations of

foreign banks.

Standards are needed to increase the liquidity resiliency of these operations during times of stress and to reduce the threat of destabilizing runs as dollar funding channels dry up and short-term debt cannot be

rolled over.

For IHCs, the standards should be broadly consistent with the standards

the Federal Reserve has proposed for large domestic BHCs, pending final adoption and phase-in of quantitative liquidity requirements by the Basel Committee.


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That is, they should be designed to ensure that, in stressed circumstances, the U.S. operations have enough high-quality liquid

assets to meet expected net outflows in the short term.

There should also be liquidity standards for foreign bank branch and

agency networks in the United States, although they may be less stringent, in recognition of the integration of branches and agencies into the global bank as a whole.

By imposing a more standardized regulatory structure on the U.S. operations of foreign banks, we can ensure that enhanced prudential

standards are applied consistently across foreign banks and in comparable ways between U.S. banking organizations and foreign banking organizations.

As with domestic firms subject to enhanced prudential standards, the Federal Reserve would work to ensure that the new regime is minimally

disruptive, through transition periods and other means.

An IHC structure would also provide the Federal Reserve, as umbrella

supervisor of the U.S. operations of foreign banks, with a uniform platform to implement a consistent supervisory program across large foreign banks.

In the case of foreign banks with the largest U.S. operations, the IHC would also help mitigate resolution difficulties by providing U.S.

regulators with one consolidated U.S. legal entity to place into receivership under title II of the Dodd-Frank Act if the failure of the foreign bank would threaten U.S. financial stability.

Branches and agencies would remain separate, but all other entities would be included.

Further, an IHC structure would facilitate a consistent U.S. capital regime for bank and nonbank activities of foreign banks under the IHC,

similar to the approach taken in other jurisdictions, such as the United Kingdom and some continental European countries.


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Some observers will, I am sure, ask if it is necessary to depart from the prevailing firm-by-firm approach to foreign banking regulation and to

adopt generally applicable requirements in implementing the Dodd-Frank enhanced prudential standards for foreign banks.

It is difficult to see how reliance on this approach can be effective in

addressing risks to U.S. financial stability, at least in the absence of extraterritorial application of our own standards and supervision, and perhaps not even then.

We would, at a minimum, need to make regular and detailed assessments

of each firm's home-country regulatory and resolution regimes, the financial stability risk posed by each firm in the United States, and the financial condition of the consolidated banking organization.

In fact, such an approach might result in the worst of both worlds--an ongoing intrusiveness into the consolidated supervision of foreign banks

by their home-country regulators without the ultimate ability to evaluate those banks comprehensively or to direct changes in a parent bank's practices necessary to mitigate risks in the United States.

Although the Federal Reserve will continue to cooperate with its foreign counterparts in overseeing large, multinational banking operations, that supervisory tool cannot provide complete protection against risks

engendered by U.S operations as extensive as those of many large U.S. institutions.

It is also important to note that while the reforms I have described today contain some elements that are more territorial than our current approach, including requiring some additional capital and liquidity

buffers to be held in the United States, they do not represent a complete departure from prior practice.

This enhanced approach would allow foreign banks to continue to

operate branches in the United States and would generally allow branches to meet comparable capital requirements at the consolidated level.


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Similarly, this approach would not impose a cap on intra-group flows, thereby allowing foreign banks in sound financial condition to continue

to obtain U.S. dollar funding for their global operations through their U.S. entities.

It would instead provide an incentive to term out at least some of this

funding in a way that reduces the risk of runs.

Requiring additional local capital and liquidity buffers, like any prudential regulation, may incrementally increase cost and reduce flexibility of internationally active banks that manage their capital and

liquidity on a centralized basis.

However, managing liquidity and capital on a local basis can have

benefits not just for financial stability generally, but also for firms themselves.

During the crisis, the more decentralized global banks relied somewhat less on cross-currency funding and were less exposed to disruptions in international wholesale funding and foreign exchange swap markets than

the more centralized banks.

Indeed, as noted earlier, in the wake of the crisis and of subsequent

stresses, many foreign banks have modified their funding practices and business models.

In revamping our approach, we will both be guarding against a return to pre-crisis practices and, more generally, ensuring that foreign banking

operations in the United States that pose potential risks to U.S. financial stability are regulated similarly to domestic banking operations posing similar risks.

Conclusion

The imperative for change in our foreign bank regulation is clear and,

indeed, mandated by Dodd-Frank.

Of course, I have provided only an outline of the three key measures that

will best navigate the middle course I have suggested.


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The all-important details are under discussion at the Board.

I anticipate that in the coming weeks we will complete our work and issue a notice of proposed rulemaking that will elaborate the basic approach I have foreshadowed.

I look forward to hearing your general reactions today and more specific

feedback after the Board has adopted a proposed rule.


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Opportunities facing Islamic finance and challenges in managing capital flows in Asia Outline of special address by Mr Tharman

Shanmugaratnam, Chairman of the Monetary Authority of Singapore, at the 8th World Islamic Economic Forum, Johor Bahru, Malaysia

The Prime Minister of Malaysia, His Excellency Dato’ Sri Najib Tun Razak, The President of Comoros, His Excellency Ikililou Dhoinine, The President of the Islamic Development Bank, His

Excellency Ahmad Mohamed Ali, Chairman of the World Islamic Economic Forum Foundation Tun Musa Hitam Ministers and distinguished guests, Ladies and gentlemen

Introduction It is my pleasure to be here today and have the opportunity to share some thoughts. Let me first congratulate the WIEF on the progress it has made in

establishing itself as a leading international forum for economic leaders and opinion shapers from a broad range of countries to discuss issues of interest in Islamic Finance and related themes in global finance.

The theme of the Forum, “Changing Trends, New Opportunities” is particularly relevant. Allow me to first offer a brief perspective on opportunities facing Islamic

finance. I will then go on to talk about the challenges we face in Asia in managing capital flows in the aftermath of the Global Financial Crisis.


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Islamic finance: opportunities for growth The Islamic finance industry is estimated to have grown by some 19% per year since 2006 – to record nearly US$1.3 trillion of total shariah compliant

assets in 2012. But there is still considerable scope for its development:

• Islamic finance presently forms less than 1% the global financial industry. • For a large number of countries, even in jurisdictions with substantial

Muslim populations, Islamic finance currently constitutes less than 5% of their financial sector. • And despite a record level of sukuk issuance in 2012, the industry as a

whole is still largely concentrated on the banking sector. There is much ahead in the journey to develop Islamic capital markets and the takaful (Islamic insurance) industry.

I believe the next 10–15 years offer significant opportunities for the growth and diversification of Islamic finance.

Let me highlight the reasons to be optimistic about its prospects: • First, Islamic financial institutions have in the main escaped significant damage in the global financial crisis.

They are well-placed to grow, at a time when many of the global banks, especially the European banks, are deleveraging or focusing on consolidating their balance sheets.

• Second, Islamic finance has much potential to diversify into new growth areas such as trade and infrastructure financing in Asia and the emerging markets.


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These new areas will allow Islamic banks to reduce their exposure to the real estate sector, and to take advantage of the stronger growth potential

of the emerging market economies. There are gaps to be filled in structured trade finance and in funding for infrastructural projects as the emerging markets grow, and as global

finance consolidates. • Third, Islamic finance can also seek to meet the increased demand for simpler and more transparent products and ‘back-to-basics’ finance.

Investors are now much more circumspect about complex products and their risks.

The crisis taught investors worldwide not only about the damage they can face from the risks that are known and unsurprising, but of the risks of ‘what we do not know’.

Islamic finance, with its focus on transparency, price certainty and risk-sharing, can ride this wave of demand for simpler and more basic investments.

However, Islamic finance will have to overcome a few important challenges in order to grow its share in global finance and contribute to cross-border finance.

These include the need to reduce fragmentation in Islamic finance markets due to differences in accepted standards of Shariah compliance between regions, jurisdictions, and in some cases even domestically within jurisdictions.

This has hampered the flow of liquidity between jurisdictions, and is in part why there is yet no Islamic equivalents to the international money and bond markets.

There is considerable progress being made to address these challenges.


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Bodies such as AAOIFI, IDB’s Islamic Research & Training Institute, and Malaysia’s International Shariah Research Academy (ISRA) have

made significant efforts to narrow the differences in acceptability of Shariah compliance. The Islamic Financial Services Board (IFSB), in conjunction with

international standards setting bodies such as the Bank of International Settlements (BIS), IOSCO and IAIS and various regulators from Islamic and conventional jurisdictions, are also formulating international standards and best practices for the industry.

Islamic finance is also seeing increasing interest in Asia. We are seeing financial institutions leveraging on the strengths and

expertise that have been developed in both Islamic and conventional financial markets. This is expanding the range of Shariah-compliant products and allowing

the Islamic finance industry to tap on broad and deep investor pools globally and in Asia. • Malaysia is widely recognised as a leader in Islamic finance, in

particular for the issuance of sukuks. • Islamic finance is also seeing growing interest in other Asian financial centres such as Singapore, Hong Kong and Tokyo.

• Just recently in mid-November 2012, institutional and private investors in Singapore and HK were the largest investors in the US$15.5 billion global sukuk issued by the Abu Dhabi Islamic Bank (ADIB).

• Between our two countries, we are seeing Malaysian banks collaborating with Singapore corporates and financial players to structure S$ denominated corporate sukuk programmes.


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And Singapore-listed companies are venturing out to tap the Ringgit sukuk market in Malaysia.

These are trends that we are keen to encourage. To repeat therefore, I am optimistic that we can realise the significant

growth potential for Islamic finance in the next 10–15 years.

Managing the challenge of capital flows in the post-crisis era Let me move on now to say a few things about the challenges that many in the emerging world face in managing capital flows, particularly in the

face of the extremely low interest rates being set in the advanced economies (AEs). We are in an unprecedented situation.

Interest rates are expected to stay extremely low in the US and much of the advanced world for a few years, reflecting decisions by their central banks to keep monetary conditions highly accommodative until their

economies resume normal growth. There is debate among economists on how effective these activist monetary policies, such as the US Fed’s QE3 strategy, will be in reviving

entrepreneurial spirits and rivate investments. If the strategy succeeds and the US economy recovers, it will be a plus for Asia as well.

In the meantime, however, there are significant implications for emerging market economies, as global investors search for better returns – better than the near-zero rates they get on cash and treasury bills.

With large amounts of liquidity now moving between markets, short-term shifts in investor sentiment leads to volatility in capital flows.


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We have seen how a shock in the European periphery can send money that was invested in emerging markets rushing back to the US or other

safe havens. To be clear about it, there is a lot that is good about capital flows, including even short term flows.

They add liquidity to markets, by bringing more buyers and sellers together.

However, we know too that capital inflows can also be too much of a good thing. They can lead to asset prices, or exchange rates, becoming disconnected

from fundamentals. And the sudden withdrawal of capital from emerging economies when investors switch from ‘risk on’ to ‘risk off’ in their portfolios can be

destabilising. As I mentioned, the current global condition is unprecedented.

The policy responses in the advanced countries too are without precedent. Globally therefore, we need some humility in understanding the benefits

and costs of QE3 and easy monetary policies in the advanced countries. But it will be wise to strengthen our policy toolkits in Asia, so that we can deal with unpredictable and often excessive capital flows.

There are some lessons that come out of our experiences in Asia and elsewhere, and policy responses that we can learn from each other.

I will mention three sets of policy responses that will inevitably have to figure in our toolkits.


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First, there is much sense in curtailing volatility in the exchange rate over the short-term.

The costs of volatile and uncertain exchange rates are high in small open economies especially – which is what most of our ASEAN economies are. Accordingly, Malaysia, Singapore and several other Asian countries have

not felt comfortable leaving their exchange rates entirely to market forces. Their central banks, within each of their monetary policy frameworks, have sought to instil a focus on longer term fundamentals.

There is merit in allowing exchange rates in Asia’s emerging economies to appreciate gradually over the long term, reflecting their more rapid growth.

If we resist these long term trends, we are likely to see more inflation in our economies.

But some stability in the short term is wise. Second, macro-prudential policies are now an important part of the policy tool kit.

Many Asian countries have introduced new macro-prudential measures to try and avoid bubbles in their property markets over the last two years.

Malaysia brought in stricter limits on loan-to-value ratios on housing loans. Singapore and Hong Kong have done similarly, and have introduced

additional stamp duties or transaction taxes to discourage speculative demand for residential properties. These targeted administrative and prudential measures are not

conventional macro-economic tools.


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But they are likely to remain part of our policy toolkit, at least for the foreseeable future, given the real risks to macro-economic stability

that an environment of very low global interest rates poses. A third and more fundamental strategy has to focus on building greater depth in Asia’s capital markets, while ensuring that our banking systems

remain sound. A good example of this strategy is in fact in Malaysia.

Bank Negara’s Financial Sector Blueprint II (2012–2020), released as part of the government’s Economic Transformation Programme (ETP), will build on the solid foundations of Malaysia’s financial system, including developing a deep and vibrant bond market.

The banks in several leading Asian countries, including Malaysia and Singapore, are generally well-managed and well-capitalised.

They were a source of strength for us during the global financial crisis. However, Asia’s capital markets, and especially the corporate bond markets, need much more depth.

Broader and deeper capital markets will allow investors to invest for the long term while hedging against risks.

They will help us meet the growing infrastructural and other long term investment needs of the region. This is therefore a very important priority in the region, and there is in fact

significant scope for future development of Asian capital markets. Regulators are working to harmonise rules and market practices across the region, such as issuance procedures and settlement standards.


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We also need to develop the securitisation markets, with appropriate safeguards, so that banks can recycle their capital.

More too is being done to boost linkages between our markets and economies.

We have to pool liquidity across our markets, so as to add depth to the Asian capital market. An example is how the Malaysian stock exchange, Bursa Malaysia, the

Singapore Exchange and the Stock Exchange of Thailand recently launched an ASEAN Trading Link. We are also cooperating to encourage financing for infrastructure projects

in the region. The ASEAN Infrastructure Fund (AIF), an initiative that was led by Malaysia, is a good example.

It will pool resources, knowledge and experience among ASEAN governments and the Asian Development Bank (ADB) for loans to sovereign or sovereign-guaranteed infrastructure projects.

The Fund will also issue bonds, so as to bring in private sector and institutional investors.

Another example of such cooperation in the region is the Credit Guarantee and Investment Facility (CGIF) amongst the ASEAN+3 countries, which aims to help companies in ASEAN+3 countries raise long term financing for infrastructure investment by providing the

governments’ guarantees on their corporate bonds, thereby reducing risk for bond-holders. Projects such as Iskandar Malaysia are also a prime example of how

intra-regional investments can be encouraged, and how countries in our region can develop competitive strengths jointly.


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• Iskandar Malaysia’s performance has been impressive – poised to exceed its targeted RM100 billion investment mark by the end of this year.

• I am glad there is good progress on the joint venture by Temasek Holdings and Khazanah Nasional, Pulau Indah Ventures Sdn Bhd to co-develop two separate sites in Medini.

• Other significant projects include a S$1.5 billion integrated eco-friendly tech-park by Ascendas and Malaysia’s UEM Land Berhad in Nusajaya (one of the five flagship zones in Iskandar).

Once completed, the park will accommodate a range of industries including electronics and precision engineering. • Just in the last month, we have seen other significant investment

commitments in Iskandar reported by Singapore companies. Iskandar Malaysia will enhance the complementary space between our two economies.

It is a win-win. To ensure continued progress in Iskandar, Singapore and Malaysia will

continue to take steps to improve connectivity, cross-border trade facilitation, and immigration processes.

Conclusion I would like to conclude by emphasising once again that I am basically

optimistic about the prospects in our bilateral and regional cooperation. We face many challenges in this post-Global Financial Crisis era.

But the opportunities for us in Asia are intact, and our ability to cooperate with each other to achieve our full potential as a region is an asset for all our countries.


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Resolving Globally Active, Systemically Important, Financial Institutions A joint paper by the Federal Deposit Insurance Corporation and the Bank

of England

Resolving Globally Active, Systemically Important, Financial Institutions Federal Deposit Insurance Corporation and the Bank of England

Executive summary The financial crisis that began in 2007 has driven home the importance of an orderly resolution process for globally active, systemically important,

financial institutions (G-SIFIs). Given that challenge, the authorities in the United States (U.S.) and the United Kingdom (U.K.) have been working together to develop resolution

strategies that could be applied to their largest financial institutions. These strategies have been designed to enable large and complex cross-border firms to be resolved without threatening financial stability

and without putting public funds at risk. This work has taken place in connection with the implementation of the G20 Financial Stability Board’s Key Attributes of Effective Resolution

Regimes for Financial Institutions. The joint planning has been productive and effective.

It has enhanced the resolution planning process in both jurisdictions, tackled key issues in relation to cross-border coordination, and identified potential challenges that will be addressed through further work.


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This paper focuses on the application of “top-down” resolution strategies that involve a single resolution authority applying its powers to the top of

a financial group, that is, at the parent company level. The paper discusses how such a top-down strategy could be implemented for a U.S. or a U.K. financial group in a cross-border context.

In the U.S., the strategy has been developed in the context of the powers provided by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Such a strategy would apply a single receivership at the top-tier holding company, assign losses to shareholders and unsecured creditors of the holding company, and transfer sound operating subsidiaries to a new

solvent entity or entities. In the U.K., the strategy has been developed on the basis of the powers provided by the U.K. Banking Act 2009 and in anticipation of the further

powers that will be provided by the European Union Recovery and Resolution Directive and the domestic reforms that implement the recommendations of the U.K.

Independent Commission on Banking. Such a strategy would involve the bail-in (write-down or conversion) of creditors at the top of the group in order to restore the whole group to solvency.

Both the U.S. and U.K. approaches ensure continuity of all critical services performed by the operating firm(s), thereby reducing risks to financial stability.

Both approaches ensure activities of the firm in the foreign jurisdictions in which it operates are unaffected, thereby minimizing risks to cross-border implementation.

The unsecured debt holders can expect that their claims would be written down to reflect any losses that shareholders cannot cover, with some


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converted partly into equity in order to provide sufficient capital to return the sound businesses of the G-SIFI to private sector operation.

Sound subsidiaries (domestic and foreign) would be kept open and operating, thereby limiting contagion effects and cross-border complications.

In both countries, whether during execution of the resolution or thereafter, restructuring measures may be taken, especially in the parts of the business causing the distress, including shrinking those businesses, breaking them into smaller entities, and/or liquidating or closing certain

operations. Both approaches would be accompanied by the replacement of culpable senior management.

This paper outlines several common considerations that affect these particular approaches to resolution in the U.S. and the U.K., including the need to ensure sufficient loss absorbency at the top of the group.

The Federal Deposit Insurance Corporation and the Bank of England will continue to work together on these resolution strategies. Resolving Globally Active, Systemically Important, Financial Institutions, Federal Deposit Insurance Corporation and the Bank of England Introduction 1 The Federal Deposit Insurance Corporation (FDIC) and the Bank of

England—together with the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, and the Financial Services Authority—have been working to develop resolution strategies for the failure of globally active, systemically important, financial

institutions (SIFIs or G-SIFIs) with significant operations on both sides of the Atlantic.


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This work has taken place in connection with the implementation of the Financial Stability Board’s (FSB) Key Attributes of Effective Resolution

Regimes for Financial Institutions (Key Attributes), as well as in connection with the reforms to the legal arrangements for handling the failure of financial institutions that were instituted in the United States (U.S.) and the United Kingdom (U.K.) in response to the recent financial

crisis. 2 The goal is to produce resolution strategies that could be implemented for the failure of one or more of the largest financial institutions with

extensive activities in our respective jurisdictions. These resolution strategies should maintain systemically important operations and contain threats to financial stability.

They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers.

These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.

3 As highlighted in the FSB’s recently published draft Guidance on Recovery and Resolution Planning, strategies for resolution may broadly be categorized as either applying resolution powers to the top of a group by a single national resolution authority (single point of entry), or

applying resolution tools to different parts of the group by two or more resolution authorities acting in a coordinated way (multiple points of entry).

Which strategy is most suitable to resolving the group will depend upon a range of factors. For example, a single point of entry strategy may offer the simplest and

most effective choice if the debt issued at the top of the group is sufficient to absorb the group’s losses.


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Where this is not the case, a multiple points of entry strategy will be more suitable, particularly if different parts of the group can continue on a

standalone basis. 4 The focus of this paper is on a single point of entry resolution approach.

It is hoped that the detail it provides on the single point of entry approach, when combined with the published FSB Guidance on Recovery and Resolution Planning, will give greater predictability for market participants about how resolution authorities may approach a

resolution. This predictability cannot, however, be absolute, as the resolution authorities must not be constrained in exercising discretion in pursuit of

their statutory objectives in how best to resolve a firm.

Post-crisis resolution strategy 5 The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions

that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial

operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their

subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.

6 The legislative frameworks and resolution regimes at the time were ill-suited to dealing with financial institution failures of this scale and interconnectedness.


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In the U.S., the FDIC only had the power to place an insured depository institution into receivership; it could not resolve failed or failing bank

holding companies or other nonbank financial companies that posed a systemic risk. In the U.K., until 2009 there was no special resolution regime available for

banks or other financial companies, whatever their size or complexity, and as a result the U.K. was reliant on standard insolvency procedures such as administration.

7 As demonstrated by the Title I requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the U.S. would prefer that large financial organizations be resolvable through ordinary bankruptcy.

However, the U.S. bankruptcy process may not be able to handle the failure of a systemic financial institution without significant disruption to the financial system.

8 Similarly, the U.K. administration process often takes time and involves significant uncertainty regarding the outcome.

Forcing large financial organizations through administration can create significant and systemic risks for the real economy by interrupting critical services, disrupting key financial relationships, and freezing financial markets. In addition, it can destroy value, harming the real economy.

9 Given these problems with the bankruptcy process, the U.S. and the U.K. authorities resorted to providing large scale public support to failing financial companies during the 2007-09 crisis to prevent further systemic

disruption. This public support has exposed taxpayers to loss and resulted in the bailout of multiple financial institutions and their creditors.


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10 Following the crisis, an overhaul of the framework for dealing with large and complex financial institution failures was required.

While it may be useful to strengthen the current bankruptcy code or administration rules to improve the handling of financial failures, systemic considerations warrant having an alternative resolution strategy.

11 A resolution strategy for a failed or failing G-SIFI should assign losses to shareholders and unsecured creditors, and hold management responsible for the failure of the firm.

The strategy should provide continuity of the critical services that the institution provides within the financial system and to the real economy, thereby minimizing systemic risk.

The strategy should also enable a prompt transition of the firm’s ongoing operations to full private ownership and control without taxpayer support.

Given the cross-border nature of G-SIFIs, the resolution strategy should ensure financial stability concerns are addressed across all jurisdictions in which the firm operates.

To be successful, such an approach will require close cooperation between home and foreign authorities. 12 Under the strategies currently being developed by the U.S. and the

U.K., the resolution authority could intervene at the top of the group. Culpable senior management of the parent and operating businesses would be removed, and losses would be apportioned to shareholders and

unsecured creditors. In all likelihood, shareholders would lose all value and unsecured creditors should thus expect that their claims would be written down to

reflect any losses that shareholders did not cover.


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Under both the U.S. and U.K. approaches, legal safeguards ensure that creditors recover no less than they would under insolvency.

13 An efficient path for returning the sound operations of the G-SIFI to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the

failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities.

In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved

firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution.

Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects.

Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.

Legislative frameworks for implementing the strategy 14 It should be stressed that the application of such a strategy can be achieved only within a legislative framework that provides authorities with key resolution powers.

The FSB Key Attributes have established a crucial framework for the implementation of an effective set of resolution powers and practices into national regimes.


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In the U.S., these powers had already become available under the Dodd-Frank Act.

In the U.K., the additional powers needed to enhance the existing resolution framework established under the Banking Act 2009 (the Banking Act) are expected to be fully provided by the European

Commission’s proposals for a European Union Recovery and Resolution Directive (RRD) and through the domestic reforms that implement the recommendations of the U.K. Independent Commission on Banking (ICB), enhancing the existing resolution framework established under

the Banking Act. The development of effective resolution strategies is being carried out in anticipation of such legislation.

U.S. regime 15 The framework provided by the Dodd-Frank Act in the U.S. greatly enhances the ability of regulators to address the problems of large, complex financial institutions in any future crisis.

Title I of the Dodd-Frank Act requires each G-SIFI to periodically submit to the FDIC and the Federal Reserve a resolution plan that must address the company’s plans for its rapid and orderly resolution under the U.S. Bankruptcy Code.

The FDIC and the Federal Reserve are required to review the plans to determine jointly whether a company’s plan is credible.

If a plan is found to be deficient and adequate revisions are not made, the FDIC and the Federal Reserve may jointly impose more stringent capital, leverage, or liquidity requirements, or restrictions on growth, activities, or operations of the company, including its subsidiaries.

Ultimately, the company could be ordered to divest assets or operations to facilitate an orderly resolution under bankruptcy in the event of failure.


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Once submitted and accepted, the SIFIs’ plans for resolution under bankruptcy will support the FDIC’s planning for the exercise of its

resolution powers by providing the FDIC with an understanding of each SIFI’s structure, complexity, and processes. 16 Title II of the Dodd-Frank Act provides the FDIC with new powers to

resolve SIFIs by establishing the orderly liquidation authority (OLA). Under the OLA, the FDIC may be appointed receiver for any U.S. financial company that meets specified criteria, including being in default

or in danger of default, and whose resolution under the U.S. Bankruptcy Code (or other relevant insolvency process) would likely create systemic instability.

Title II requires that the losses of any financial company placed into receivership will not be borne by taxpayers, but by common and preferred stockholders, debt holders, and other unsecured creditors, and that management responsible for the condition of the financial company will

be replaced. Once appointed receiver for a failed financial company, the FDIC would be required to carry out a resolution of the company in a manner that

mitigates risk to financial stability and minimizes moral hazard. Any costs borne by the U.S. authorities in resolving the institution not paid from proceeds of the resolution will be recovered from the industry.

U.K. regime 17 In the U.K., the Banking Act provides the Bank of England with tools for resolving failing deposit-taking banks and building societies.

Powers similar to those of the FDIC are available, including powers to transfer all or part of a failed bank’s business to a private sector purchaser or to a bridge bank until a private purchaser can be found.


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The Banking Act also provides the U.K. authorities with a bespoke bank insolvency procedure that fully protects insured depositors while

liquidating a failed bank’s assets. These powers have proved valuable; for example, during the crisis they allowed the authorities to transfer the retail and wholesale deposits,

branches, and a significant proportion of the residential mortgage portfolio of a failed building society to another building society. 18 The Banking Act powers do not, however, provide a wholly effective

solution to the failure of a large, complex, and international financial firm. The critical economic functions of a G-SIFI are currently intertwined legally, operationally, and financially across jurisdictions and legal

entities. For U.K. firms, these functions frequently reside in the same entities as the firms’ core unsecured liabilities.

Using the existing statutory transfer powers would involve separating and transferring large and complex businesses from within operating entities to a purchaser or bridge bank, while leaving behind the remaining

liabilities and bad assets in the failed firm to be wound up through insolvency. These operating companies may have several thousand counterparties,

customers, and contracts. Such a transfer would be almost impossible to achieve over a resolution weekend without destroying value and causing financial stability

concerns in multiple jurisdictions. 19 The introduction of a statutory bail-in resolution tool (the power to write down or convert into equity the liabilities of a failing firm) under the

RRD is critical to implementing a whole group resolution of U.K. firms in a way that reduces the risks to financial stability.


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A bail-in tool would enable the U.K. authorities to recapitalize an institution by allocating losses to its shareholders and unsecured

creditors, thereby avoiding the need to split or transfer operating entities. The provisions in the RRD that enable the resolution authority to impose a temporary stay on the exercise of termination rights by counterparties in

the event of a firm’s entry into resolution (in other words, preventing counterparties from terminating their contractual arrangements with a firm solely as a result of the firm’s entry into resolution) will be needed to ensure the bail-in is executed in an orderly manner.

20 The existing Banking Act does not cover nondeposit-taking financial firms, notably investment banks and financial market infrastructures (clearing houses in particular), the failure of which, in many cases, would

also have significant financial stability consequences. The Banking Act also has limitations with regard to the application of resolution tools to financial holding companies.

The U.K. is in the process of expanding the scope of the Banking Act to include these firms.

This is expected to be achieved through the introduction of the U.K. Financial Services Bill, which is due to complete its passage through Parliament by the end of this year.

21 In addition to expanding the U.K. resolution regime, the Financial Services Bill will significantly enhance the U.K.’s approach to banking supervision.

Going forward, the framework for prudential supervision in the U.K. will emphasize supervisory judgment, rather than supervision based solely on rules.

Under this framework, considerations of resolvability or ease of resolution would become a core part of the supervisory process.


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22 In conjunction with the Financial Services Bill, the adoption of the recommendations of the ICB will also significantly improve the

resolvability of the U.K. domestic retail bank by ringfencing it from the rest of the group. This will help to preserve core domestic intermediation services if a

group-wide resolution is not feasible for some reason. 23 To ensure that banks are resolvable, the Financial Services Authority (and in the future, the Prudential Regulation Authority (PRA)) will

require firms under the Financial Services Act 2010 to produce Recovery and Resolution Plans (RRPs). Firms will submit the information that the authorities will need to prepare

resolution plans and to assess resolvability. Where barriers to resolution are identified, firms will be required to remove them through changes to their structure and operations.

The proposed RRD provides authorities with the necessary powers to achieve this, including the ability to require changes to the legal or operational structures of institutions, and to require firms to cease

specific activities.

Description of the resolution strategies U.S. approach to single point of entry resolution strategy 24 Under the U.S. approach, the FDIC will be appointed receiver of the top-tier parent holding company of the financial group following the

company’s failure and the completion of the appointment process set forth under the Dodd-Frank Act. Immediately after the parent holding company is placed into

receivership, the FDIC will transfer assets (primarily the equity and


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investments in subsidiaries) from the receivership estate to a bridge financial holding company.

By taking control of the SIFI at the top of the group, subsidiaries (domestic and foreign) carrying out critical services can remain open and operating, limiting the need for destabilizing insolvency proceedings at

the subsidiary level. Equity claims of the shareholders and the claims of the subordinated and unsecured debt holders will likely remain in the receivership.

25 Initially, the bridge holding company will be controlled by the FDIC as receiver.

The next stage in the resolution is to transfer ownership and control of the surviving operations to private hands. Before this happens, the FDIC must ensure that the bridge has a strong

capital base and must address whatever liquidity concerns remain. The FDIC would also likely require the restructuring of the firm—potentially into one or more smaller, non-systemic firms that could

be resolved under bankruptcy. 26 By leaving behind substantial unsecured liabilities and stockholder equity in the receivership, assets transferred to the bridge holding

company will significantly exceed its liabilities, resulting in a well-capitalized holding company. After the creation of the bridge financial company, but before any

transition to the private sector, a valuation process would be undertaken to estimate the extent of losses in the receivership and apportion these losses to the equity holders and subordinated and unsecured creditors according to their order of priority.


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In all likelihood, the equity holders would be wiped out and their claims would have little or no value.

27 To capitalize the new operations—one or more new private entities—the FDIC expects that it will have to look to subordinated debt or even senior unsecured debt claims as the immediate source of capital.

The original debt holders can thus expect that their claims will be written down to reflect any losses in the receivership of the parent that the shareholders cannot cover and that, like those of the shareholders, these

claims will be left in the receivership. 28 At this point, the remaining claims of the debt holders will be converted, in part, into equity claims that will serve to capitalize the new

operations. The debt holders may also receive convertible subordinated debt in the new operations.

This debt would provide a cushion against further losses in the firm, as it can be converted into equity if needed.

Any remaining claims of the debt holders could be transferred to the new operations in the form of new unsecured debt. 29 The transfer of equity and investments in operating subsidiaries to the

bridge holding company should do much to alleviate liquidity pressures. Ongoing operations and their attendant liabilities also will be supported by assurances from the FDIC, as receiver.

As demonstrated by past bridge-bank operations, the assurance of performance should encourage market funding and stabilize the bridge financial company.


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However, in the case where credit markets are impaired and market funding is not available in the short term, the Dodd-Frank Act provides

for FDIC access to the Orderly Liquidation Fund (OLF), a fund within the U.S. Treasury. In addition to providing a back-up source of funding, the OLF may also

be used to provide guarantees, within limits, on the debt of the new operations. An expected goal of the strategy is to minimize or avoid use of the OLF.

To the extent that the OLF is used, it must either be repaid from recoveries on the assets of the failed financial company or from assessments against the largest, most complex financial companies.

The Dodd-Frank Act prohibits the loss of any taxpayer money in the orderly liquidation process.

U.K. approach to single point of entry resolution strategy

30 The U.K.’s planned approach to single point of entry also involves a top-down resolution. On the basis that the RRD will introduce a broad bail -in power, the U.K.

authorities would seek to recapitalize the financial group through the imposition of losses on shareholders and, as appropriate, creditors of the firm via the exercise of a statutory bail-in power.

This U.K. group resolution approach need not employ a bridge bank and administration, although such powers are available in the U.K. and may be appropriate under certain circumstances.

31 Current proposals for implementing such a strategy incorporate a period in which equity and debt securities would be transferred from the shareholders and debt holders to an appointed trustee.


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The trustee would hold the securities during a valuation period in which the extent of the losses expected to be incurred by the firm would be

established and, in turn, the recapitalization requirement determined. During this period, listing of the company’s equity securities (and potentially debt securities) would be suspended.

Once the recapitalization requirement has been determined, an announcement of the final terms of the bail-in would be made to the previous security holders.

This announcement would include full details of the write-down and/or conversion.

32 Debt securities would be cancelled or written down in order to return the firm to solvency by reducing the level of outstanding liabilities. The losses would be applied up the firm’s capital structure in a process

that respects the existing creditor hierarchy under insolvency law. The value of any loans from the parent to its operating subsidiaries would be written down in a manner that ensures that the subsidiaries remain

solvent and viable. 33 Completion of the exchange would see the trustee transfer the equity (and potentially some of the existing debt securities written down

accordingly) back to the original creditors of the firm. Those creditors unable to hold equity securities (for example, for reasons of investment mandate restrictions) would be able to request that the

trustee sell the equity securities on their behalf. The trust would then be dissolved and the equity securities (and potentially debt securities) of the firm would resume trading.


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The firm would now be recapitalized and primarily owned by the (appropriate layer of) original creditors of the institution.

As described later, the process would be accompanied by restructuring measures to address the causes of the firm’s failure and to restore the business to viability.

34 The U.K. has also given consideration to the recapitalization process in a scenario in which a G-SIFI’s liabilities do not include much debt issuance at the holding company or parent bank level but instead

comprise insured retail deposits held in the operating subsidiaries. Under such a scenario, deposit guarantee schemes may be required to contribute to the recapitalization of the firm, as they may do under the

Banking Act in the use of other resolution tools. The proposed RRD also permits such an approach because it allows deposit guarantee scheme funds to be used to support the use of

resolution tools, including bail-in, provided that the amount contributed does not exceed what the deposit guarantee scheme would have as a claimant in liquidation if it had made a payout to the insured depositors.

That is consistent with the contribution requirement that is already imposed on the Financial Services Compensation Scheme in the U.K. in the exercise of resolution powers and simulates the losses that would have been incurred by those deposit guarantee schemes during bank

insolvency. But insofar as a bail-in provides for continuity in operations and preserves value, losses to a deposit guarantee scheme in a bail -in should be much lower than in liquidation.

Insured depositors themselves would remain unaffected. Uninsured deposits would be treated in line with other similarly ranked

liabilities in the resolution process, with the expectation that they might be written down.


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35 Following the recapitalization process, the firm would be restructured to address the causes of its failure.

It should then be solvent and viable, and as a result in a position to access market funding.

In recognition of the fact that it will take time for losses to be assessed for purposes of recapitalization, and that it will take time to execute the restructuring plan that will underpin the firm’s viability, immediate access may prove difficult.

In certain circumstances, to reduce the immediate funding need and so facilitate market access, illiquid assets might be removed from the balance sheet of the firm and transferred into an asset management

company to be worked out over a longer period. 36 If market funding were not immediately available, temporary funding may need to be provided by the authorities to meet the firms’ liquidity

needs. The funding would only be provided on a fully collateralized basis with appropriate haircuts applied to the collateral to reduce further the risk of

loss. In the unlikely event that losses were associated with the provision of temporary public sector support, such losses would be recovered from the

financial sector. 37 It is important to note that the strategy described above would not necessarily be appropriate for all U.K. G-SIFIs in all circumstances.

Other strategies may be more appropriate depending on the structure of a group, the nature of its business, and the size and location of the group’s losses.


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For example, in cases where the losses on assets in a particular operating subsidiary were potentially so great that they could not be absorbed by

bailing in at group level or where the business had incurred such significant losses and was so weighed down by toxic assets that the capital needs in resolution were too difficult to estimate credibly, resolution at the level of one or more operating subsidiaries may be more

appropriate. In this situation, the application of resolution tools to operating subsidiaries would be easier if the subsidiaries providing critical

economic services were operationally and financial ly ringfenced from the rest of the group. 38 This is one of the advantages of the ringfence which is being

introduced in the U.K. It will provide flexibility in the event of fatal problems elsewhere in the group to transfer the ringfenced entity to a bridge bank or purchaser in its entirety.

If losses were concentrated in the ringfenced entity and capital in the ringfenced entity was insufficient to absorb them, then losses could be borne by creditors of the ringfenced bank (including debt holders where the ringfenced bank had issued debt into the market).

This could be achieved either by bail-in or by transferring the operations of the ringfenced bank to a bridge bank, leaving uninsured creditors behind in administration.

Draft legislation to establish this ringfence of the largest retail deposit-takers is due to be introduced into Parliament early in 2013 and if passed will provide valuable additional flexibility in implementing

resolution strategies to preserve the provision of core services in the U.K. business of U.K. G-SIFIs.


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Key common considerations for U.S. and U.K. approaches 39 As outlined above, high-level transaction structures have been developed for each jurisdiction.

As discussed in the FSB Guidance on Recovery and Resolution Planning, for any resolution to be effective, consideration needs to be given in advance to various preconditions and operational requirements.

Several of these considerations in relation to a top-down resolution strategy are discussed in more detail below.

Resolution and restructuring measures 40 A top-down resolution by definition focuses on assigning losses and

establishing new capital structures at the top of the group. This approach keeps the rest of the group, potentially comprised of hundreds or thousands of legal entities, intact.

However, a top-down resolution would need to be accompanied, or shortly followed, by significant restructuring measures to address the causes of the firm’s failure and to underpin the firm’s viability.

Such a restructuring may include shrinking the G-SIFI’s balance sheet, breaking the company up into smaller entities, and/or selling or closing certain operations.

The newly restructured companies will all need to have strong corporate governance and management oversight, which would likely necessitate significant changes to management and board personnel and processes.

In both countries, it is likely that supervisory actions will continue after the return to private ownership to ensure that the firm is on a stable and


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sustainable footing and the problems that caused the firm to fail in the first place have been properly dealt with.

41 In the U.S., effective governance will be an important issue for both the transitional bridge financial company and the newly capitalized entity or entities into which the bridge will transition.

The FDIC, as receiver, will control the bridge financial company and would immediately appoint a temporary board of directors and Chief Executive Officer (CEO) to run the bridge.

The claims of the failed G-SIFI’s unsecured creditors will be converted into equity and, as a result, the former creditors will become owners of the new private sector operations.

They will thereafter be responsible for electing a new board of directors, which will in turn appoint a new CEO.

42 During the period in which the FDIC controls the bridge financial company, decisions will be made on how to on simplify and shrink the institution.

It also would likely require restructuring of the firm—perhaps into one or more smaller, non-systemic firms. Consideration will also be given to how to create a more stable, less systemically important institution.

Required changes, including divestiture, may be influenced by the failed firm’s Title I resolution plan. Once determined, the required actions and relevant time frames for their

execution will be specified in formal supervisory agreements with the new owners of the private sector operations. 43 The required actions would be executed in private markets by the new

owners.


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For example, the new owners might be required to sell a portion of their branch structure to reduce their footprint, divest their foreign operations,

or separate their commercial and investment banking operations. The resulting new private sector operations would be smaller, more manageable—and perhaps more profitable.

They would also be easier to examine and supervise. Importantly, all new operations must be resolvable under bankruptcy without public support.

44 In the U.K., similar considerations would enter into decisions on the restructuring process. Depending on the specific timeline for resolution, the restructuring may

occur primarily either during the trustee stage (before the delivery of equity securities to the creditors) or during the stage following the dissolution of the trust.

The extent of the restructuring measures required would depend on the cause of failure, and the extent to which losses were contained within a particular pool of assets or legal entity.

If losses at the firm were localized, the restructuring measures required may be limited. These would likely require a sale or wind-down of relevant business lines

and withdrawal from loss-making activities. The senior management that were responsible for bringing the firm into distress would also be replaced.

On the other hand, if losses at the firm were pervasive and spread across multiple business lines, a more fundamental restructuring of the firm’s business would be required.


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This would likely include a complete governance overhaul and a thorough reorganization of the activities of the institution.

In the extreme case, much of the institution may enter managed wind-down over a prolonged period of time.

In such a scenario, it is likely that a legal and operational ringfencing of a banking group’s retail banking activities from the group’s investment banking activities would prove particularly valuable in facilitating such a restructuring.

Maintaining financial stability

45 Both the U.S. and U.K. resolution proposals are designed to maintain financial stability by ensuring that critical business functions continue to be performed.

Critical business functions are generally performed at the level of the operating subsidiaries—assets of the holding companies of U.S. and U.K. G-SIFIs tend to comprise little more than the equity stakes in the operating subsidiaries.

The newly resolved group would be solvent and viable, and should be in a position therefore to access market funding or, if necessary, funding from the authorities as discussed above.

Liquidity will be downstreamed in a “business as usual” manner to the operating subsidiaries immediately following the resolution weekend.

As described above, the balance sheets of the operating subsidiaries should be broadly unaffected by the resolution action at the top of the group.

To recapitalize the operating subsidiaries that had incurred losses, the equity or debt held by the parent in those subsidiaries would need to be written down.


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The parent and, indirectly, the subsidiary operating companies may also be subject to change of control procedures arising from a switch of

ownership from the existing shareholders to creditors. Provision of critical shared services across the group should be unaffected.

46 Given minimal disruption to the balance sheet of the operating companies, and given that the group should be recapitalized following the assignment of losses to shareholders and creditors, counterparties

should not have strong incentives to cease trading with the operating companies during and following the resolution. The contingency plans are designed to minimize the triggering of

cross-defaults or closeout of netting arrangements at the operating companies. In certain cases, a stay on termination rights may be applied to ensure

that termination of counterparty relationships cannot be triggered solely as a result of entry into resolution. A stay may assist in promoting the continuity of a variety of critical

economic functions that are dependent on maintaining counterparty relationships (for example, those functions relating to wholesale market activities) and also avoiding the rapid, disorderly, and potentially value-destructive closeout of financial contracts and liquidation of

securities. The stay could also minimize the closeout risk that may result from cross-default clauses within financial contracts.

In the scenario in which the holding company is placed into receivership, the stay would extend to certain subsidiary counterparties subject to financial contracts that reference the holding company.


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Given cross-border considerations, it is important that stays on termination apply to both domestic and foreign operations of G-SIFIs.

In certain cases, authorities cannot currently extend stays on termination to foreign operations.

Supporting actions by host authorities may be required (as included in the Key Attributes), or it may be necessary to introduce clauses that recognize foreign resolution actions, including stays on termination, into counterparty documentation.

47 Similarly, because the group remains solvent, retail or corporate depositors should not have an incentive to “run” from the firm under resolution insofar as their banking arrangements, transacted at the

operating company level, remain unaffected. In order to achieve this, the authorities recognize the need for effective communication to depositors, making it clear that their deposits will be

protected. 48 If continuity of critical functions is to be achieved, the firm will need continuing access to core services provided by the financial market

infrastructures (for example, payment systems and central counterparties) during and following resolution. To achieve this, authorities in both the U.S. and U.K. have begun a

process of engaging with such infrastructures to develop effective procedures relating to the treatment of members who have entered resolution.

Minimization of cross-border coordination risk

49 It should be stressed that a key advantage of a whole group, single

point of entry approach is that it avoids the need to commence separate territorial and entity-focused insolvency proceedings, which could be disruptive, difficult to coordinate, and would depend on the satisfaction


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of a large number of pre-conditions in terms of structure and operations of the group for successful execution.

Because the whole group resolution strategies maintain continuity of business at the subsidiary level, foreign subsidiaries and branches should be broadly unaffected by the resolution action taken at the home holding

company level. The strategies remove the need to commence foreign insolvency proceedings or enforce legal powers over foreign assets (although, as

discussed later, it may be necessary to write down or convert debt at the top of the group that are subject to foreign law). Liquidity should continue to be downstreamed from the holding

company to foreign subsidiaries and branches. Given minimal disruption to operating entities, resolution authorities, directors, and creditors of foreign subsidiaries and branches should have

little incentive to take action other than to cooperate with the implementation of the group resolution. In particular, host stakeholders should not have an incentive to ringfence

assets or petition for a preemptive insolvency—preemptive actions that would otherwise destroy value and may disrupt markets at home and abroad.

50 A key part of the work undertaken by the U.S. and the U.K. has been to identify the regulatory obligations of foreign authorities in response to a resolution originated by a home authority.

Where any impediments to effective whole group resolution have been identified, authorities are in the process of exploring methods to overcome them.

51 The Key Attributes stress the importance of a globally coordinated approach to resolution, and emphasize that resolution authorities should


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consider the potential impact of their resolution actions on the financial stability of foreign jurisdictions.

The Key Attributes propose a framework that would facilitate cross-border cooperation between resolution authorities.

This framework would help to ensure that local resolution authorities support a resolution carried out by a foreign authority. 52 A central element of the cross-border cooperation process set out in the

Key Attributes is the establishment of Crisis Management Groups (CMGs)—groups composed of supervisors, central banks, and resolution authorities of the key jurisdictions in which a G-SIFI operates.

Members of these groups are expected to enter into firm-specific cross-border cooperation agreements that detail the proposed means by which a particular resolution should be coordinated between authorities.

To provide a platform for such cooperation agreements, authorities in the home jurisdiction are required to submit firm-specific resolution strategies to members of the CMG for consultation by the end of 2012.

53 These resolution strategies set out at a high level the key elements of the approach to resolution and outline the use of key resolution powers. The strategies will be translated into detailed resolution plans for each

firm during the first half of 2013. These resolution plans will provide specific detail on implementing the proposed resolution strategy, including consideration of entities to which

resolution powers may be applied and the possible roles of relevant national resolution authorities. Subsequently, firm-specific resolvability assessments will be developed

by the end of 2013.


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The resolvability assessments will identify barriers to implementation of the resolution plans, and will be key to demonstrating the extent to which

the resolution plan for each G-SIFI is feasible and credible without severe systemic disruption and without exposing taxpayers to loss. In addition, certain U.S. and U.K. G-SIFIs have been required to make

their first full RRP submissions in 2012 to support the development of viable resolution plans by the authorities. These submissions will help to expose, among other things, actions that

firms will need to take to improve their resolvability.

Write-down of liabilities and conversion of debt into equity

54 Under a top-down resolution, shareholders and certain creditors at the top of the group absorb losses and recapitalize the group as whole.

For a top-down approach to work, there must be sufficient loss-absorbing capacity available at the top of the group to absorb losses sustained within operational subsidiaries.

55 In the U.S., the capital structures of large financial holding companies are characterized by equity and large amounts of unsecured debt of various maturities.

This debt is structurally subordinated within the group, and limited external unsecured debt tends to be raised at entities below the financial holding company.

Regulation may be adopted to ensure that sufficient debt is held at the top-tier holding company level. 56 In the U.K., on the other hand, financial holding companies at the top

of the group often do not account for a significant proportion of the group’s unsecured debt raised by groups externally.


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Looking ahead, either the groups could restructure so that more debt is issued out of the holding company or the U.K. authorities could look to

bail-in the liabilities of the top operating companies within each group. The latter course would require careful planning given that senior unsecured bonds typically rank alongside other unsecured liabilities that

are unlikely to be bailed-in. Detailed consideration of this part of the resolution strategy for individual banking groups will need to take account of the precise provisions of the

RRD as eventually passed into law. Also, both the draft RRD and the U.K. government’s plans for implementing the ICB report include requirements aimed at ensuring

that banks have sufficient capital and debt in issue to make them resolvable using bail-in or other resolution tools. The U.K. authorities will in due course consider how the final versions of

those requirements should be applied to U.K. G-SIFIs given their group structures and resolvability. 57 Consideration also needs to be given to ensuring that debt issued at the

top of the group that is subject to foreign law can be written down or converted alongside liabilities subject to the law of the home jurisdiction. This may be crucial to ensuring that the firm’s recapitalization needs can

be met and that creditors are treated fairly. Ensuring that foreign law securities can be written down or converted into equity alongside securities issued under the law of the home

jurisdiction may require the inclusion of contractual recognition of foreign resolution proceedings within debt contracts.


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Valuation 58 During resolution, a valuation process will need to be undertaken to assess the losses on assets that the firm has incurred and the capital

needed under stress assumptions to restore confidence in the firm, which will determine the extent to which creditor claims should be written down and converted.

The valuation will determine how far up the capital structure the write down or conversion of debt may need to apply (that is, whether shareholders and subordinated debt holders can fully absorb losses in order to recapitalize the firm, or whether senior unsecured creditors

would also need to be included). The valuation process will in turn determine what financial instruments if any—for example, common equity in the new firm or warrants—the

different classes of original creditors of the firm should receive. 59 Given the differences in the U.S. and U.K. resolution processes, the precise valuation requirements and timelines are unlikely to be the same

for the two jurisdictions. Consideration is being given in both jurisdictions as to how much of the valuation process can be prepared in advance of resolution (for example,

as part of enhanced preparation under the U.K. Proactive Intervention Framework). Consideration is also being given as to whether new financial statements

would be required, and whether the firm’s external auditors would need to be replaced for the valuation process to provide sufficient comfort to the market that the ongoing operations were fully (re)capitalized and solvent.

An effective valuation process should facilitate the issuance of new securities and other financial instruments, and would likely be required by rating agencies in order to make a judgment on the creditworthiness of the resolved institution.


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The U.S. and U.K. authorities are considering how a credible valuation

could be carried out quickly and effectively, and with flexibility to respond to the characteristics of particular institutions and the nature of their failures.

Listing requirements post-resolution 60 To return the firm to the market effectively, the public listing of its equity and debt securities would need to resume. Insofar as new debt or equity instruments are issued, listing rules may

require that a prospectus or other offering documentation be provided to investors. This would likely include audited financial statements for the firm, and

may therefore take a significant amount of time to achieve. 61 Under the U.S. approach, a new parent entity is established during resolution.

Therefore, new securities would need to be issued in satisfaction of creditor claims. Such securities would either need to be issued pursuant to effective

registration statements, or may, in certain instances, be listed pursuant to an exemption from registration. 62 In the case of a U.K. resolution, new equity and debt securities would

not necessarily need to be issued following resolution. Under certain circumstances, it is possible, subject to a number of conditions, that existing equity and debt securities could resume trading

without the need for a prospectus.


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63 In both jurisdictions, engagement with securities regulators well in advance of, and also during, resolution will be key to ensuring that public

listing can be achieved in a timely manner following resolution.

Conclusion

64 In both the U.S. and the U.K., legislative reforms already made or planned in response to the financial crisis provide new powers for resolving failed or failing G-SIFIs.

The FDIC and the Bank of England have developed resolution strategies that take control of the failed company at the top of the group, impose losses on shareholders and unsecured creditors—not on taxpayers—and

remove top management and hold them accountable for their actions. These strategies provide an efficient path for returning the systemically important parts of the G-SIFI to the private sector by exchanging or

converting a sufficient amount of creditor claims from the failed company into capital in the newly resolved entities. Because the resolution action is taken at the top of the group and by the

home authorities, continuity of all critical services would be maintained and subsidiaries (foreign and domestic) would remain open and operating with access to sufficient liquidity. As a result, the strategy achieves the important goals of imposing market

accountability and maintaining financial stability in all jurisdictions in which the firm operates. 65 The FDIC and the Bank of England continue to work to ensure that

their respective resolution strategies will be fully operational. Importantly, the process of cross-border dialogue that has facilitated the above strategies reflects a shared public interest in developing the

capacity to resolve a G-SIFI in a credible and effective manner, and offers a model for multilateral resolution planning more broadly.


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Past Imperfect, Present Tense and Future Conditional Speech by Mr Rundheersing Bheenick,

Governor of the Bank of Mauritius, at the Annual Dinner in honour of Economic Operators, Pailles.

Taking stock

I have been here nearly six years and I thought it opportune tonight to look back, take stock before the past is truly past, and then try to peer into our hazy economic future as we

continue to battle through what certainly looks like an extended period of economic uncertainty.

The past six years The most obvious change at the Bank in these past six years has been the new and, some might say, sumptuous building. I inherited that, and since moving in, I have been conscious of the

necessity for the Bank to deliver even better value for money than in the past. For as Lord Kelvin has said:

Large increases in cost with questionable increases in performance can be tolerated only in race horses and fancy women. We had to pay greater attention to our performance. The Bank plays a supportive role in the economy.


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But the global financial crisis – which happened to coincide with my assuming

the role of Governor; I trust not a case of post hoc ergo propter hoc – encouraged me to look a little

beyond our traditional role to embrace that of promoting socio-development by giving new life to some of the little-used statutory powers of the Bank.

So I set out to improve governance by putting in place the Monetary Policy Committee (MPC).

I called upon external talents and developed clear lines of communication with economic agents. The MPC has been worth its salt and I pressed for statutory changes to

make it more transparent and accountable by publishing the minutes of its meetings and the individual voting pattern of MPC members. I also embraced an open-door policy responding to the concerns of the

various economic stakeholders going well beyond the banking industry, to include real sector operators, academia, opinion leaders, and consumer associations.

We have regular public consultations through press conferences and public addresses. I initiated, amongst others, MERI − the Mauritius Exchange Rate Index

−, PLIBOR – the Port Louis Interbank Offered Rate − and the Inflation Expectations Survey to focus more sharply on expectations to help us track changing market sentiment.

We initiated two new regular reports, one on Financial Stability and the other on Inflation.


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In addition, we have brought in some internal reorganisation endowing the institution with a flatter structure enabling more delegation, faster

response, and greater flexibility in decisionmaking. New operating units were created to address new issues, such as financial stability and Islamic finance, or to give sharper focus to specific work

areas such as financial markets and compliance. Banking supervision and regulation were strengthened; the payments system was modernised allowing for cheque truncation and bulk clearing;

financial market infrastructure was spruced up with single-maturity auctions of Treasuries; financial literacy programmes were initiated. All these required strong emphasis on capacity-building and training, and

continuous interaction with regional and global networks to keep up to the mark.

Above all, I have been steering affairs, guided by Rabindranath Tagore’s

great prayer,

Give me the strength never to disown the poor, nor bend my knees before insolent might. We continue to prize our independence and we defend it in the best interests of the country.

Often we remind the most powerful in the land that our concerns extend not least to pensioners and those constrained to live off their savings; for our task at the Central Bank extends to promoting a stable and growing economy for all.

It is vital for the Bank to respond to the interests of all sectors, not just the most powerful, the best-connected, or the most vociferous.

Now if Paul Getty’s formula for success was …rise early, work late and strike oil


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I have had to adapt that to the circumstances of Mauritius where there is no black gold.

Not finding oil here, the Bank has taken to buying gold; we bought two metric tonnes of it from the IMF in November 2009 for 2 billion rupees: that gold is now worth nearly 3½ billion rupees.

The profit from this should pay for a few tower blocks or even a few new botanical gardens.

And to ensure all Mauritians have easy access to a similar deal, we now offer for sale to the public solid gold bars; so do come by and make a mint while the stocks last.

This offer comes during the course of our 45th anniversary year as the central bank in Mauritius and we have had a series of international events in celebration.

As a more lasting commemoration, we shall be issuing a souvenir book on central banking, the economy and Mauritian society.

Riding the storm Now, many theorists have speculated on the causes of the continuing

international financial crisis − perhaps as many as those whose speculation promoted it! Some here have contributed to this mountain of analysis.

On these occasions, I usually offer a new Law to illuminate the issue of concern.

We’ve had Maradona’s law of interest rates; Einstein’s law of success; Newton’s laws on physical response; and now I offer you Poul Andersen’s law.


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This is the obverse of the law of Occam’s razor for simplicity of explanatory hypotheses.

So I offer you tonight Andersen’s law of the shaving brush, in which he declared: I have yet to see any problem, however complicated, which, when looked at in the right way, did not become still more complicated. This law underpins much of the writing about the recent crisis.

But for my own part I prefer to go straight to the point, as Liaquat Ahmed has done in his brilliant analysis of the Great Depression, when he wrote: More than anything else…the Great Depression (1929–31) was caused by the failure of intellectual will and a lack of understanding about how the economy operated. Similarly, I put down the lingering crisis to the dual impact of market

failure in the capital market and supervisory and policy failure at the level of financial boards and the regulators. Incredibly, other banking Boards did not see the demise of Barings as

prime evidence of a fatal flaw that could engulf the banking world and much beyond, as it did. To correct this flaw required just a little imagination and courage.

Unfortunately, this turned out to be beyond the grasp of every western bank board, every regulator and supervising agency, every Minister of Finance and every Government.

Thus the poor tax payer has had to pick up the tab for the gross failure of top financial management, leaving the banksters’ bonuses and golden parachutes largely intact.


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Those in charge just lacked the courage to ensure that if banks went bust so must the bankers.

Which rather reminds me of Lord Salisbury’s observation on the political scene:

You will find as you grow older that courage is the rarest of qualities to be found in public life. So, where are we now in Mauritius in the lingering crisis?

We’ve done rather well in fact. In the last six years the total assets of banks have expanded by 70 per cent; our 21 banks have almost 35,000 shareholders and employ over 7,000 staff.

I have granted five new banking licences, the public now has access to 216 branches with 2.5 million accounts – or 2 accounts per head of population.

More than half of the bankable population are internet-banking users. The footprints of our banks stretch from the Indian Ocean islands, to Malawi, Mozambique and Zimbabwe on the continent, and across to

Maldives and India. The list of the Top 80 Banks in Africa in terms of assets includes three of our banks.

We have consistently logged positive economic growth, and enjoyed social peace with low inflation and moderate unemployment.

Despite the lingering global economic crisis, our banking and financial system has remained robust, resilient and well-managed. Strong supervision and prudent management have earned us a coveted

place on the short list of countries that actually had a rating upgrade this year when the likes of the United States, France and, more recently, the


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European Stability Mechanism, have been stripped of their coveted triple-A ratings.

Banks in Mauritius have continued to make extraordinary profits, beyond those of even our top six companies in the real economy!

Let’s hope our top bankers will share this wealth judiciously with all stakeholders to the benefit of all the people of this land. A fair deal for bank customers is very much at the top of our agenda.

It is not exactly a secret although it may not be very widely known in financial circles but we do have very fishy banks in Mauritius – and large ones too.

It is also an area where there are many sharks. Worse, these fishy banks are all under water.

Now, before you look suspiciously at the banker sitting at your table, let me give you the names of these fishy banks. Do I feel a chill running through our bankers? Out with the names then!

They are Sudan bank, Nazareth bank, and Saya de Malha bank. These banks, which do not require a bank licence, are within our

territorial waters of 2 million km2 and are very fishy indeed. They provide us with our white fish for the dinner table and occasionally, like now, with a fishy tale for dinner table chat as well.

We have here a clear case of fishy banks without fishy bankers. If any of our scoop-hungry press is ruminating over a catchy headline:

“Very Fishy Banks in Mauritius, Governor says”.


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Let me gently remind them of the benchmark for this kind of mis-reporting set by a cub-reporter covering the visit of the Archbishop of

Canterbury to the US, landing in New York. The Archbishop had been advised to be cautious with the scandal - mongering press.

“Be discreet: be very discreet; but with a smile”. On arrival he was hijacked by a bevy of press men clamouring for a story.

One reporter asked “What do you think of the night clubs in New York?” Remembering to be discreet, with a smile, the Archbishop ironically

responded “Are there any night clubs in New York?” Headlines next day: Archbishop’s first question on landing in New York “Are there any night clubs here?”

Some people have continued to express dismay that we are not continuing to achieve the 5% growth that they had come to feel was our birth-right.

May I say, this is just unrealistic. It arises from a failure to understand the dynamics of economic growth.

These dynamics change as you emerge from the developing to the developed stage.

To move into the higher income bracket, escaping the middle-income trap is a long haul. It requires quite different capacities and is not done at the sprint of 5%

but more at the pace of a long-distance runner.


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It is good to remind ourselves − especially if we are inclined to agonise over the estimated 3.4% GDP growth rate this year − that 1% on our

national income now is far greater than 5% was twenty years ago. Why?

Simply because the national cake is much bigger! Just the annual incremental output in 2012 – at an estimated nominal Rs21 billion – is greater than the entire GDP of the country was as recently as

1987. “Growth at any cost” has never been our credo. Equitable growth, inclusive growth, sustainable growth is what we have

been pursuing with, as even the most carping critic must concede, impressive results in terms of rising national income, a stable multi-ethnic society, and a democratic polity.

Our track record may not be perfect; our present may be tense; and our future may look conditional – that may in fact well serve as an apt diagnosis of our predicament at any point in our recent history.

What we should avoid is the risk of blowing it all by pursuing an unrealistic agenda of higher growth by monetary fixes. Instead of growing at a brisk sprint, galoping inflation is the more likely

outcome if we rush down this route. We must adapt to the “new normal” of reduced growth in the western economies on whose coattails our export-driven economy has been

riding. What we need to power future growth is not cheap labour but increasing productivity, greater competitiveness, more innovation and a more agile,

cerebral management in both the public and the private sectors.


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But if we have indeed weathered the storm, some of our sails are looking rather shabby, and badly in need of a refit.

But what sort of refit do we need? And what sort of strategy must we devise to continue to face up to the

turbulent world?

Lessons we have learned We should be wise to acknowledge another of oilman Paul Getty’s maxims, this time on banking:

If you owe the bank $100, that is your problem. If you owe the bank $100 million, that’s the bank’s problem. Which reminds me of the story of the very distinguished banker, if there

are any left standing. Our banker was attending a grand international conference of bankers.

The sessions that day had been long, with detailed workshops and breakout sessions. After a formal dinner he paused for a night-cap in a quiet bar in the hotel.

As he was relaxing over a screwdriver, his favourite cocktail, a fashionably-dressed lady, slid into the seat beside him, flashed a smile and engaged him in conversation.

He could not remember her in the conference sessions, so he explained he was a banker at the conference of international bankers taking place at the hotel.

She took up his offer of a drink and settled down with a screwdriver, too.


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“Much obliged”, she said, sipping appreciatively, and giving him her best come-hither look.

As our banker just looked into his glass, wondering who he was dealing with, she added, “I also oblige – for a fee of course.”

“I oblige my clients anytime”, she went on. Our banker was trying to puzzle this out.

She vaguely reminded him of a Churchillian wartime speech as she continued: “I oblige them in the train; I oblige in the car; I oblige in the office, I

oblige in the lift, I oblige on the golf course…” “Oh, blow me!” interrupted our banker, as the penny finally dropped, “why − you are a banker, like the rest of us! Tell me, which bank are you

with?” Now, I have sanitised the story considerably for sensitive ears, but you get the gist of it!

So, be on your guard when you come across an obliging banker! If there is one thing we must learn, it is how to bring banking and

accountancy back in from the righteous wind of public anger, for a refit with refreshed ethics, a new sense of corporate probity and a bolder capacity for corporate governance.

That is exactly what we seek to achieve by the new Guidelines on Corporate Governance that we introduced in August this year. Not to be outdone, the Banker’s Association has announced that it is

coming up with a new Code of Ethics and Banking Practice.


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Not a minute too soon, one might be tempted to say!

So I must say that I am very pleased to hear that after the Diamond era of super bonuses and the alleged massaging of the figures in rampant rate-rigging, one of the largest banks concerned is to refocus on the retail trade.

Good news indeed! For here we are initiating the separation of domestic banking from

international banking business, as a sound precaution against any further global infection. Let’s just hope that bankers everywhere remember whose money they are

speculating on − not their own money but yours! So what can we learn from the past few years?

To be sure, we should be more vigilant in identifying the first tell-tale signs of bubbles. We should be wary of unsustainable credit levels and fat profit margins.

Banks must again pursue the function of promoting the optimum allocation of capital, and not just sit on it.

We must also remember that real estate is just houses, buildings and land that have fundamental economic, social and environmental functions, only some of whose value appears in the accountants’ books .

We need to account for all these functions more clearly. We may also draw lessons for the future as we approach key decisions on advancing the regional integration agenda with Common Market for

Eastern and Southern Africa, Southern Africa Development Community, Association of African Central Banks and the rest.


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For we need forms of management in business and political governance that rise above the self-interest of the nation-state.

When 90% of the people of the south western Indian Ocean are living in poverty − I speak principally of Madagascar and the Comoros − we might ask ourselves, not how we can continue to be in the lead at the top of the

Mo Ibrahim Index for Africa, but what have we done with that leadership to secure development in our region to relieve poverty, and to promote growth.

What we lack now is a clear vision for our future, a long-term picture of where we want to be in 2030 based on greater intra-regional cooperation and reinvigorated trade, amongst others.

To turn round the famous Clinton adage on political priorities, it seems to me that on the regional integration issue: It’s all about trade, stupid!

A future prospectus We have been promoting greater financial integration and facilitating regional banking initiatives.

The IOC is promoting new regional ventures in air and sea transport and in communications; many businesses are extending their regional links.

But we would do well to think ahead about combining regional fiscal and monetary management and the development of regional governance through some sharing of sovereignty.

But if intra-regional trade is where the EU, and indeed the USA, began, we have yet to reach the starting blocks. We need free movement of capital and labour; we need social union with


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common frameworks for labour law, portable pensions and social security; we must foster greater international competitiveness and

probity; we need fewer cartels and more competition. We need to nurture greater savings and investment with a regional fund for development and less reliance on external aid programmes.

Banking union is a very distant prospect; and dare I even mention that far-off dream of a common currency?

For our dreams need to keep in touch with reality and not turn into debilitating daydreams. If our dreams are to be, then as Tagore has declared:

We have no time to lose, and having no time we must Scramble for our chances. We are too poor to be late… Or as Ovid remarked, for those who still have some Latin:

Tempus edax rerum. And for those who don’t have the Latin, I might broadly translate that as

Time [is] the devourer of all things. That is why I have put so much effort in recent years into the tasks of getting banking ready for regional lift-off.

For I am doing nothing less than banking on the future of Mauritius as a regional leader in this field.

We must avoid the pitfalls that are testing the EU, seeing the task not to enrich ourselves but to enrich all the peoples of these beautiful African lands.


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As I close, let me say that last year some of you were kind enough to say they liked my speech.

Others suffered a mild bout of indigestion and were less kind. A few are still smarting from the mere recollection.

But words, whether meant in earnest, or spoken half in jest, are just precursors of greater things.

I trust that, over my six years as Governor, I have adequately demonstrated that I go well beyond word-smithing. In these matters, I am a disciple of the Athenian Statesman, still

celebrated for his rhetorical prowess, Demosthenes, who declared (and here I will save you from the original Attic Greek): First in oratory is action; second is action; and again third is action!


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Opinion of the European Banking Authority on the recommendations of the High-level Expert Group on reforming the structure of the EU banking sector Introduction and legal basis 1. The High-level Group on reforming the structure of the EU banking sector was set up by the European Commission in February 2012 with a

mandate to determine whether, in addition to ongoing regulatory reforms, structural reforms of EU banks would strengthen financial stability and improve efficiency and consumer protection, and if that is the case, to make recommendations as appropriate.

2. On 2 October 2012, the Group published its final report (“the Report”) which recommends actions in the five following areas:

a. Mandatory separation of proprietary trading and other high-risk trading activities when these activities are material within a group b. Possible additional separation of activities conditional on the recovery

and resolution plan c. Possible amendments to the use of the bail-in instruments as a resolution tool

d. Review of the capital requirements on trading assets and real estate related loans

e. Strengthening banks’ governance and controls 3. The EBA competence to deliver an opinion is based on Article 34(1) of Regulation No 1093/2010 of the European Parliament and of the Council

of 24 November 2010 establishing a European Supervisory Authority


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(European Banking Authority) amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC1. In accordance with

Article 14(5) of the Rules of procedure of the EBA, the Board of Supervisors has adopted this opinion.

General comments

4. The EBA welcomes the contribution of the Report to the discussion on possible initiatives to strengthen the regulatory framework of the EU. The introduction of structural measures to complement the existing and

forthcoming regulatory reform is being considered in several Members States. The EBA emphasises the need to ensure consistency across the Single

Market in order to foster level playing field and to avoid regulatory arbitrage. Otherwise, there is a risk that the development of structural measures at

the national level ends up supporting a ring fencing of national establishments and contributes to a segmentation of the Single Market. The EBA stands ready to contribute to the design of an EU framework

and to monitor possible flexibility left to national authorities. 5. The EBA emphasises the need to strike an appropriate balance in the trade off between preserving the core features of the traditional European

model of universal banking and strengthening the resilience of the financial sector by segregating riskier capital market business into a separate legal entity.

The proposals put forward by the High Level Group are mindful of balancing these two objectives by preserving the benefits of universal banking thanks to a separate legal entities approach within a single banking group rather than by adopting a complete separation of

activities.


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However, only a thorough impact assessment could provide an evaluation of the potential benefits of such measures on the European banking

sector and on the real economy and to compare them with their costs. In conducting this impact assessment, the EBA suggests that particular attention should be devoted to the impact of the increase in the cost of

capital and funding for trading firms to assess whether this would be commensurate to the objectives of the reform and would not create unintended adverse consequences.

The possible consequences on the structure of the market for investment banking services in the EU should also be assessed. 6. The EBA would also like to stress the need to maintain full consistency

between the legislation on bank recovery and resolution and any additional structural measures. As the draft Directive on Bank Recovery and Resolution already provides

strong incentives to modify business models away from complex firm structures, which would not allow for a smooth management of a crisis, the assessment of additional structural measures should focus on the incremental net benefit of a legal obligation to segregate trading

activities. Within this framework, it will be appropriate to consider that in the absence of a legal segregation, as proposed by the High Level Group, it

might be extremely difficult for a supervisory authority to exercise its discretionary judgment and impose a break up of a universal bank, especially if other competent authorities are not responding with similarly harsh measures in comparable cases.

Some common, EU-wide legal constraints could be helpful in supporting the supervisory work on bank resolvability.


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This consideration, however, also points to the need to maintain an appropriate sequencing and coordination of the different legislative

measures. 7. Implementation of any structural measures, such as a legal separation of risky financial activities from deposit-taking within a group, would

need to be reasonably enforceable by competent authorities. Clear and fair criteria must be established in order to determine situations where this separation is mandatory, bearing in mind that the purpose of

this breakdown is to protect the socially most vital parts of the banking group and to limit the taxpayers’ stake in the trading parts of the group. 8. Any structural measure should not be viewed as a substitute for

adequate supervision. The crisis showed that any form of banking business carries a high potential for systemic risk.

This is true for liquidity and maturity transformation in traditional banking as well as for complex derivatives transactions conducted on banks’ accounts in the trading book.

All types of activities generating systemic concerns should be subject to intensive supervision.

The fact that certain business is done on wholesale markets, between parties who should be able to properly assess the risks stemming from the transactions, and does not entail an immediate impact on retail business and payment activities is not a sufficient reason to reduce supervisory

coverage. During the past 20 years, major operational losses faced by individual institutions occurred from activities considered non-risky, where risk

management was inadequate.


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9. These measures should be accompanied by review clauses and macro-prudential monitoring.

Since structural measures are easily eroded via financial innovations, they should be accompanied by arrangements for swift review, while macro-prudential authorities should be requested to closely monitor the

migration of risks to non regulated financial intermediaries and the overall effect on the build up of risks in the financial system as a whole. One should avoid that such structural breakdown unintentionally feeds

the development of the shadow banking system. 10. Beyond such structural measures, the Report also “strongly supports the use of designated bail-in instruments within the scope of the BRR

Directive, as it improves the loss-absorbency of the bank”. It calls for a clear definition of the position of bail-in instruments in the hierarchy of commitments, which would facilitate the pricing and trading

of such instruments and the resulting market discipline and monitoring. 11. The EBA also considers that there is a need to further develop the bail-in framework in the BRR Directive in order to improve its

predictability. As already expressed in the 3 March 2011 Opinion on “Technical Details of a Possible EU Framework for Bank Recovery and Resolution”, the

EBA would rather support a two tier regime where bail-in requirements would be applied explicitly first to a certain category of debt instruments (targeted approach) and, if this proved insufficient, only in a second stage and within a proper administrative procedure for resolution to the

remaining classes of debtors (comprehensive approach). Bail-in needs to be carefully designed in order to ensure legal and operational certainty and prevent the risk that its implementation impair

the pricing mechanism of banks’ liabilities and cause unintended


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consequences, triggering destabilising effects on other financial institutions and the financial stability as a whole.

In the absence of a targeted approach, there is a risk that a wide ex ante scope of bail-in instruments turns out to be limited once the resolution occurs.

12. As noted in the abovementioned EBA Opinion, requiring credit institutions to issue and hold a minimum percentage of their liabilities as “bail-inable” debt instruments, besides ensuring a minimum

loss-absorbing capacity, has also the advantage to create large market volumes, which in turn will provide market participants with an incentive to standardise contracts, and rating agencies to focus properly on rating such debt instruments.

13. The EBA believes that clear requirements for a minimum amount of loss-absorbing liabilities, calibrated according to a thorough impact assessment and combined with a comprehensive statutory approach to

bail-in would ensure strict adherence to creditors’ hierarchy and would be appropriately targeted, while preserving the essential features of a comprehensive statutory approach.

Specific comments 14. On the mandatory separation of proprietary trading activities and other significant trading activities’ proposal of the Report, significant work on the calibration of the trigger for mandatory separation will need

to be carried out before any translation into the EU regulatory framework. The Report adopts a two-stage approach based firstly on trading book and available for sale-related quantitative indicators to set a preliminary

view on which banks can be subject to separation and secondly, a supervisors’ assessment based on more complex criteria which would eventually determine the need for separation.


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The EBA stands ready to contribute to possible Commission’s work on the calibration of the threshold to be applied by National supervisors in

order to ensure a clear identification of the banks for which a ring-fence of trading activities is relevant. As a preliminary remark, it should be underlined that some of the assets

which are referred to for the first threshold may be similar to the assets required for the Liquidity Coverage Ratio, which may not be satisfactory, if one wants to avoid conflicting regulations.

Therefore, the EBA suggests that available for sale components of liquidity portfolios are excluded from the first threshold calculation. To ensure a consistent application of these thresholds in the Single Market, there should be a need for technical standards to adopt a

common definition and accounting framework. Moreover, the EBA could provide some mediation at the EU level to ensure consistent application across the EU.

15. Regarding the activities to be ring-fenced, the Report introduces some exceptions by stating that “the provision of hedging services to non-banking clients which fall within narrow position risk limits in

relation to own funds, to be defined in regulation, and securities underwriting and related activities do not have to be separated”. To ensure a consistent application of such exceptions across the EU, the

EBA stands ready to contribute to the definition of these hedging services. 16. According to the Report, “transfer of risks or funds between the

deposit bank and the trading entity within the same group would be on market-based terms and restricted according to the normal large exposures rules on interbank exposures”.


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In such organisation, there will be a need for clear rules on the transfer of risks between the “deposit bank” and the “trading entity” in a bank

holding company. However, the abovementioned restriction according to the normal large exposures rules on interbank exposures is not applicable in the current

framework since the treatment of credit institutions’ intra-group exposures is not harmonised. Article 113 (4)(c) of the 2006/48 Directive offers Member States the

possibility to “fully or partially exempt exposures, including participations or other kinds of holdings, incurred by a credit institution to its parent undertaking, to other subsidiaries of that parent undertaking or to its own subsidiaries, in so far as those undertakings are covered by

the supervision on a consolidated basis to which the credit institution itself is subject”. An update of the large exposures regulation – which is foreseen in the

Report – will therefore be necessary to implement these rules on risk transfer between a deposit bank and a trading entity within a group. 17. Moreover, any financial support between the deposit bank and the

trading entity will have to be ruled by clear and transparent principles that would go beyond simple reference to market price. The EBA stands ready to provide its expertise in setting up such

standards and monitor their correct application throughout the EU. 18. The EBA also underlines that the draft Directive establishing a framework for the recovery and resolution of credit institutions and

investment firms (“BRR” Directive) introduces measures on intra-group financial support. Thus, Institutions operating within the same group should be able to

enter into agreements to provide financial support to other entities within the group experiencing financial difficulties.


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Such release of the legal restrictions for intra-group financial support within a group would have to be implemented consistently with

intra-group financing restrictions between “deposit” and “trading” institutions. 19. Regarding additional functional separation of activities in the context

of recovery and resolution plans, the EBA stands ready to promote a consistent application of recovery and resolution plans’ content and assessment across the EU.

To fulfil this objective, the EBA should set binding technical standards to be applied by national supervisors (including the ECB) and resolution authorities.

The EBA should then have a mandate to conduct a rigorous review to check that consistency has been achieved. To ensure a consistent application of these standards on recovery and

resolution, such ex post review will be a crucial component. 20. As already mentioned in the general comments, the Report suggests possible amendments to the use of the bail-in instrument as a resolution

tool. The EBA agrees that “such debt should be held outside the banking system” which would require appropriate mechanisms in order to prevent

the acquisition of such securities by the banking sector (e.g. introducing a particular risk-weight for such debt). Moreover, the EBA welcomes the suggestion to use bail-in instruments

(i) In remuneration schemes for top management and (ii) By introducing a mandatory share of variable remuneration into

bail-in bonds.


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Such measures could be adopted in a swift manner and may efficiently contribute to the overall efforts to reduce moral hazard and restore

confidence between the public and the banking system. 21. As regards the recommendations to improve the robustness of the trading book capital requirement by

i) Setting an extra, non-risk based, capital buffer requirement for all trading book assets; and/or by

ii) Introducing a strict floor risk-based requirement, the EBA understands that the Group’s initiative is brought to the general review of the capital requirements in the trading book conducted under the aegis of the Basel Committee which would bring a global answer to this particular issue.

The EBA considers that such extra capital buffer may be justified with reference to market risk and operational risk, but one should underline that a major driver for bringing down banks during the crisis (or at least

generating systemic risk that justified public bail-outs) has been counterparty risk, especially in derivatives transactions. Any additional capital requirement related to trading assets should,

therefore, also refer to counterparty risk and explicitly mention derivatives transaction together with trading operations in order to capture the underlying risk generated by these activities.

22. Finally, the Report calls for a consistent application of loan-to-value and loan-to-income ratio in all member states, which is strongly supported by the EBA.

To ensure this consistency, ex post monitoring should be conducted by microprudential and/or macroprudential authorities across the EU. Andrea Enria, Chairperson

For the Board of Supervisors


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Opinion of the European Insurance and Occupational Pensions Authority of on interim measures regarding Solvency II Legal Basis 1. This opinion is issued under the provisions of Article 29(1) (a) of Regulation (EU) No 1094/2010 of the European Parliament and of the

Council of 24 November 2010 (hereafter the ‘Regulation’) in conjunction with Directive 2009/138/EC of the European Parliament and the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (hereafter Solvency II Directive).

2. As established in Article 29(1) (a) of the Regulation, EIOPA shall play an active role in building a common Union supervisory culture and consistent supervisory practices, as well as in ensuring uniform

procedures and consistent approaches throughout the Union. 3. As established under Article 1 (6) of the Regulation EIOPA shall contribute to improving the functioning of the internal market, including

in particular a sound, effective and consistent level of regulation and supervision, (Art. 1(6)(a)) preventing regulatory arbitrage and promoting equal conditions of competition (Art. 1(6)(d)). EIOPA shall also contribute to enhancing consumer protection (Art. 1(6)(f)).

4. As established under Article 8 (1) of the Regulation EIOPA’s task is to contribute to the establishment of high quality common regulatory and supervisory standards and practices (Art. 1(6)(a)) and to contribute to the

consistent application of legally binding Union acts ensuring consistent, efficient and effective application of the acts referred to in Art. 1 (2) of the Regulation (Art. 1(6)(b)).

The fact that the Solvency II Directive has entered into force, means that it is considered “Union law”, but it will not have legally binding effect until after the date of its application, which is currently set to 1


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January 2014 in accordance with the ("Quick Fix") Directive 2012/23/EU of 12 September 2012.

5. This opinion is addressed to the national competent authorities represented in EIOPA’s Board of Supervisors.

Context 6. During the Board of Supervisors (BoS) meeting of September 2012, Members expressed their strong concerns with respect to the current status of the OMNIBUS II negotiations which might further delay the application of the Solvency II Directive.

7. In its explanatory memorandum to the Proposal for the Solvency II Directive the European Commission states:

“The present solvency rules are outdated. They are not risk sensitive, they leave too much scope to Member States for national variations, they do not properly deal with group supervision

and they have meanwhile been superseded by industry, international and cross-sectoral developments. This is the reason why a new solvency regime, called Solvency II, which

fully reflects the latest developments in prudential supervision, actuarial science and risk management and which allows for updates in the future is necessary.”

8. In addition, in the absence of a final agreement on Solvency II, European supervisors may be forced to develop national solutions in order to ensure sound risk sensitive supervision.

Instead of reaching consistent and convergent supervision in the EU, different national solutions may emerge to the detriment of a good functioning internal market.


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9. The BoS mandated the Chair of EIOPA to write to the OMNIBUS II trialogue parties setting out its concerns.

In his letter, dated 4 October 2012, the Chair not only expressed the need for a stable and reliable time plan but also the need to reflect on an earlier implementation of some Solvency II elements.

{Note: Do you remember the letter?}

Undertakings which are well-governed and which, in particular, measure

correctly, mitigate and report the risks which they face will be more likely to be prepared for the new regulatory framework and act in the interests of policyholders.


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10. In that regard it is of key importance that there will be a consistent and convergent approach with respect to the preparation of Solvency II.

In the run-up to the new system the following key areas of Solvency II need to be addressed in order to ensure proper management of undertakings and to ensure that supervisors have sufficient information at

hand. These are the system of governance, including risk management system and a forward looking assessment of the undertaking's own risks (based

on the ORSA principles), pre-application of internal models, and reporting to supervisors. 11. EIOPA sets out below its expectations for the national competent

authorities. These actions are consistent with EIOPA’s obligation to foster supervisory convergence.

12. EIOPA will, taking into account its objective under Article 1 Para 6 and its tasks and powers under Article 8 of the Regulation, contribute to the consistent efficient and effective preparation of supervisors and

insurance and reinsurance undertakings for the application of the Solvency II Directive. 13. As a follow-up to the opinion, and by making use of its powers under

Article 16 of the Regulation, EIOPA will publish guidelines addressed to national competent authorities on how to proceed in the interim phase leading up to Solvency II.

14. Within 2 months of the issuance of the guidelines, each national competent authority shall confirm whether it complies or intends to comply with the guidelines.

In the event that a national competent authority does not comply or does not intend to comply, it shall inform EIOPA, stating its reasons.


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15. EIOPA will publish the fact that a national competent authority does not comply or does not intend to comply with that guideline.

Proposed actions by national competent authorities

16. As part of the preparation for Solvency II, national competent authorities should put in place, starting on 1 January 2014 certain important aspects of the prospective and risk based supervisory approach

to be introduced in order to address the concerns set out above. 17. National competent authorities are expected to ensure that insurance and reinsurance undertakings have in place an effective system of

governance which provides for sound and prudent management of the undertaking and an effective risk management system including a forward looking assessment of the undertaking's own risks (based on the ORSA principles).

18. National competent authorities are expected to ensure that insurance and reinsurance undertakings have in place an effective risk-management system comprising strategies, processes and reporting procedures

necessary to identify, measure, monitor, manage and report, on a continuous basis the risks, at an individual and at an aggregated level, to which they are or could be exposed, and their interdependencies.

19. National competent authorities are expected to review and evaluate with respect to the undertakings concerned the system of governance, the assessment of the risks which those undertakings face or may face and the assessment of the ability of those undertakings to assess those risks

taking into account the environment in which the undertakings are operating. 20. Through internal model pre-application processes, national

competent authorities engaged in pre-application of internal models should continue to work with undertakings to form a view on undertakings’ degree of readiness for internal model applications, and


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should also follow subsequent evolutions to the internal model framework.

21. National competent authorities are encouraged to request all the information necessary for applying a prospective and risk based supervisory approach.

22. National competent authorities are expected to ensure that the requirements mentioned above are applied in a manner which is proportionate to the nature, scale and complexity inherent in the business of the insurance and reinsurance undertaking.


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How can financial institutions achieve the goal of early and effective internal triggers, while avoiding negative market reaction to recovery actions taken?

Comments received on the FSB consultative document on Recovery and Resolution Planning

On 2 November 2012, the Financial Stability Board (FSB) published its consultative document on Recovery and Resolution Planning. Interested parties were invited to provide written comments by 7 December 2012.

Some of these comments to the question: How can financial institutions achieve the goal of early and effective internal triggers, while avoiding negative market reaction to recovery actions taken? are available below.

UBS

As part of regular risk management, firms should have early warning signals which, when breached, could trigger the initiation of preventive actions.

These early warning indicators serve to monitor disruptions (minimum to severe) and ensure appropriate management attention and action before going in a recovery situation.

The use of early warning signals will allow firms to respond to threats prior to them becoming so severe as to trigger a formal recovery response. With respect to recovery measures, senior management of firms and

regulators need to ensure that communication is sufficiently forthcoming, factual, clear and transparent to avoid unwarranted reactions by market participants.


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Credit Suisse It is essential that triggers are viewed as

'soft' triggers, i.e. trigger breaches lead to predetermined escalation and information process up to senior management level within the firm.

Recovery triggers should not lead to automatic, compulsory reactions as this may jeopardize flexibility to develop a discretionary response in accordance with the specifics of the situation and is counterproductive in a stress scenario.

We also agree that this can also help avoid awkward situations where an ill-timed public disclosure might be forced by the existence of hard triggers, which could exacerbate distress.

British Bankers’ Association

It is important that the recovery plan and its trigger framework enable the G-SIFI to identify the need to take action before the market does.

The metric escalation governance and escalation process must also be supported by a realistic communication plan that seeks to avoid unhelpful reputational impacts in the markets that may

exacerbate the situation, and that remedial action is implemented fully and without delay. It is absolutely vital however that the recovery programme and its

associated metrics should be treated as highly confidential by all those party to the information therein and that neither the bank nor any of the authorities with access to it should disclose it in any way.


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Deutsche Bank The question should be focused on the execution of recovery actions rather than triggers.

Internal triggers documented within an institution’s recovery plan – whether they are early warning indicators or triggers as to invoke

recovery governance procedures – should be subject to strict confidentiality. Confidentiality provisions should apply to the preparation and

implementation of any aspect of the recovery planning process. There should be no expectation that the process of recovery planning affects the criteria or level of expectation used to apply listing and market

disclosure rules.

Interesting parts from Deutsche Bank’s Response to FSB Consultative Document on Recovery and Resolution Planning: Making the Key Attributes Requirements Operational Triggers vs. early warning indicators:

It should be very clear that there is a difference between recovery triggers and early warning indicators.

We contend that some of the quantitative triggers listed on page 8 should be considered to be early warning indicators rather than recovery triggers since they don’t reflect the financial health of an institution.

Examples include GDP forecasts and three-month LIBOR.


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When considering the appropriateness of triggers, on page 9 the FSB has pointed out that some firms do not have specific recovery triggers and

also mentions that between three and seven triggers are the norm. It is not necessarily the case that there will be an ideal number of triggers which can be identified for the industry as a whole and therefore trying to

determine this may be counterproductive.

Triggers and the link to risk management:

The proposed guidance mentions that triggers should be aligned but shouldn’t be limited to existing triggers, which we take to mean those already embedded within the bank’s risk management framework - for

example those linked to the bank’s risk appetite and regulatory requirements. We recommend that instead the guidelines should refer to situations

“where existing triggers are not sufficient” in order to reflect the work that has already been done and to avoid the assumption that there must be a suite of separate triggers.

Assuming authorities have reviewed the arrangements and consider that the firm is able to take into account the various warning signs and indicators, the firm should not automatically be expected to have a certain number of supplementary triggers over and above those already being

used. The focus of the assessment should be to understand how triggers are combined and supported by high quality management information.

Group-level planning:

We recommend the FSB include in the guidance the explicit expectation that recovery planning is done at group level and that there should not be a proliferation of local level requirements.


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In the proposed guidance there is no clear statement about the appropriateness of local frameworks.

If these are ultimately implemented, there is a need for guidance about how authorities and firms should coordinate.

Scenario design:

We support the approach taken by the FSB and consider the elements

listed on page 9 to be comprehensive. We agree that conceptually the practice of reverse stress-testing may provide a helpful perspective and is good practice within risk

management. Any requirements for reverse stress-testing should be in this context and used to support recovery planning, but should not be a mandatory part of

the framework.

Definition of triggers:

We believe trigger definition should be at the discretion of the institution

and that supervisors should work with them to identify the right metrics for each bank. This is highly dependent on the risk management framework and risk

profile of the institution and so should be considered on a firm-specific basis. Recovery triggers should reflect the institution’s financial health in terms

of sufficient liquidity and capitalisation in order to prevent a near-default or default situation of the firm. Examples of such recovery triggers are the Common Equity Tier 1 ratio,

the stressed net liquidity position as well as the firm’s economic capital adequacy.


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These universally apply to all types of financial institutions irrespective of their portfolio composition.

To identify triggers, we have employed guiding principles and this type of approach may be helpful to reflect in the guidance.

We believe that appropriate triggers should be:

- integrated into standard risk management practices;

- transparent, with unambiguous definitions and good internal understanding;

- related to the bank’s stress-testing processes with metrics embedded in that process; and

- relevant to the Recovery Plan and viability of the firm.

Quantitative triggers:

Referring to the potential quantitative triggers listed we would make the following observations:

- The proposed guidance refers to the renewal of wholesale funding and withdrawal of deposits and other funding.

We recommend considering these risk types separately.

For example, in the case of liquidity risk, rather than looking purely at renewal of wholesale funding or deposit activity (which would be very

bank-specific in terms of relevance) supervisors should be encouraged to ensure that a bank’s recovery trigger is aligned with its approved Liquidity Risk Management framework.

Where possible a stressed net liquidity position should be used as the recovery trigger (therefore incorporating inflows and outflows,

including deposits and wholesale funding) until such time as the Liquidity Coverage Ratio (LCR) is implemented.

The LCR should subsequently become the trigger.


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- Some of the suggested triggers are based on external factors such as LIBOR, GDP, etc.

These may be considered more appropriate for scenario planning or as early warning indicators.

Early warning indicators:

A firm-specific approach should also be encouraged for early warning

indicators which need to be portfolio - and therefore institution - specific, in order to ensure an effective monitoring and default prevention process.


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Implementation of the Basel III Framework At its meeting on 13-14 December, the Basel Committee

on Banking Supervision discussed the progress of its members in implementing the capital adequacy reforms within Basel III.

The Basel Committee has been actively monitoring on

a continuing basis the progress of members in implementing the Basel III package of regulatory reforms, as well as the implementation of Basel II and Basel 2.5.

To date, it has published three progress reports and two reports to the

G20.

The number of member jurisdictions that have published the final set of

Basel III regulations effective from the start date of 1 January 2013 is 11.

These include Australia, Canada, China, Hong Kong SAR, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland.

Seven other jurisdictions - Argentina, Brazil, the European Union,

Indonesia, Korea, Russia and the United States - have issued draft regulations, and have indicated they are working towards issuing final versions as quickly as possible.

Turkey will issue draft regulations early in 2013.

Stefan Ingves, Chairman of the Basel Committee and Governor of the Sveriges Riksbank, said "While some jurisdictions have not been able to meet the planned start date, a large number will be ready to begin

introducing the new capital requirements as planned on 1 January 2013."

Mr Ingves also said, "The globally agreed timeline includes a number of milestones from 2013 to 2019, designed to provide for a gradual phasing in of the new capital requirements.

http://www.bis.org/bcbs/implementation/bprl1.htm

http://www.bis.org/bcbs/implementation/bprl1.htm


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It is expected that as remaining jurisdictions finalise their domestic regulations during 2013, they will incorporate all the remaining

transitional deadlines in line with the original global agreement, even where they have not been able to meet the 1 January 2013 start date.

Hence, by the end of 2013, almost all Basel Committee jurisdictions will be implementing Basel III in accordance with the agreed timetable.

This is an absolutely critical step towards strengthening the resilience of

the global banking system."

"Furthermore", Mr Ingves added, "even though there are delays in

implementing the regulations, national supervisors are ensuring that internationally active banks are, where necessary, making steady progress in strengthening their capital base in accordance with the Basel III framework."

All Basel Committee members have reiterated their commitment to

implement the globally-agreed reforms, and several members are due to undergo a peer review of the consistency of their final regulations during 2013.

At the conclusion of this set of peer reviews, all jurisdictions that are the

home regulator for global systemically important banks (G-SIBs) will have been subject to a peer review of their Basel III implementation.

Other jurisdictions will be subject to peer reviews shortly thereafter.


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Governor Jeremy C. Stein At the Global Research Forum, International Finance and Macroecomomics, Sponsored by the European Central Bank, Frankfurt am Main, Germany Dollar Funding and Global Banks

Thanks very much. It's a pleasure to be part of this panel on the future of financial globalization.

I will focus my remarks on one important aspect of this issue--namely, the growing use of wholesale dollar funding by global financial institutions. I'll begin by briefly discussing research I've been doing, along with my

coauthors Victoria Ivashina and David Scharfstein, which examines some of the consequences of this funding model during times of market stress. I'll then touch on the policy implications of this and related work. But

first, the usual disclaimer: The views that follow are my own and do not necessarily reflect the thinking of my colleagues on the Federal Open Market Committee.

By way of background, the dollar liabilities of foreign banks have grown rapidly in the past two decades and now stand at about $8 trill ion, roughly on par with those of U.S. banks.

A significant proportion of foreign banks' dollar liabilities are raised via U.S. branches, most of which are legally precluded from raising deposits insured by the Federal Deposit Insurance Corporation.

The main source of funding for these branches, therefore, comes from uninsured wholesale claims such as large time deposits, making the cost


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and availability of such dollar funding highly sensitive to changing perceptions of these banks' creditworthiness.

In our work, we asked how shocks to the ability of foreign banks to raise dollar funding might lead to changes in their lending.

We began with a simple conceptual model: Imagine a European bank that lends in euros to European firms and in dollars to U.S. firms. To finance its euro-denominated lending, it funds itself by issuing

insured euro deposits to its local retail deposit base. By contrast, to finance its dollar-denominated lending, it raises funds in the wholesale dollar market.

Because the bank's dollar liabilities are uninsured, an adverse shock to the bank's perceived creditworthiness will result in a spike in its dollar funding costs.

At the same time, the cost to the bank of funding in euros is unchanged to the extent that its euro deposits are insured.

So we might expect such a shock to induce the bank to shift its funding away from the U.S. wholesale market and toward the European deposit market.

But what are the consequences of this adjustment, both for the geographic distribution of its lending and for the functioning of foreign exchange (FX) swap markets?

Note that if the bank wants to maintain the volume of its dollar-based lending, it will have to tap its insured deposit base to raise more euros and then swap these euros into dollars using the FX swap market.

However, if the induced funding realignment is big enough, and if arbitrageurs have limited capacity to take the other side of the trade, this


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large swap demand can cause a breakdown in the usual overed-interest-parity (CIP) relationship--a breakdown of the sort that we

have seen during times of extreme market stress. In this case, the direction of the deviation would be such that the cost of synthetic dollar borrowing--in other words, euro borrowing combined

with an FX swap--would go up and would approach that of the now-elevated cost of funding directly in the wholesale dollar market. And given that any method of dollar funding--direct or synthetic--has

become more expensive relative to euro funding, it then follows that an adverse shock to a global bank's perceived creditworthiness leads to a decline in its dollar-denominated lending relative to its euro-denominated lending.

So, two principal effects of the dollar funding shock are intimately connected: a widening of the so-called CIP basis in the FX swap market, and a reduction in credit supply to firms that borrow in dollars.

To test the model's implications, my coauthors and I focused on events in the second half of 2011, when the credit quality of a number of large euro-area banks became a concern and U.S. prime money market funds

sharply reduced their lending to those banks. In a span of four months, the exposure of money funds to euro-area banks fell by half, from about $400 billion in May to about $200 billion in

September. Coincident with this contraction in dollar funding, the CIP basis widened in the direction predicted by our model, increasing the cost of obtaining

synthetic dollars via the FX swap market. We used data from the international syndicated loan market to test the model's predictions about the reaction of lending to this type of funding

stress.


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We found that dollar-denominated lending by euro-area banks fell relative to their euro-denominated lending, while this result did not hold for U.S.

banks. We also found that, even holding fixed the identity of the borrowing firm, a syndicate formed to make a dollar-denominated loan during this period

was less likely to include euro-area banks, while the same was not true of syndicates making euro-denominated loans. Finally, euro-area banks that relied most on funding from U.S. money

market funds also cut back most sharply on their dollar-denominated lending. This last result is similar to one in recent work by my Fed colleagues

Ricardo Correa, Horacio Sapriza, and Andrei Zlate. They documented that the U.S. branches of foreign banks that experienced the most shrinkage in their dollar-denominated large time

deposits--funding that had been mostly provided by money market funds prior to mid-2011--cut their U.S.-based commercial and industrial lending by more than banks that fared better on this score.

Taken together, these findings have two types of policy implications: one for central bank responses to dollar funding pressures and another for measures to regulate foreign banking firms that rely heavily on short-term wholesale funding.

This analysis underscores that the Federal Reserve's temporary dollar liquidity swap lines with the European Central Bank and other central banks are an effective response to stresses in dollar funding markets.

Last week, the FOMC approved the extension of these swap lines through February 1, 2014.

These lines have helped avert fire sales of dollar assets and maintain the flow of credit to U.S. households and firms.


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Although we documented cutbacks in dollar lending in the latter half of 2011 by foreign banks reliant on wholesale dollar funding, those cutbacks

likely would have been more pronounced in the absence of the swap lines I will now turn to regulation. It is useful to bear in mind that our current regulatory regime evolved

during a period when the U.S. operations of foreign banks were largely net recipients of funding from their parents. However, their reliance on less stable, short-term wholesale funding

increased significantly in the decade leading up to the financial crisis, when U.S. branches of foreign banks began borrowing large volumes of dollars to send to their foreign parents.

Such activity increases the vulnerabilities I described earlier. And it may not only pose the risk of a cutback in lending, but could also threaten the safety and soundness of the foreign banks themselves--and of

the U.S. entities exposed to those banks. The regulation of U.S. branches of foreign banks has changed little over the past decade, even in the face of these significant changes in the global

banking landscape. However, last week, the Federal Reserve Board proposed new rules for foreign banking organizations that would address some of the concerns

that I've discussed and thereby mitigate the attendant risks to U.S. financial stability. These proposed rules apply enhanced prudential standards to foreign

banking organizations and are designed to increase their resiliency. Importantly, the rules will not disadvantage foreign banks relative to domestic U.S. banking firms, but rather the rules seek to maintain a level

playing field.


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To avoid or mitigate potential disruptions in wholesale dollar funding markets, the proposed rules require foreign banking organizations to hold

sufficient high-quality liquid assets to meet expected near-term net outflows in a stress scenario. These rules should reduce the pressure on foreign banks that rely heavily

on short-term dollar funding to either sell illiquid dollar assets or cut back on dollar lending in times of financial stress. By helping to alleviate disruptions in dollar funding markets the rules

should also reduce the reliance on swap lines in a future stress episode. Finally, the central role played by money market funds in the 2011 episode is a reminder of the fragility of these funds themselves--and of the

risk created by their combination of risky asset holdings, stable-value demandable liabilities, and zero-capital buffers. The events following the Lehman Brothers bankruptcy in 2008 provide

even starker evidence of the risks that money market funds pose for the broader financial system. In light of these vulnerabilities, I welcome the recent proposed

recommendations by the Financial Stability Oversight Council for further money market fund reforms. To conclude: Financial globalization undoubtedly brings with it

substantial benefits. At the same time, it creates important challenges for financial stability and for the appropriate design of regulation.

The research discussed in conferences such as this one will help us better understand and respond to these challenges.

Thank you, and I look forward to your questions.


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The Comptroller of the Currency Speaks to Community Bankers About Risk Management

Remarks by Thomas J. Curry, Comptroller of the Currency, Before the 8th Annual Community Bankers

Symposium, Chicago, Illinois Good morning. It’s a pleasure to be here in Chicago, and to have this opportunity to talk about some of the

issues affecting community banks. The past few years have been extraordinarily challenging for all financial institutions and for community banks and thrifts in particular.

Margins are under pressure, the regulatory environment is evolving, and creditworthy borrowers are hard to find.

Commercial real estate, a bread-and-butter product for many community institutions, is still suffering from high vacancy rates, as well as a significant level of problem assets.

However, the environment is getting better for small banks and thrifts. I don’t want to minimize the difficulties, but we are seeing real improvements in asset quality, liquidity, underwriting, and capital,

among other indicators. The number of problem banks is beginning to stabilize, and the volume of problem assets is falling.

After the financial crisis and the recession that followed, these steady signs of improvement are welcome indeed.

But as the industry moves to a better place, we ought to ask ourselves what it was that differentiated the more than 460 banks and thrifts that


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failed over the past few years from those that not only survived, but in many cases thrived.

Clearly, the ones who made it had stronger capital, better liquidity management, better underwriting, and, in most cases, smaller asset concentrations.

They are the ones who stuck to their knitting, served their communities, and didn’t try to reach too far for profits.

They are the community banks that maintained their reputations, and were able to build upon their customers’ trust and confidence. But as important as each of those characteristics was, the strength of the

community banks that prospered in difficult times came from more than just the sum of those parts. In fact, I would say it was something far more fundamental.

They managed to prosper through hard times because they had effective risk management systems in place.

In one sense, that’s almost self-evident. After all, banking is a business of managing risk, of understanding how decisions that are made today will affect the condition of the bank in the

future, and planning accordingly. And importantly, the banks that were successful weren’t those with the fanciest systems.

They were the institutions that focused on understanding the risks they were taking on and anticipating the future consequences of those risks.

I’d like to spend the rest of my time today on the subject of risk management, and in particular on enterprise risk management.


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And yes, that’s a subject broad enough to capture almost everything you do in managing your institutions.

But I’ll limit my comments to a few specific areas that I think are particularly important today, including capital planning, stress testing, and operational risk, which I’m sure will be more than enough for the

time we have available. If you haven’t seen it yet, then I would encourage you to take a look at the OCC’s Semiannual Risk Perspective, which we published for the first

time this spring. The report highlights three areas of risk that are front and center for the OCC, and each of them illustrates the importance of enterprise risk

management. The first has to do with the aftereffects of the housing-driven boom-to-bust credit cycle.

The second involves the challenge of increasing revenues in a slow-growth economy, and the third is focused on the potential for banks and thrifts to take excessive risks to improve profitability.

None of this is really new: we’ve seen booms turn into busts before, and we’ve dealt with the consequences that followed.

And of course, we’ve gone through cycles where revenue growth and earnings were hard to come by, and some banks and thrifts took on inappropriate risks to compensate.

But there is something different about this cycle. It’s been far more challenging than any I’ve experienced in my working career, and it has been far more painful to work through it.


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And for all the improvements we’re seeing, creditworthy borrowers who want loans are still hard to find.

This is a time where banks and thrifts of all sizes need to manage their operations carefully to ensure that they aren’t planting the seeds for the next crisis.

Reaching out on the risk spectrum for earnings can be problematic. We have seen institutions cutting back on operating controls to enhance

income, and this is a cause for concern. And I would say that’s where a strong enterprise risk management or a strong risk assessment system comes in.

Enterprise risk management is an integrated approach to identifying, assessing, managing, and monitoring risk in a way that maximizes business success.

It starts at the top, with the board and senior management making decisions about the institution’s business model and its appetite for risk, but it can’t be successful unless those policies are filtered into the bank’s

culture. A strong risk culture is proactive, and it drives the way your bank sets strategy and makes decisions.

It also translates into how your management team and employees anticipate and respond to risk throughout the bank.

This means that individual risks aren’t considered only within the lines of business or by function, although the board and management can and should think about them in this way.


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It also means that risk and risk management are considered in their totality across the bank, as well as how different risks are related and

interact with one another. So one aspect of enterprise risk management involves sharing information and breaking down the silos.

For example, your loan staff should be talking with compliance staff when developing new products or services.

This is especially important, and we’ve seen problems in the past when silos prevent these two groups from talking to each other. The fact is, everyone with a vested interest in new product decisions

should be involved in the conversation, and that includes your supervisor. The regulatory agencies can be good resources to help you make sure you’ve identified all aspects of new product decisions that should be

considered. Another key element of risk management involves taking advantage of the guidance issued by the OCC and other regulators and tailoring it to

your own unique circumstances. Stress testing is an example.

Our guidance describes a variety of methods that community banks can use to stress test their portfolios, and provides one example of a simple stress test framework.

However, each institution is different, and every bank and thrift will need to decide for itself what method is most appropriate for its own specific circumstances.


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The key here—and the purpose of the guidance—was to encourage community banks to do some simple stress testing, and to help them

understand how to do it. I want to underscore that we’re not requiring community banks to have the types of sophisticated models and processes that we expect from

larger institutions, or that we think banks have to go hire consultants to meet our expectations. What we really want to see is that your banks do consider some form of

stress testing or sensitivity analysis of your key loan portfolios on at least an annual basis. The goal is to help you analyze “what ifs”—what happens if a group of

borrowers or an industry segment runs into problems—what will be the impact on your loan portfolios, your earnings and your capital. Community banks that have incorporated such concepts and analyses

into their credit risk management and strategic and capital planning processes have demonstrated the ability to minimize the impact of negative market developments more effectively than those that did not use stress testing.

Risk management is also a key element of a bank’s capital planning process, a point that we highlighted in guidance issued earlier in the year.

In fact, the first step in capital planning is the identification and evaluation of all material risks. Again, every bank is different in the way it funds itself, its willingness to

enter new lines of business, or its tolerance for asset concentrations, among other factors. Not every risk can be offset by the addition of capital—overly high CRE

concentrations, for example—but once risks are identified, management and the board can begin to assess the institution’s capital needs.


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Of course, capital isn’t the only buffer available to banks and thrifts to provide a cushion against economic shocks.

A well-managed allowance for loan and lease losses is also a vital risk management tool, and it’s one that I hope each of you is monitoring very closely.

As the quality of some classes of assets has improved and charge-offs have moderated, there has been a tendency to reduce quarterly provisions, in many cases to levels that are inadequate to cover

charge-offs. It would be short-sighted to say that banks and thrifts can’t engage in some level of reserve releases, given the improvement we’ve seen in the

fundamentals, and we at the OCC aren’t saying that. But I have warned on several occasions lately that we are monitoring this trend very closely, and we’re ready to take action if necessary.

In this context, let me say that this is a trend each of you should be monitoring as well.

One of the key lessons of the financial crisis has to do with the importance of capital and reserves. If you are letting your reserves decline rapidly, our examiners will want to

see that you have a carefully-considered strategy for matching the allowance to risk in your loan portfolio. Finally, I said toward the outset that I wanted to discuss operational risk.

I doubt that any single area of risk management has occupied as much of my time since I became Comptroller in April as operating risk.

From the foreclosure processing mess to fair lending violations to credit card marketing issues, the risk of loss that results from the failures of


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people, processes, systems, and external events has become a significant safety and soundness issue.

I’m sure that all of you noted that the problems I cited are all ones that involved large banks and thrifts, not community institutions.

However, I want to caution each of you to be particularly vigilant about monitoring and managing operational risk, particularly in areas that involve the fair treatment of your customers.

Op-risk failures are the surest way to undermine the reputation of your bank, and one of the greatest advantages community banks and thrifts have in today’s marketplace is their reputation.

Your customers trust you and want to do business with you, and that is a vital resource that you should protect at all costs. The op-risk example highlights one key aspect of enterprise risk

management, and that is the competitive advantage it confers on those who do it well. Whether it is taking the steps necessary to safeguard your reputation or

matching your long term capital needs against your risk profile, risk management should not be viewed as a defensive strategy, but as a proactive means of gaining a competitive advantage in the market.

The reason I am so concerned about all of this is simple. Community banks and thrifts play a vital role in supporting local economies throughout the country, and America’s families and

communities can’t be successful unless you are. So our goal in promoting sound risk management is to help ensure that the nation’s smaller banks and thrifts remain healthy, profitable, and

strong enough to serve communities across the United States. Thank you.


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Jan F Qvigstad: On learning from history – truths and eternal truths

Speech by Mr Jan F Qvigstad, Deputy Governor of Norges Bank (Central Bank of Norway), at the Norwegian Academy of Science and Letters, Oslo, I have received valuable assistance in preparing this speech.

Outside the Bank, I would like to thank Mike Bordo, Marc Flandreau, Henrik Mestad, Henrik Syse and Knut Sydsæter.

At the Bank, I would like to thank the following persons in particular for their contributions: Øyvind Eitrheim, Amund Holmsen, Jon Nicolaisen, Øystein Olsen, Øystein Sjølie, Birger Vikøren

NS Mari Aasgaard Walle. I would also like to thank Helle Snellingen for her contribution to the translation of the text into English.

Introduction All scientific and scholarly disciplines have a particular, and not immutable, set of truths.

Mathematics and theology are possible exceptions, though for different reasons. As the late Professor Knut Sydsæter underscored when assisting me with

this speech; in mathematics new results are proved on the basis of fundamental axioms and become new truths.


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Theology also relies on truths, even eternal truths.

Even if logical proofs of God’s existence have long been an important pursuit, it is safe to say that the truths in theology today stem from faith. The discipline of economics can readily be formulated in the language of

mathematics, and economic models are usually tested empirically before gaining acceptance. Conflicts arise when theories that appear to be patently true are

unsupported by empirical evidence, or when contradictory theories find support at the same time. In other words, we economists are in a borderland between faith and the

strict proofs of mathematics. The notion of learning from history cannot easily be explored without invoking the American physicist Thomas Kuhn.

This year is the 50th anniversary of the publication of his groundbreaking work, The Structure of Scientific Revolutions.

According to Kuhn, disciplines progress within an established set of truths – a paradigm. Observations irreconcilable with the paradigm are tolerated as

inexplicable. Eventually, however, the number of inexplicable observations can become so overwhelming that the paradigm breaks down.

New truths have to be established – a paradigm shift occurs. Such shifts can be painful.


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The old paradigm will usually be defended by those whose training lies in a more distant past, often persons in positions of leadership in academia

and government bureaucracy. Long before Kuhn, Henrik Ibsen touched upon the same idea in An Enemy of the People.

Dr. Stockman talks about the few who attain the new truths, unlike the compact majority that have yet to embrace them.

Social scientists, like economists, face some peculiar problems when attempting to learn from history. First, we do not have a laboratory in which we can perform experiments.

Second, economic policy is part of the reality we observe. The outcome of a particular measure will depend both on shifting

economic conditions and on economic agents’ expectations of the effect of that measure. It goes without saying that in a situation like that, drawing useful lessons

from history can be a challenge. Scientific truths provide a common basis for further research and development, but they can be a scourge if they are not challenged.

The recognition of economic correlations lays the groundwork for good economic policy, resulting in a better life for more people.

The outcome can be disastrous if the established truths lay the foundation for bad economic policies. Economics as a discipline has in the past hundred years undergone

several prominent paradigm shifts, with widespread impacts and implications.


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What have we learned from 1930 to the present day? More than five years have passed since the turbulence in financial markets began.

Today’s situation resembles the one Governor Nicolai Rygg described in his annual address in 1933:

“The figures for world output are truly disheartening. A recent estimate of the number of unemployed is an appalling 30 million.”

Except for the phrasing and style, that speech could be cut and pasted from that address in 1933 to describe the situation today.

The queues of the unemployed that we used to see in 1930s-vintage black-and-white photographs we are now seeing on television in living colour.

Youth unemployment in southern Europe is especially high. The Red Cross is setting up food banks in Spain.

The middle class is being hit by higher taxes, lower pensions and unemployment. Political scientists tell us that this is a recipe for social and political

unrest. In May 1945, the work began to rebuild our country after the Second World War.

At that time, Friedrich Georg Nissen was the highest-ranking official in the Ministry of Finance.


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Nissen trained in the law, and the photograph of him in Einar Lie’s book on the history of the Ministry of Finance shows a man formally dressed in

a three-piece suit. He believed that the central government budget should be balanced each year.

Fiscal policy was conducted based on this principle, which leading politicians also agreed with.

Tax revenue was to be spent, but not a penny more. Broadly speaking, the prevailing paradigm up until the Great Depression of the 1930s – both in economic policy and in economic theory – was that

the authorities’ role should be limited to keeping domestic order and ensuring a stable and predictable regulatory and operating framework. Prices adjust automatically to supply and demand, and the general view

was that markets were self-correcting. Following the Depression, a new truth emerged, with John Maynard Keynes and Norway’s own Ragnar Frisch at the forefront: prices and

wages do not adjust that quickly – nor can we expect that markets will automatically ensure full employment. Hence, government should play a more active role in economic policy.

At the Ministry of Finance, Nissen kept to the traditional view. But the political leadership, and eventually the younger economists who

started at the Ministry, had other plans. The economy was to be managed.

Keynes’ idea that the budget should be used actively to manage demand and output over an economic cycle was to them an obvious truth.


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In a Kuhnian sense, the older civil servants had to go for the new thinking to gain ground.

The legal experts at the Ministry had to give way to the young economists.

The new regulatory regime was enthusiastically implemented after the war, and crowned with success. The contrast between the blight of the interwar years and the postwar boom was stunning.

The ambition was not only to keep unemployment low. Which industry sectors should be allowed to invest?

What type of dwellings should we build? Who should be able to buy a car and have a telephone installed?

In the 1950s and 1960s, these were questions in respect of which the central government had firm views.

Keynes, regulation and planning were predominant truths in the former government building for several decades. Yet neither did these truths remain eternal.

In the 1970s, deficits ballooned when the government used countercyclical policies to “build a bridge” over the global downturn.

But it was a bridge to nowhere. Inflation took off and government finances were strained to breaking point. The policy of micro-managing the economy had gone too far.


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Wage and price controls at the end of the 1970s, the last gasp of the postwar paradigm, did little to help.

Norway was close to being placed under IMF administration. In fact, it was not possible to steer the economy towards permanent

prosperity. The old doctrines collapsed.

New ideas for managing the economy took shape because the old system no longer functioned. Underlying the new truths was the notion that economic policy needed to

operate through the proper market incentives and that economic policy must be sustainable and predictable. At the Ministry of Finance, the new ideas took hold primarily because a

younger generation was taking over, just as when Nissen was pushed aside. Political micro-management lost considerable traction.

Through the 1990s and up to the mid-2000s, economic growth was high and both inflation and unemployment low in much of the world.

Cyclical fluctuations were moderate. The new truths appeared to be working well.

This period is known as the Great Moderation. But underneath the positive developments, imbalances were building up both within and across countries.


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As we have all experienced, it is easy to ignore the bill as long as the food keeps coming and the conversation keeps flowing.

Countries and governments can live with deficits for a while, but sooner or later the bill has to be paid.

Budget deficits and high sovereign debt levels meant that the authorities had little slack when the financial crisis hit in autumn 2008. Countries rapidly embarked on an unavoidable path of fiscal austerity at

the very time that demand was falling and unemployment rising. Unsound fiscal policies have particularly severe consequences when they coincide with a financial crisis.

Capital markets were unable to manage the large pool of savings from emerging market economies in Asia. Safe yields had fallen and the search for returns provided fertile ground for

creativity in financial markets. Governments worldwide allowed the banking system to grow in the belief that regulations were sufficiently stringent, that a large banking sector is a

benefit and that banks’ self-interest would prevent them from taking excessive risk. The regulations, which in the 1980s were regarded as overly rigid, had

been introduced during the crisis of the early 1930s as a still -vivid memory. The well-known Glass-Steagall Act had been passed in 1933 precisely to

prevent financial sector excesses. Banks that took deposits from the public were subjected to strict rules concerning the amount of risk they could take.


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Deposits were guaranteed by deposit insurance, and banks could draw on central bank liquidity if necessary.

Investment banks whose customers were professional investors had a freer hand, but no safety net.

Banking gradually became a growth industry in many countries. Strict regulations in one country prompt banks to flee to another.

The result was the dilution or elimination of many regulations that attempted to rein in the imagination of the financial sector. The rationale behind the Glass-Steagall Act was discarded.

This trend was universal. Unfettered financial markets were apparently a success.

Mortgage-backed securities enabled more Americans to become homeowners, and a bullish stock market was good for pension funds – as long as it lasted.

Big banks can easily give rise to big ideas about the importance of a country.

But the financial crisis showed that big banks above all give rise to a political headache and a massive bill for taxpayers. Banks that are so large that they can undermine the entire financial

system cannot easily be allowed to fail. The Basel Committee on Banking Supervision seeks to ensure that different countries operate on a level playing field.


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While this is a good thing, the result was often compromise whereby the country with the weakest regulations set the standard.

One must also recognize that the new rules introduced in the 1980s did not take into account banks’ ability and creativity in terms of circumventing these rules.

Rules intended to mitigate the risk of financial instability actually encouraged banks to take on ever more risk.

What do economists do when regulations do not work? Well, paradoxically, what we do is argue that we need to regulate more and better.

There is now a version III of the Basel rules, which have grown from 37 to 616 pages.

Andy Haldane, Executive Director of Financial Stability at the Bank of England estimates that, all together, the rules – once they are fully incorporated in national legislation in Europe – will number 30,000 pages.

Is this really the way to go? Has the pendulum swung too far?

Are we facing a new paradigm shift?

In spite of lessons learned: back to square one The philosopher Henrik Syse has reminded me of this very phenomenon.

Truths we took to be eternal often prove to bear the stamp of their time. We then find new truths and throw out the old ones.


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Following the policy failures in the 1970s, many economists believed that Keynes and his disciples were wrong, and “Keynesian” almost became a

term of abuse, referring to irresponsible government spending.

But to draw such a conclusion is to go to extremes.

Keynesian policy is often appropriate in a contractionary period, but it also involves saving in times of growth – a component that had been

widely forgotten.

The economists Carmen Reinhart and Kenneth Rogoff have summarised the experience of financial crises all over the world over the past 800 years.

They show that history repeats itself. The “truth” most often proclaimed in boom periods just before the

bubble bursts is the belief that “this time is different”, which is also the ironic title of the book. Although history never repeats itself exactly, some key features recur: one

recurring feature is that boom periods are confused with an increase in the economy’s growth capacity. Good times are mistakenly interpreted as perfectly normal.

When times are good, it is difficult to gain acceptance for setting aside funds.

There are always unsolved tasks in a society, and these tasks attract attention. In the 1930s, Ragnar Frisch understood that it is difficult for politicians to

recognise good times at the time. He believed that it was the task of economists to ascertain the cyclical situation.


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When the crisis arrived in 2007, government finances were in disorder. Deficits and debt rose to such high levels that it was difficult for many

countries to borrow money. When credibility is lost and lenders draw the line, Keynesian policy has reached its limit.

These countries now have no other choice than to cut welfare schemes and public spending.

The political fury we are now witnessing in Athens, Madrid and Rome is being directed at today’s political leaders. Perhaps their rage should be directed at those who were in positions of

responsibility in the good times, instead of at those who are now left with the washing-up. We have furthered our understanding of economics over the many

decades since Keynes, Frisch and others laid the basis of modern economics after the 1930s crisis. Theories have become more advanced, and methods and calculations far more complex.

We have reams of regulations. Perhaps one lesson to be learnt from history is that the simplest method

can sometimes be the best, as Andy Haldane has argued. Friedrich Georg Nissen’s rule that budgets should always balance was not particularly sophisticated, but if his ideas had been followed before

the crisis, many countries would now be better off. However, the principles behind Nissen’s ideas were not completely unfamiliar when European politicians drew up the Maastricht Treaty at

the beginning of the 1990s.


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The Treaty contained simple rules for economic policy: budget deficits should be below three percent and government debt below 60 percent of

GDP. The rules sparked debate, and academics the world over – including in Norway – ridiculed them as far-fetched and hopelessly rigid.

And as so often before, the rules soon sank into oblivion particularly after the major EU countries Germany and France had pushed them aside.

In retrospect, we can acknowledge that simple rules of thumb can often be useful.

A current account deficit exceeding 4 percent of GDP is often a harbinger of future problems.

Spain is a case in point: government finances were fairly healthy, but deficits were building up in the private sector. Inflation of more than 4 percent is usually a sign of economic instability.

If unemployment in a country is persistently above 4 percent, there is probably something wrong both with the functioning of the labour market and with the level of political ambition.

And the financial crisis has shown that total banking sector lending in the most heavily indebted countries has often been more than 4 times GDP.

In this situation, any rescue packages would be too expensive for taxpayers – Ireland and Iceland are two examples. This is a familiar element in our everyday lives.

Speed limits are an example of such a rule.


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Calculating the optimal speed for a specific car on a specific road is extremely complicated.

It would require considerable knowledge of both mechanics and physics. Speed limits help us.

Of course, it might be optimal to drive faster or slower than the speed limit, but the rule is simple to understand and easy to enforce.

This simple rule helps to shape our behavioural patterns to ensure efficiency and safety in the traffic system. Simple rules can also make it easier to resist the temptation to postpone

problems. Economists call this the time inconsistency problem.

Odysseus solved his time inconsistency problem by having himself tied to the mast and instructing his crew to plug their ears with wax and ignore him when he would later ask them to steer the ship towards the song of the Sirens.

That was an easy rule for the crew to follow. But rules can be too simple.

They must be used only as points of reference, not as excuses for doing nothing. Economic policy rules should be common knowledge.

An independent body should be established to tell us when we are “speeding”, and procedures must be in place to implement measures to solve the problem.


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The new "Fiscal Compact" in the euro area is a tightening of the Maastricht Treaty, precisely to prevent the simple rules from being

broken.

We should be less concerned about what is completely right and correct according to the prevailing truths, and more concerned about avoiding

major mistakes, irrespective of what the truth might be. And this is the line of thinking behind our inflation target for monetary policy and the fiscal rule for oil revenue spending.

We must be humble and constantly search for new knowledge. But as I have shown, there is a tendency for this humility to vary with the

business cycle. Marc Flandreau and Mike Bordo tell me that during upturns, the colossal blunders of yesterday are forgotten by politicians, journalists and central

bank governors, but not by economic historians. And right now, their profession is enjoying its golden age.

Simple economic rules can perhaps prevent countries from getting into difficulties, but once the rules have been broken and the crisis is a fact, the solution is anything other than simple.

Real problems must be solved by real measures. That takes time and is painful, as we are witnessing in Europe today.

Much of the adjustment in real terms is still to come, and there is still some way to go before we will be able to say that the global economy is on safe ground.

The full consequences of inadequate regulation of financial institutions became visible only after the crisis was a fact.


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However, macroeconomic imbalances were widely recognized beforehand.

In the mid-2000s, Federal Reserve Chairman Alan Greenspan raised the key rate to reduce the US savings deficit.

But long-term interest rates were kept low by the Asian savings surplus that found its haven in the US. International organisations such as the IMF and the OECD pointed out

what needed to be done, but the solution required measures to be implemented by a number of countries with differing interests and finding a good solution for the global community proved to be too difficult.

The global community is nonetheless sometimes able to make decisions that benefit all countries.

I witnessed this myself in Washington at the IMF’s meeting in October 2008 following the Lehman Brothers collapse. The alternative then was a black hole.

In that kind of situation, it is easier to reach agreement. In many ways, central banks are the response the authorities could apply

when crises arose. Central banks were established to exercise control over the monetary system, enabling states to issue banknotes people could trust and

providing banks with a bank for their own deposits and from which they could, in the last resort, borrow from in times of crisis. Confidence in the monetary unit is the mainstay of our financial system.


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The following may serve as an illustration: It costs 50 øre to produce a banknote.

For every 100-krone banknote Norges Bank issues, we apparently create wealth of NOK 99.50 – out of thin air.

But people still sleep soundly in their beds – including those with money under their mattresses – because we are confident that the money can be exchanged for real goods.

It is, of course, tempting to take advantage of this confidence. History is full of kings and governments who have attempted to do just that.

In 1716, the Scottish economist John Law established a bank that soon assumed the role as the first central bank of France.

John Law saw the possibility of printing banknotes to finance promising development projects in the New World. Excessive confidence in the potential for profits fuelled both the printing

presses and equity prices in Paris.

The bubble burst and John Law fled to Italy.

Today, the European Central Bank and the central banks in the UK and the US are using money they have produced themselves to purchase

government bonds and other securities.

They are taking advantage of the confidence the central bank enjoys to

buy time to enable European countries to tackle the underlying problems.

Some lessons Tonight’s theme is “Learning from history”.


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And in this title lies a question, in both the positive and normative senses.

The answer to the question of whether we actually learn from history would probably have to be “yes and no”. Sometimes we learn, sometimes we do not.

Economic crises seem to be a necessary precondition for learning. And this may still be the case.

We have some capacity to learn from our own mistakes – particularly if they are traumatic enough – but limited capacity to learn from other people’s mistakes.

This is something we recognise from raising children. To the frustration of their parents, children seem to be more interested in

having their own experiences than listening to parents’ advice, however good it might be. The answer to the normative question “should we learn from history?” is

obviously “yes”. And which lessons should we learn?

Allow me to venture to select three lessons on the basis of what I have said so far. First: the simplest solution is often the best.

Simple rules, whether for fiscal policy or banking regulation, will often prevent the worst errors.

And when the yellow warning light starts flashing, action must be taken.


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Second: confidence is essential, also for economic policy.

Confidence is easily eroded and difficult – and costly – to restore. Confidence must be earned.

The resolution of today’s crisis will also follow a smoother path if there is confidence in institutions – banks, central banks and governments. Borrowing costs will then decrease more quickly, the need for

government cuts will diminish accordingly, and the good times will return sooner. Third: we have no magic wand.

If a country has real economic problems, real adjustments must be made to solve them.

Central banks cannot solve the problems, but what they can do is lend money when there is none available elsewhere, giving countries more time to implement necessary reforms.

Deficits must be reduced. Unrestrained printing of money has led to problems on many occasions through history.

If printing money is not followed up by action – in euro area countries, in the UK and in the US – Mario Draghi, Mervyn King and Ben Bernanke run the risk of being recorded in history in the same chapter as the

Scotsman John Law. The full title of my speech today is “Learning from history: truths and eternal truths”.


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I have ventured to outline three lessons that are hopefully are universally valid.

But we can never be sure. I mentioned Ibsen’s “Enemy of the People”.

Allow me to conclude with Doctor Stockmann’s comments: Yes, believe me or not, as you like; but truths are by no means as

long-lived as Methuselah – as some folk imagine. A normally constituted truth lives, let us say, as a rule seventeen or eighteen, or at most twenty years –seldom longer.

Ibsen’s play has been long-lived. It is still performed all over the world, 130 years after it was written.

Not because the Norway of the 1880s never loses its appeal, nor because Doctor Stockmann found eternal truths.

It is because the play raises questions of a more enduring nature. Perhaps we have to recognise that the closest we can get to eternal truths

is, precisely, eternal questions?


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Matthew Elderfield: Micro-macro schizophrenia – Banking Union and the European capital dilemma Address by Mr Matthew Elderfield, Deputy

Governor of the Central Bank of Ireland and Alternate Chairman of the European Banking Authority, to Bloomberg, Dublin, 26 November 2012.

European regulators face a dilemma – a bad case of policy schizophrenia – in deciding the pace of the next steps of bank recapitalisation.

With the fiscal policy break full on, and the monetary policy throttle full back, what is the right calibration for prudential capital policy? From the micro-prudential perspective, the answer is more and faster.

From the macro prudential perspective, fear of pro-cyclicality and debt sustainability might suggest: take care.

This has been a central dilemma for policymakers in the Eurozone in many countries. As I would like to discuss today, this will be a key policy choice for the

European Central Bank under a banking union. The European summit conclusions of 29 June gave official birth to the concept of a banking union and the single supervisory mechanism.

These steps arose out of the pressing need to break the debilitating link between weak banking systems and constrained sovereign finances.

While there is a continuing debate on the details, this is to be done by facilitating the direct recapitalisation of banks, from pooled European


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resources following the successful introduction of a common European banking supervisor, for Eurozone countries.

Banking union also holds out the prospect of strengthening the framework for European banking supervision, if implemented successfully.

Creating some distance between supervisors and the banks they regulate (and, indeed, from the political systems of the banks they regulate) can help improve the capacity for challenge and ensure a broader, more

detached, perspective on problems. Bringing in a foreigner to do your supervision is not, alas, the magic solution to all the woes of a banking system.

But the single supervisory mechanism holds open the prospect of an institutional framework, a broader skill set and more diversity of experience that should help insulate supervisors from the pressures –

subtle and direct, cultural and political – that come from long-time and close proximity to their regulatory charges and their champions. In addition to strengthening banking supervision and breaking the link

between banks and sovereigns, the banking union also may allow the development of a deeper single market, although here there are considerable uncertainties and potential risks due to the fact that only a subset of the European Union will be taking the steps towards banking

union. The proposed way to square the circle between the single market and the banking union is to provide for a bifurcation between regulation and

supervision. Banking supervision for the Eurozone (and opt-in countries) will be undertaken by the single supervisory mechanism operated by the ECB.


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But regulation, that is to say the process of agreeing policy on rules, will remain with the EBA.

However, matters are not quite so straightforward and concerns have been raised in a number of quarters.

For example, the distinction between supervisory standards or practices on the one hand and regulations on the other is easier in the abstract and becomes blurred in some areas.

In the space left for national discretion under current EU directives and regulations, should the EBA seek to develop a common single market rulebook – or should the ECB do its own thing?

I would think that where issues arise from divergent interpretations of existing EU law or of differences in definitions and standards, the EBA and all 27 supervisors should have an opportunity to discuss and consider efforts at further convergence before the ECB sets off on its own.

However, in areas of supervisory practices (such as SREP, risk assessment, inspection methodologies and the like) I would think it makes sense to preserve some flexibility for national discretion at the level

of the 27, but that it will be essential for the ECB to move forward with plans to develop a common supervisory model. What would, however, be more worrying is if the different principal

supervisors in the single market, now including the ECB, were to take measures that sought to ring fence or discourage cross-border banking structures or activities that spanned their respective domains.

In this respect, my personal view is that the ECB’s stance towards Euro clearing by LCH is an unfortunate precedent and it is important that this philosophy does not spill over into banking supervision.


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But equally, it is important that the FSA’s approach to incoming branches and to liquidity and capital support from banking groups based elsewhere

in the EU does not undermine the single market. This issue underlines another important role that the EBA plays, beyond that of policy and rule maker: its mediation mandate to resolve disputes

between supervisors and ensure the application of EU law. This is a crucial role which has yet to be tested in earnest. And it could be of increasing importance as a tool to tackle supervisory

actions which undermine the operation of the single market for banks. Both the policy-making and mediation roles of the EBA raise what has become a key issue in the political negotiations on the banking union,

namely the voting arrangements that will apply in the future. It is clear that the concerns of the UK and other “out” countries will need to be addressed.

I think it would be unfortunate if the “ins caucus” sought to agree a common position on matters before engaging in debate around the EBA table, so as to benefit from the views of other countries – and indeed I

would not see the caucus leading to a block vote, as individual supervisors will still retain their responsibility for policy-making. But, as I said, the governance and voting arrangements for the EBA

clearly need to change. Another key point of discussion relates to the scope of the ECB’s responsibilities in terms of the number of banks it is responsible for, and

the speed with which its new mandate is implemented. It is clear that at the outset, a core group of systemically important banks will be subject to direct ECB supervision, albeit with some supervisory

tasks delegated to national supervisory authorities.


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However, an open question subject of considerable debate relates to the timing of any subsequent assumption of responsibility for banks from

programme countries and/or smaller banks. Broadly casting the ECB’s mandate to cover all banks will avoid any disruptive capital flows between institutions subject to the two different

regimes, and will also acknowledge the fact that severe problems have arisen from clusters of banks that sit below any obvious systemic threshold, but which nevertheless have imperilled the finances of governments.

Ireland and Spain are, of course, examples of this. This approach was considered at the October EU summit.

There is, however, a practical question regarding the speed with which the ECB can reasonably assume responsibility – and potential reputational risk – for such a large universe of credit institutions, even

with a model involving significant delegation of tasks to national authorities. This points to the need to articulate some transitional arrangements.

One approach might be a transitional phase of supplemental, but not direct ECB supervision, for the wider set of small banks.

In this interim period, the ECB would issue its supervisory manual for use by national supervisory authorities for the smaller banks too. And, crucially, the ECB could be given the power to step in to inspect the

financial soundness of any particular bank or subset of banks outside of the systemic group but which are flashing red on its radar. A small supervisory SWAT team could be sent in to kick the tires

alongside the national supervisor that retains direct supervisory responsibility.


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And, if necessary, the ECB could elect to bring particular banks under its direct supervisory power.

This would allow it to gradually expand its remit during the transitional period and have the absolute right to troubleshoot problems beyond the systemic group, which is surely what recent experience has proved

necessary. Another key challenge will be to develop the operating model of the ECB’s new supervisory responsibilities.

I have two thoughts here. First, while the high-level governance framework of the ECB’s

supervisory responsibilities (as distinct from its monetary policy ones), remains under negotiation, it seems likely that there will be some sort of high-level supervisory board put in place.

At the other end of the spectrum, will be the national supervisory authorities conducting decentralised tasks. The exact design of the arrangements for escalation and decision making

between the two are of crucial importance. While there will necessarily be a framework of committees and panels for certain types of decisions and policy-making, it is vital that there is clear

accountability and the capacity for decisive executive decision-making, particularly in times of crisis. In moments of crisis or market disruption, supervisors are required to

take dozens of decisions in short periods of time. It is important that the organisational design of the single supervisory mechanism recognises this reality.


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Indeed, this is the negative flipside that distance between supervisor and bank can bring.

So, one reasonable design principle – both for the regulated bank in search of a speedy answer and for the depositor in need of decisive supervisory action – one such principle must be that of efficiency and

effectiveness in the escalation and decision making process of the new supervisor. My second thought on the ECB’s new operating model relates to

supervisory culture. A clearly articulated supervisory culture and philosophy will be important for guiding front-line supervisors and for ensuring consistency in practice.

It is important that supervisors who engage day-to-day with banks understand the risk appetite of senior management and their willingness to tackle problems.

Tone and culture, as well as the underlying supervisory model, will be key in setting expectations.

Seventeen national supervisors (at least) will be converging into a new pan-European structure, uniting diverse cultures rooted in different market structures, as well as reflecting a range of different supervisory practices.

Should the focus be on rule breaches or risks? Business models or audit reports?

Should supervisors talk more to the CEO or to the compliance officer? How central a role should enforcement play for prudential breaches?


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And how should senior management distil down the essence of the new supervisory model and approach, so that it can be communicated and

understood easily by both firms and front-line staff? For example, in Ireland, our new approach is one of “assertive, risk based supervision underpinned by a credible threat of enforcement.”

That is designed to put a few concepts front and centre: that we operate a risk-based approach, differentiating based on impact and probability; that there are consequences and accountability for non-compliance; and

that our supervisors are empowered to insist upon actions to mitigate risk where we are not satisfied by the explanation from a firm’s management. The best driver for creating this common supervisory culture and model

is through the development – jointly by the supervisors that will use it – of a risk assessment framework. This will provide a common vocabulary across the banking union for the

description and identification of risk, and set out clear rules of the game for supervisors regarding risk appetite and how problems are to be mitigated.

It will therefore be an early, important task, for the ECB to develop a common risk assessment framework and a protocol for on and off-site inspections.

Stepping back from this long to-do list, it must be pretty obvious what the central challenge is for the new single supervisory mechanism. The key first call to be made is around the “European capital question”:

is there enough capital in the European banks, in light of asset quality problems and the requirements of CRD IV, and, if not, how quickly should you remedy the deficit?

This raises the policymaking dilemma, which one might call Micro – Macro Schizophrenia: the tension between the micro-prudential


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imperative to require more capital, more quickly, and macro-prudential concerns over the implications for pro-cyclicality and sovereign debt

sustainability. It’s most obvious form may be found in peripheral Eurozone countries but the condition is, of course, widely observed!

The micro-prudential supervisor’s concern for more capital, faster, is rooted in skepticism over the asset quality of the European banks’ balance sheets, due to practices of forbearance and failure to recognise

embedded losses. It is compounded by the concern that the use of bank internal models, creating risk weights from historical losses, is masking or understating

problems. And it is heightened by the imminent challenge facing the European banks as they start on the foothills of CRD IV/Basel 3 implementation, with the five-year transition to higher capital requirements just beginning

and the banks collectively facing a staggering capital gap of €349.3billion. The micro-prudential supervisor who argues for tougher, faster bank capital standards might also pray in aid of a macro-prudential argument:

that a lengthy transition incentivises banks to hoard capital and avoid lending, so get it over with! However, there are two other competing macro-prudential concerns.

One is pro-cyclicality. The Basel 3 framework addressed the pro-cyclicality problem, but

perhaps like a general fighting the last war it sets out the case for a countercyclical buffer to be built up to provide a drag on frothy, imprudent lending in good times.

But times are now certainly not good, so is there a case for the release of capital – or the deferral of new requirements?


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The argument here is that increasing capital requirements inhibit lending and encouraged deleveraging, therefore harming growth.

In a speech prior to his exposition on the Dog and Frisbee, the Bank of England’s Andy Haldane hinted that there might be a case to be made for some such adjustment.

Adair Turner shortly after tackled the question of the design of countercyclical buffers, but dismissed the case for any relaxation in Basel 3 implantation on the grounds that the Basel Committee’s analysis

showed that the long-term benefits of sticking to the plan outweighed the costs. However, he acknowledged risks to SME lending.

And perhaps the Basel analysis might have a different colour if it was conducted now in the depths of the sovereign debt crisis?

The other macro-prudential concern is around debt sustainability and the linkage between weak banking systems and stressed sovereign finances. The problem here, of course, is that if countries with sovereign debt

concerns need to borrow more to recapitalise their banks, then this harms their debt sustainability requires more austerity, which in turn impacts on the real economy and feeds back into the banks.

This is a highly damaging feedback loop that needs to be broken. The former US Treasury Secretary Hank Paulson famously spoke about the need for a bazooka to sort out the crisis, by which he meant using a

vast amount of money to convince the markets that the problem has been solved. But for countries with debt problems, they need to borrow more to afford

the ammunition for the bazooka, so their debt sustainability gets worse.


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The room for manoeuver for ever tougher capital requirements brought forward faster and faster is therefore severely constrained.

In this respect, the feedback loop will only be broken by investment, rather than borrowing, from outside of the loop.

This, of course, is where the banking union is supposed to come in, but back to that in a minute. This micro-macro dilemma has more than faint echoes of the debate on

fiscal policy. Is more austerity needed or is there a case for stimulus?

Do you stick to Plan A or move to Plan B. The recent IMF analysis on the fiscal multiplier – whereby it contended that fiscal corrections in certain countries have a larger than previously

considered drag on growth – casts new light, indirectly, on the dynamic of the bank-sovereign debt negative feedback loop. If you want to embrace the micro-prudential instinct for ever more capital

but need to cut spending to get there, be wary of the multiplier impact back into the economy and on the business prospects of the banks you are trying to strengthen in the first place.

So, is there a cure for the Micro-Macro Schizophrenia condition? Well, there are perhaps three competing schools of thought regarding treatment: what we might call the St Augustine, Schwarzenegger and Dell

cures. The St Augustine approach proposes: “make me very, very capital virtuous, but not yet.”


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The policymaker is advised to adopt even tougher capital rules in the future, but to push back their start date and in the meantime use

relaxation and/or deferral of prudential capital standards as a countercyclical stimulus to the economy, perhaps like the Roosevelt administration apparently did in the New Deal.

The St Augustine solution seems to suffer a number of defects, however. It creates an even bigger eventual capital ascent for the banks.

Doesn’t the yet bigger capital mountain ahead cast a long shadow and still encourages hoarding? Indeed, it seems that one lesson from the Basel implementation process

is that transition periods have only limited value as markets anticipate their end point and put pressure on banks to be early adopters: to be fair to the industry, this was a point they made at the time.

But most fundamentally, the St Augustine approach suffers from the fact that the compelling logic of Basel 3 has not really changed and that there is every possibility the banks need more capital to get through their current travails, not just some future ones.

The contrasting treatment is the Schwarzenegger cure, to be specific the approach which involves a muscular saviour arriving from the future to protect the present day.

The answer here is to fast forward Basel 3 implementation and immediately bring forward the full future requirements of 2018 to the present day of 2013.

The argument here is to get it all over with quickly and avoid a half-decade of anaemic growth caused by constrained lending as banks slowly meet Basel 3, hoarding capital and deleveraging along the way.


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This prudent, conservative approach has a lot going for it and is appealing to a micro-prudential regulator.

In Ireland we have sought to put the loan losses in the banks behind them by rigorously capitalising for future projected losses.

Our tool has been the stress test, in its capital shortfall variant: you project forward losses over a three year period under a severe stress scenario, calculate the shortfall that arises against a prescribed hurdle rate and, crucially, require that to be filled now.

In Ireland we went a step further and used an outside party, to come up with a wholly independent calculation of projected loan losses.

This lead to a capital requirement that was €8 billion higher than that projected by the banks themselves. That is the equivalent to 4.9% of Irish GDP.

In UK GDP terms, the amount would have been £76 billion. This is clearly a significant number no matter which way you look at it.

And then as a further measure we required an additional buffer of capital for projected losses beyond the stress test period, to a value of €5.3bn.

Should Ireland or other EU member states adopt the Schwarzenegger school and fast forward all the way to Basel 3 as soon as possible? As I say, that has strong attractions for a micro-prudential supervisor.

But there are two absolutely necessary conditions for this to make sense. First, it would have to be absolutely clear that the tougher capital

requirement cannot be met by deleveraging, as that would defeat the purpose and exacerbate the macro-prudential problem.


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Second, we have the sovereign debt negative feedback loop to worry about.

Accelerated Basel implementation shouldn’t come at the cost of worse debt sustainability.

So, this approach also only makes sense if there is European direct capital support to make this happen. In the absence of these essential conditions, we then have the third

approach, the Dell school. This is, of course, named after Michael Dell, one of the innovators of just-in-time manufacturing.

This involves making sure that banks stay above their current minimum capital requirements, and living with that just up until the point of need of recapitalization and public support, to meet Basel 3 or stress losses.

Call this a just-in-time approach to backstops, if you like. Banks therefore make their slow progress towards full Basel 3 compliance

step-by-step. This may involve a protracted period of uncertainty, but you are not adding fuel to the sovereign debt crisis fire by trying to accelerate the

implementation process through more sovereign borrowing. Which school of thought would I adopt to resolve the micro-macro dilemma?

In a nod to the St Augustine school, it certainly makes sense to take off the table any thought about attempting to impose an additional counter-cyclical buffer for the foreseeable future.


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With the end point of CRDIV clear, supervisors should require European banks to set out their capital plans for achieving their trajectory to full

compliance with CRD IV. Banks should start reporting on a full end point CRDIV basis to their supervisors, so the size of the task is very transparent to us.

And they should build on the EBA recapitalisation process, maintaining the quantum of capital that meets the EBA requirements as a platform for further progress to CRDIV.

It will be informative to see the banks’ projections regarding loan losses and future profitability in assessing the realism of their plans.

And it will be necessary to stress test them, which should be done in a coordinated way at an EU level orchestrated by the EBA. This will allow supervisors to assess the realism and resilience of the

plans. I think some fine-tuning of the stress test approach makes sense.

Trying to satisfy insatiable market expectations of conservatism in a stress test risks being very pro-cyclical. Rather than calculating a capital shortfall for immediate remedy, the recent US stress tests have moved to using the stress test as a tool for

restricting dividends and share repurchases. This would seem to be a useful refinement that Europe could follow too.

Stress tests were originally conceived as diagnostic tools, considering a range of scenarios and providing a basis for management and supervisory judgement, rather than as automatic capital formulae.


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However, if the stress tests show a bank’s plans to be hopelessly implausible, then it may indeed be better to bite the bullet and look to an

early capital injection or explicit backstop. There is, however, also a need for a rigorous examination of asset quality.

Apparently higher capital ratios provide illusory comfort if they are based on avoidance of embedded loan losses. Ireland has taken a very stringent approach to asset quality reviews.

We have used third parties to assess the quality of legal security and loan file data integrity, as well as conducting detailed loan file reviews and independently modelling loan losses.

We have also pressed the Irish banks to re-underwrite their mortgage and SME portfolios that are in arrears to establish a more granular view of embedded losses.

And we have required more rigorous provisioning practices and disclosure of impairment.

However, it is clear that Ireland is not the only jurisdiction where significant questions have been raised over the asset quality underlying banks’ actual balance sheet strength.

It makes sense to undertake a pan-European asset quality review exercise of some sort. Capital plans, diagnostic stress tests and rigorous asset quality reviews would seem a reasonable course of action to underpin and strengthen a

Dell-style just-in-time approach to the capital problem. But there is another crucial element that needs to be in place, in case the need for capital injections does in fact arise.


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This raises the last subject I want to mention: the appropriate sequencing of the introduction of the single supervisory mechanism with a new

European resolution mechanism. And related to this is the question of the role of the ESM concerning direct bank recapitalisation.

The sequencing debate goes something like this: if the single supervisory mechanism is implemented in the course of 2013 - and a pan-European Deposit Guarantee Scheme is a distant prospect – when should you

introduce new resolution powers, ESM direct recapitalisation and/or a pan European resolution Authority and Fund? There is an Irish-orientated debate on retrospective ESM recapitalisation,

but I want to put that to one side and argue that for the banking union to be a success for Europe as a whole it is important that the sequencing debate is concluded sensibly.

You do not want the ECB to start its new mandate without the full toolkit of European resolution and recapitalization arrangements operational and at hand.

To do otherwise places the new single supervisory mechanism in a precarious position at the moment of its inception. What, for example, of the question of accountability for triggering the use

of taxpayer funds? One of the mantras behind banking union from creditor countries is that liability means the need for responsibility.

In other words, mutualisation of risk through direct recapitalization requires joint supervisory control and responsibility.

But I would suggest the reverse applies too and creates an awkward scenario for the ECB.


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The ECB may wish to exercise its supervisory discretion and require more capital even when minimum Pillar 1 requirements are met, such as

through Pillar 2 charges, stress test results or maybe even accelerated CRDIV implementation. But these actions could trigger the use of national taxpayer funds

and therefore a vicious cycle of further sovereign debt, more austerity for particular taxpayers (to which it has no accountability) and a negative feedback into the bank it is trying to sort out.

If a European institution is taking on the responsibility of such an important call then surely some European arrangements need to be in place to deal with the consequences?

This is an invidious position to impose on the new supervisor right at its birth. To switch from analogies bazooka-like, it is a distinctly unpleasant

situation to be asked to put out a fire, but to find your fire extinguisher is half full – and that the only way to get a re-load is to increase debt and austerity.

So, this then, is my overriding and final conclusion. To be a success, the new single supervisory mechanism of the banking union needs to have a well-considered relationship with the EBA and a

strong commitment to the single market. It needs to have a best practice supervisory toolkit, effective and efficient decision-making procedures, a top-notch risk assessment framework and

a robust, jointly shared, supervisory culture. But above all, the European political process needs to ensure that the new resolution rules and ESM direct recapitalisation tools are fully operational

for the new supervisor when it takes on its onerous responsibilities.


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If not, the ECB itself is at risk of succumbing to a very nasty case of micro-macro schizophrenia.


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Opening Remarks at the High Level Seminar of “Macro - prudential policy: Asian Perspective” Distinguished Managing Director Kahn,

Distinguished First Deputy Managing Director Lipsky, Ladies and Gentlemen,

Good Morning. It is a pleasure to meet friends old and new in Shanghai in this beautiful autumn to discuss macro-prudential policy.

On behalf of the People’s Bank of China, I want to extend the warmest welcome to representatives from international organizations and officials from central banks, ministries of finance and financial regulators.

Reviewing the global financial crises in history, we know that a crisis will prompt fresh institutional reforms in addition to causing massive damages.

Since the outbreak of this round of crisis, the international community has agreed on the need to strengthen efforts to implement macro prudential policy.

In the past few decades, the many new developments in financial sector undergone, as reflected in positive feedbacks and pro-cyclicality in the economic and financial system, worked together with various other factors and ingredients such as insufficient early warning, inappropriate

management and contagion, and produced the worst crisis since the “Great Recession”. A key lesson from this crisis is that risk prevention should focus not only

on single financial institution or single sector, but also on systemic risks.


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Macro-prudential policy is the very solution that addresses systemic risks. After the outbreak of the crisis, the International Monetary Fund and the

Financial Stability Board stated clearly that implementing macro-prudential policy should be central banks’ responsibility. Countries have since then also enhanced central banks’ macro-prudential

policy functions in their financial reform. At the request of G20 financial summit, the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) and other

standard-setting bodies are working to develop institutional arrangements and tools to strengthen macro-prudential policy, establish mechanism to mitigate pro-cyclical factors, raise regulatory standards on systemically important financial institutions, and improve risk disposal

and settlement arrangements. The international practice of strengthening macro prudential policy will be a boost to China’s financial reform and development.

The Chinese financial system has basically withstood the shocks of the recent crisis because of the following reasons.

First, continued economic growth has created a benign environment. Second, after the Asian financial crisis, joint stock reform of state-owned commercial banks enhanced their overall strength and resilience and

strengthened the foundation for financial stability. Third, the financial legislation system and supervision ability has improved.

Fourth, the financial market, including delivery of services and product innovation, was not sophisticated, and this helped ward off crisis.

Currently, China’s financial system faces the challenge of guarding against systemic risks.


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On one hand, to address deep-rooted problems in the economic structure and the uneven and unbalanced growth, it is necessary to adopt

sustainable and sound macro-economic policies; the expansion of domestic credit supplies remains strong and cross-border capital movement contains potential risks.

Excessive liquidity, inflation, asset price bubbles, periodic non - performing loans and other risks may build up and undermine asset quality and resilience of China’s financial sector.

One the other hand, in the past few years, many financial institutions are offering cross-sector and cross-market products; financial share-holding companies have established complex internal structures and moved into diversified businesses; new-type of financial institutions are heavily

involved in the financial market activities. Given China’s domestic situation, the stability of the financial system and macro-economic policies are directly related.

Due to the large share of bank credit in total financing, there is a close relationship between fluctuation of credit supply and economic cyclical change on one hand and systemic financial risks on the other.

Therefore, the establishment of counter-cyclical adjustment mechanism is our priority in strengthening macro prudential policy.

The People’s Bank of China, with a mandate in China’s macro-economic management and financial stability, needs to build a counter-cyclical adjustment mechanism to increase flexibilities in macro-economic management.

Meanwhile, it is necessary to strengthen monitoring on systemically - important financial institutions to prevent and properly manage potential systemic risks.

Macro-prudential policy is a relatively new concept in China.


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To avoid misunderstanding and simplification of it as just capital

requirement, capital buffer, liquidity, leverage, etc, first of all, we need to clarify its essential meaning, framework and concrete content. In general, firstly macro-prudential policy is counter-cyclical.

Secondly, it needs to deal with market failure such as herding phenomena to enhance financial market soundness and prudence of market participants.

Thirdly, along with globalization, rapid expansion of financial market, increasing complex financial instruments and trading, it is necessary to formulate and implement broader international standards.

Today, thanks to an IMF initiative, we gather to discuss macro prudential framework based on lessons learned in crisis, to analyze macro prudential policy tools and their effects, to reflect the changing roles of central banks in macro prudential management.

We need to reexamine the relationship between monetary policy, financial stability and macro prudential management, and its policy implications.

These are very challenging topics and deserve thorough discussion. I wish this seminar a great success!

Thank you!


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The Governor of the Bank of England Her Majesty the Queen has been pleased to

approve the appointment of Mark Carney as Governor of the Bank of England from 1 July 2013. He will succeed Sir Mervyn King.

Welcoming the appointment the Chancellor of the Exchequer, the Rt Hon George Osborne MP, said:

“Mark Carney is the outstanding candidate to be Governor of the Bank of England and help steer Britain through these difficult economic times.

He is quite simply the best, most experienced and most qualified person in the world to do the job. He has done a brilliant job for the

Canadian economy as its central bank Governor, avoiding big bail outs and securing growth.

He has been chosen by the rest of the world to be the chair of the international body, the Financial Stability Board, charged with strengthening global financial regulation after the financial crisis.

Along with its central role in monetary policy, this Government has put the Bank of England back in charge of regulating our financial system so that we don’t repeat the mistakes of the last decade.

Mark Carney is the perfect candidate to take charge of the Bank as it takes on these vital new responsibilities. He will bring strong leadership and a fresh new perspective.


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I look forward to working with Mark as we continue to rebalance our economy, deal with our debts, and equip Britain to succeed in the global

race. We needed the best – and in Mark Carney we’ve got it.”

Notes for editors 1. Mr Carney is currently Governor of the Bank of Canada, having taken up his office on 1 February 2008. He also currently serves as Chairman of the Financial Stability Board

(FSB) and as a member of the Board of Directors of the Bank for International Settlements (BIS). He is also a member of the Group of Thirty, and of the Foundation Board

of the World Economic Forum. 2. Prior to becoming the Governor of the Bank of Canada, Mr Carney was Senior Associate Deputy Minister of Finance (2004 – 2007) and Deputy

Governor of the Bank of Canada (2003 – 2004). Prior to that, Mr Carney had a thirteen-year career with Goldman Sachs in its London, Tokyo, New York and Toronto offices.

Mr Carney has a bachelor's degree in economics from Harvard University (1983 – 1988) and a Masters and Doctorate in economics from Nuffield College, Oxford University (1991 – 1995).

3. Mr Carney was born in Fort Smith, Northwest Territories, Canada in 1965. As a Canadian citizen he is a subject of Her Majesty The Queen.

He is married to Diana Fox Carney, an economist and British citizen. They have four daughters. Mr Carney has indicated he intends to apply for British citizenship.


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4. Mr Carney has indicated he intends to serve for five years.

5. Under the Bank of England Act 1998, as expected to be amended by the Financial Services Bill which is currently being considered by Parliament, the Governor of the Bank of England is appointed by Her Majesty the Queen on advice from the Prime Minister.

He was advised by the Chancellor of the Exchequer, who oversaw the appointment process, and, as with other public appointments, consulted the Deputy Prime Minister.

The selection panel for the recruitment process comprised Sir Nicholas Macpherson, Permanent Secretary HM Treasury; Tom Scholar and John Kingman, Second Permanent Secretaries, HM Treasury; and Sir David

Lees, Chair of the Court of the Bank of England. 6. Her Majesty The Queen has also been pleased to approve, under the Bank of England Act 1998 as amended by the Banking Act 2009, the

Chancellor and Prime Minister’s recommendations for the re-appointment of Charles Richard Bean as Deputy Governor of the Bank of England for Monetary Stability from 1 July 2013.

Mr Bean has agreed to stay on for a year to help oversee the extension of the Bank of England’s responsibilities and the transition to the new Governor.

He has asked to stand down on 30 June 2014.


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UBS trading losses in London: FINMA finds major control failures The proceedings launched by the Swiss

Financial Market Supervisory Authority FINMA into UBS's trading losses in London have highlighted serious deficiencies in risk management and controls at UBS's Investment Bank.

In FINMA's view, the fraudulent transactions executed by the rogue trader would have been detected sooner if these deficiencies had not existed.

As soon as the unauthorised trading activities became known, FINMA imposed preventive measures to limit UBS's operational risks. Now that its proceedings have been completed, FINMA is appointing an

independent third party to ensure that corrective measures are successfully implemented.

In September 2011, FINMA together with the UK regulator, the FSA, launched a comprehensive independent investigation into the events at

UBS (press release). Its aim was to clarify the circumstances that led to serious unauthorised trading losses at UBS's London office and review the control mechanisms

at UBS's Investment Bank. In December 2011, FINMA initiated formal enforcement proceedings (press release).

Today, FINMA is publishing a summary report detailing the conclusions of the proceedings and disclosing the measures it has taken as well as those implemented as a first step immediately after the trading losses

became known.

http://www.finma.ch/e/aktuell/pages/mm-ubs-untersuchung-20110916.aspx

http://www.finma.ch/e/aktuell/pages/mm-ubs-enforcementverfahren-20120203.aspx


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The far-reaching immediate measures ordered by FINMA include capital restrictions and an acquisition ban on the Investment Bank.

Moreover, any important, new business initiative which the Investment Bank intends taking must initially be approved by FINMA.

In order to monitor the progress of the measures imposed, FINMA is appointing an independent investigator and, at a later stage, will engage an audit firm to review whether the steps taken by UBS have proved effective.

FINMA is also further examining whether UBS must increase capital backing for its operational risks.

Background to the trading losses

In mid-September 2011, UBS discovered that trader X, who was employed on the Exchange-Traded Fund (ETF) desk of its Investment Bank in London, had been engaging in unauthorised trading.

The ETF desk traded in a variety of financial instruments designed to meet the investment needs of UBS clients. The desk also traded on its own account.

As a director-level employee, trader X executed transactions for the bank's account in excess of his defined limits and concealed the risk exposures.

By using a range of prohibited mechanisms, he succeeded for a substantial period in covering up the actual scale of his trading positions and the risk they posed.

The mechanisms used included one-sided internal futures positions, the delayed booking of transactions and fictitious deals with deferred settlement dates. UBS suffered losses of USD 2.3 billion.


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Trader X also created a mechanism, which he referred to as the "umbrella", for smoothing out profits and losses.

On 20 November 2012 trader X was found guilty on charges of fraud by abuse of position and not guilty on charges of false accounting at the end of his trial in London.

Unclear monitoring responsibilities

Responsibility for monitoring and controlling the ETF desk was split between the line managers in the front office and three separate control functions.

The Operations unit was responsible, among other things, for ensuring that the ETF desk's trades were correctly recorded and processed.

Product Control, part of the Finance department, was responsible for ensuring correct reporting and plausibility checking of profits and losses, while Risk Control was tasked with monitoring and evaluating the risks from trading activities.

Line managers were uncertain of what their functions and responsibilities were as regards monitoring the ETF desk.

One aggravating factor was that, following a reorganisation in April 2011, the direct line manager was located in New York. No specific arrangements were made for transferring responsibility for

monitoring. Warnings did not get as far as the new direct line manager in New York and ended up instead with the previous line manager in London.

He received and acknowledged them, even though this was no longer his responsibility.


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Between June and July 2011, it became clear on at least four occasions that trader X had exceeded his limits.

In one of these cases, he revealed to his manager in New York that he had made a profit of USD 6 million by taking a position of more than USD 200 million, far in excess of his approved risk limit.

The line manager first congratulated trader X on the profit and only later reminded him that he needed permission to exceed his limit.

The inadequacy of the controls was also made clear by an incident in August 2011 in which fictitious ETF trades with deferred settlement dates generated irregularities amounting to half a billion dollars.

These warning signals were accepted without further investigation.

Control functions too weak

The three control functions also failed to properly investigate the many warnings triggered by transactions from the ETF desk. For example, the

unusually large profits generated by the ETF desk starting in the first quarter of 2011 were not critically examined. It was common knowledge in the London trading room that the ETF

desk caused many reconciliation errors, often as a result of late or incorrectly booked transactions. These concerns were discussed neither with the Product Control unit nor

with senior management. Starting in June 2011, the reconciliation errors became substantial, with the unexplained amounts sometimes exceeding USD 1 billion.

Operations saw its role as providing services to trader X and raised no serious questions about his activities.


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Although reconciliation errors remained unresolved over several weeks, explanations provided were implausible, and inconsistencies were

occasionally escalated, trader X's managers and controllers were too quick to accept his explanations. Even at a meeting held on 24 August 2011, managers came to the

conclusion that no large amounts of money were at risk. In August 2011, trader X once again persuaded Product Control that losses of one billion dollars shown in the trading systems were incorrect.

His assurance that he would correct these "booking errors" in the near future was accepted without objection. In fact, trader X's aim was to remove the bank's losses, at least

temporarily, from the books. In addition, an important control report was not produced at all for a period of several months without anyone noticing this fact.

FINMA's main findings

On the basis of these findings, FINMA has reached the following conclusions:

The direct line managers failed to properly monitor the ETF desk in London. Trader X's relationship with his l ine manager and the internal control functions was based too much on trust and too little on control.

The front office monitoring instruments deployed by the line

manager responsible for the ETF desk had major shortcomings and were not used properly.

The control functions had too little understanding of the trading

activities in question and were therefore unable to challenge the ETF desk's actions.


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UBS's various control functions did not collate their information to produce an overall picture.

Operational risks were evaluated to a large extent on the basis of a

self-assessment process, which was carried out just once a year by traders and internal controllers. Improvements to this process had

been in train since January 2011, but were completed too late.

Reporting channels and responsibilities were unclear and led to confusion.

The relocation of direct supervision of the ETF desk from London

to New York was badly managed and led to a situation in which the London desk was not adequately monitored from April 2011 onwards.

UBS sent out misleading signals by awarding pay increases and

bonuses to a trader who had clearly and repeatedly breached compliance rules, and by accepting him onto a junior management

programme.

Immediate measures implemented by FINMA

As soon as the trading losses were discovered, FINMA imposed until further notice a range of preventive measures on UBS:

Any new business initiatives which UBS intends to take in its investment bank and which are likely to lead to increased operational

complexity require prior approval from FINMA.

The risk-weighted assets of UBS's Investment Bank are subject to an upper limit which reduces gradually over the period 2012 to 2015.

The risk-weighted assets of the London branch are also subject to

an upper limit which reduces over time.

UBS's Investment Bank is prohibited from making new acquisitions.


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UBS's corrective measures

Since the trading losses, UBS has introduced a large number of organisational measures to strengthen its risk management and control

capabilities.

Action has been taken on the personnel front, core processes in the front and back offices have been modified, and deficiencies in the processing of trades have been addressed.

These, along with other measures, are currently being implemented.

Further measures taken by FINMA

In a newsletter to market participants published on 13 December 2011 (FINMA Newsletter), FINMA specified its expectations regarding

controls to prevent unauthorised trading.

As part of its supervisory remit, FINMA is checking the extent to which the most important supervised institutions meet these expectations. FINMA is closely supervising the implementation of the corrective

measures at UBS and has now decided on the following additional actions:

FINMA is appointing an independent investigator to control the implementation and completion of the corrective measures at UBS.

Once the project is completed, FINMA will engage an audit firm to review whether the measures implemented by UBS have proved effective.

FINMA is further examining whether UBS must increase capital backing for its operational risks.

The ruling dated 21 November 2012 and the report published today mark

the end of the formal enforcement proceedings initiated by FINMA against UBS on 16 December 2011.

http://www.finma.ch/e/aktuell/pages/mm-handelstransaktionen-20111213.aspx


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In coordination with FINMA, the Financial Services Authority (FSA) in the UK is also closing its enforcement proceedings and is imposing a fine

of GBP 29.7 million on UBS.


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Dear Member,

The regulatory arbitrage challenges and opportunities between the banking and the insurance sector are always important and profitable for many, especially for consultants that are experts in both areas.

For example, you can see an interesting job description: “Head of Risk & Compliance - Up to £200,000 package”

The candidate needs to have strong expertise in the core Risk Management areas like: - Compliance to Basel II, II.5 and Basel III - Compliance to Solvency II

You can read more at: http://jobview.monster.co.uk/getjob.aspx?jobid=115693460&WT.mc_n=Indeed_UK&from=indeed

I have to confess: I am a collector of ideas that lead to regulatory arbitrage opportunities, especially between the banking and the insurance balance sheet.

Almost every financial product is subject to some form of supervision and regulation, which is usually different in banking and insurance. This is an opportunity. The same product can be structured to become a “banking

product” or an “insurance product”. I know. Basel iii and Solvency ii are supposed to eliminate regulatory arbitrage opportunities.

Every time I think something like that, I have to admit that firms (and countries) will always do their best to exploit opportunities and have competitive advantages.

This week I will start from an interesting phrase:

http://jobview.monster.co.uk/getjob.aspx?jobid=115693460&WT.mc_n=Indeed_UK&from=indeed

http://jobview.monster.co.uk/getjob.aspx?jobid=115693460&WT.mc_n=Indeed_UK&from=indeed


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“The changes in banking regulation make more important the role of

insurers as providers of long-term ***bank funding***” Who said that?

Gabriel Bernardino, the Chairman of EIOPA (the European Insurance and Occupational Pensions Authority, one of three European Supervisory Authorities).


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Global Shadow Banking Monitoring Report 2012

Executive Summary The “shadow banking system” can broadly be described as “credit

intermediation involving entities and activities outside the regular banking system”. Although intermediating credit through non-bank channels can have

advantages, such channels can also become a source of systemic risk, especially when they are structured to perform bank-like functions (e.g. maturity transformation and leverage) and when their interconnectedness with the regular banking system is strong.

Therefore, appropriate monitoring and regulatory frameworks for the shadow banking system needs to be in place to mitigate the build-up of risks.

The FSB set out its initial recommendations to enhance the oversight and regulation of the shadow banking system in its report to the G20 in October 2011.

Based on the commitment made in the report, the FSB has conducted its second annual monitoring exercise in 2012 using end-2011 data.

In the 2012 exercise coverage was broadened to include 25 jurisdictions and the euro area as a whole, compared to 11 jurisdictions and the euro area in the 2011 exercise.

The addition of new jurisdictions brings the coverage of the monitoring exercise to 86% of global GDP and 90% of global financial system assets. The exercise was conducted by the FSB Analytical Group on

Vulnerabilities (AGV), the technical working group of the FSB Standing


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Committee on Assessment of Vulnerabilities (SCAV), using quantitative and qualitative information, and followed a similar methodology as that

used for the 2011 exercise. Its primary focus is on a “macro-mapping” based on national Flow of Funds and Sector Balance Sheet data (hereafter Flow of Funds), that

looks at all non-bank financial intermediation to ensure that data gathering and surveillance cover the areas where shadow banking-related risks to the financial system might potentially arise.

The main findings from the 2012 exercise are as follows: - According to the “macro-mapping” measure, the global shadow

banking system, as conservatively proxied by “Other Financial

Intermediaries” grew rapidly before the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007. The size of the total system declined slightly in 2008 but increased

subsequently to reach $67 trillion in 2011 (equivalent to 111% of the aggregated GDP of all jurisdictions). Compared to last year’s estimate, expanding the coverage of the

monitoring exercise has increased the global estimate for the size of the shadow banking system by some $5 to $6 trillion.

- The shadow banking system’s share of total financial intermediation

has decreased since the onset of the crisis and has remained at around 25% in 2009-2011, after having peaked at 27% in 2007. In broad terms, the aggregate size of the shadow banking system is

around half the size of banking system assets. - The US has the largest shadow banking system, with assets of $23

trillion in 2011, followed by the euro area ($22 trillion) and the UK ($9

trillion).


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However, the US’ share of the global shadow banking system has declined from 44% in 2005 to 35% in 2011.

This decline has been mirrored mostly by an increase in the shares of the UK and the euro area.

- There is a considerable divergence among jurisdictions in terms of:

(i) the share of non-bank financial intermediaries (NBFIs) in the overall financial system;

(ii) relative size of the shadow banking system to GDP; (iii) the activities undertaken by the NBFIs; and (iv) recent growth trends.

- The Netherlands (45%) and the US (35%) are the two jurisdictions

where NBFIs are the largest sector relative to other financial institutions in their systems.

The share of NBFIs is also relatively large in Hong Kong (around 35%), the euro area (30%), Switzerland, the UK, Singapore, and Korea (all around 25%).

- Jurisdictions where NBFIs are the largest relative to GDP are Hong

Kong (520%), the Netherlands (490%), the UK (370%), Singapore (260%) and Switzerland (210%).

Part of this concentration can be explained by the fact that these jurisdictions are significant international financial centres that host activities of foreign-owned institutions.

- After the crisis (2008-2011), the shadow banking system continued to

grow although at a slower pace in seventeen jurisdictions (half of them being emerging markets and developing economies undergoing

financial deepening) and contracted in the remaining eight jurisdictions.


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- National authorities have also performed more detailed analyses of their NBFIs in the form of case studies.

Although further data and more in-depth analysis may be needed, these studies illustrate the application of risk factor analysis (e.g. maturity/liquidity transformation, leverage, regulatory arbitrage) to narrow down to a subset of entities and activities that might pose

systemic risk.

- Among the jurisdictions where data is available, interconnectedness risk tends to be higher for shadow banking entities than for banks.

Although further analysis may be needed with more cross-border and prudential information, shadow banking entities seem to be more dependent on bank funding and are more heavily invested in bank

assets, than vice versa. - Regarding finance companies, which are a focus area for this year’s

report, the survey responses from 25 participating jurisdictions

suggest the existence of a wide range of business models covered under the same label.

The responses also underlined the important role finance companies

play in providing credit to the real economy, especially by filling credit voids that are not covered by other financial institutions. A few jurisdictions have also emphasised the need to enhance

monitoring of the sector as finance companies may be liable to specific risk factors and/or regulatory arbitrage. However, since the size of the sector is limited, participating

jurisdictions do not see significant systemic risks arising from this sector at present.

Going forward, the monitoring exercise should benefit from continuous

improvement and thorough follow-up by jurisdictions of identified gaps and data inconsistencies.


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It is also important that the monitoring framework remains sufficiently flexible, forward-looking and adaptable to capture innovations and

mutations that could lead to growing systemic risks and arbitrage. Further improvements in data availability and granularity will be essential for the monitoring exercise to be able to adequately capture the

magnitude and nature of risks in the shadow banking system. This is especially relevant for those jurisdictions that lack fully developed Flow of Fund statistics (e.g. China, Russia, Saudi Arabia) or have low

granularity at the sector level resulting in a relatively large share of unidentified NBFIs (e.g. UK, euro area-wide Flow of Funds). Data enhancing efforts may leverage off on-going initiatives to improve

Flow of Funds statistics (e.g. the IMF/FSB Data Gaps initiatives) or on supervisory information and market intelligence as a complement to Flow of Funds data.

Survey data or market estimates can also be used more extensively for those parts of the shadow banking system (e.g. hedge funds) for which Flow of funds do not provide a reliable estimate.

The use of additional analytical methods based on market, supervisory and other data to conduct deeper assessment of risks, for example, maturity transformation, leverage and interconnectedness would also provide significant value added to the report.

Lastly, the mostly entity-based focus of the “macro-mapping” should be complemented next year by obtaining more granular data on assets/liabilities (e.g. repos, deposits) or expanding activity-based

monitoring, to cover developments in relevant markets where shadow banking activity may occur, such as repo markets, securities lending and securitisation.

In addition to existing supervisory and market information, the implementation of some of the shadow banking regulatory


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recommendations, such as the transparency recommendations from the FSB Workstream on securities lending and repos (WS5), is expected to

provide the necessary data for such an enriched monitoring.

Introduction Efficient monitoring of the size and of the adaptations and mutations of

shadow banking are important elements for strengthening the oversight of this sector, which is a key priority for the FSB and the G20. In its report “Shadow Banking: Strengthening Oversight and Regulation”

to the G20 (hereafter October 2011 Report), the FSB set out approaches for effective monitoring of the shadow banking system and has published the results of its first attempt to map the shadow banking system using data from eleven of its member jurisdictions and the euro area.

It also committed to conducting annual monitoring exercises to assess global trends and risks in the shadow banking system through its Standing Committee on Assessment of Vulnerabilities (SCAV), drawing

on the enhanced monitoring framework defined in the report. Based on this commitment, the FSB recently conducted its annual monitoring exercise for 2012, significantly broadening the range of

jurisdictions covered to include all 24 FSB member jurisdictions, Chile, and the euro area. This expanded coverage enhances the comprehensive nature of the

monitoring, since participating jurisdictions represent in aggregate 86% of global GDP and 90% of global financial system assets (up from 60% and 70% per cent, respectively).

The exercise was conducted by the Analytical Group on Vulnerabilities (AGV), the technical working group of the SCAV, during summer 2012, using end-2011 data as well as additional qualitative information and market intelligence.


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This report summarises the preliminary results of the 2012 monitoring exercise.

1. Methodology In its October 2011 report, the FSB broadly defined shadow banking as the system of credit intermediation that involves entities and activities fully or partially outside the regular banking system, and set out a

practical two-step approach in defining the shadow banking system: - First, authorities should cast the net wide, looking at all non-bank

credit intermediation to ensure that data gathering and surveillance

cover all areas where shadow banking-related risks to the financial system might potentially arise.

- Second, for policy purposes, authorities should narrow the focus to

the subset of non-bank credit intermediation where there are:

(i) Developments that increase systemic risk (in particular maturity/liquidity transformation, imperfect credit risk transfer

and/or leverage), and/or (ii) Indications of regulatory arbitrage that is undermining the benefits of financial regulation.

Based on the above approach, the FSB recommended that authorities enhance their monitoring framework to assess shadow banking risks through the application of a stylised monitoring process, guided by seven

high-level principles. This process would require authorities to first assess the broad scale and trends of non-bank financial intermediation in the financial system

(“macro-mapping”), drawing on information sources such as Flow of Funds and Sector Balance Sheet data (hereafter Flow of Funds data), and complemented with other relevant information such as supervisory data.


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Authorities should then narrow down their focus to credit intermediation activities that have the potential to pose systemic risks, by focusing in

particular on activities involving the four key risk factors as set out in the second step (i.e. maturity/liquidity transformation, imperfect credit risk transfer and/or leverage).

In line with these recommendations, the 2012 annual monitoring exercise primarily focused on the “macro-mapping” or the first phase of the stylised monitoring process through collecting the following data and information from 25 jurisdictions and the euro area:

(i) Flow of Funds data as of end-2011 based on the template used for the 2011 monitoring exercise and recommended in the October 2011 report;

(ii) A short analysis of national trends in shadow banking; and (iii) Additional data and qualitative information on “finance companies” based on a survey questionnaire.

In addition, on a voluntary basis, several jurisdictions provided case studies on specific entities or activities involved in non-bank financial intermediation in their jurisdictions.

Flow of Funds data are a useful source of information in mapping the scale and trends of non-bank credit intermediation.

They provide generally high quality, consistent data on the bank and non-bank financial sectors’ assets and liabilities, and are available in most jurisdictions, though there is room for improvement.

The components related to the non-bank financial sector, and especially the “Other Financial Intermediaries (OFIs)” sector (which typically includes NBFIs that cannot be categorised as insurance corporations or pension funds or public sector financial entities), can be used to obtain a

conservative proxy of the size of the shadow banking system and its evolution over time.


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In order to cast the net wide, the macro-mapping needs to be conservative in nature, looking at all non-bank financial intermediation so as to cover

all areas where shadow banking-related risks might potentially arise (for example through adaptation and mutations). This would alert the authorities to areas where adaptations and mutations

could lead to points of risk in the system. Authorities could then conduct more detailed monitoring for policy purposes, with an eye towards identifying the subset of non-bank

financial intermediation where there are (i) Developments that increase systemic risk (in particular maturity/liquidity transformation, imperfect credit risk transfer and/or

leverage), and/or (ii) Indications of regulatory arbitrage that is undermining the benefits of financial regulation (Exhibit 1-1).


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2. Overview of macro-mapping results The main results of the 2012 exercise at macro-mapping the shadow

banking system can be briefly summarised as below: - Aggregating Flow of Funds data from 20 jurisdictions (Argentina,

Australia, Brazil, Canada, Chile, China, Hong Kong, India, Indonesia,

Japan, Korea, Mexico, Russia, Saudi Arabia, Singapore, South Africa, Switzerland, Turkey, UK and the US) and the euro area data from the European Central Bank (ECB), assets in the shadow banking system in a broad sense (or NBFIs, as conservatively proxied by financial

assets of OFIs - OFIs comprise of all financial institutions that are not classified as banks, insurance companies, pension funds, public financial institutions, or central banks) grew rapidly before the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007.

The total declined slightly to $59 trillion in 2008 but increased subsequently to reach $67 trill ion in 2011 (Exhibit 2-1).

- Expanding the coverage of the monitoring exercise has increased the global estimate for the size of the shadow banking system by some $5 to 6 trillion in aggregate, bringing the 2011 estimate from $60 trillion with last year’s narrow coverage to $67 trillion with this year’s broader

coverage. The newly included jurisdictions contributing most to this increase were Switzerland ($1.3 trillion), Hong Kong ($1.3 trillion), Brazil ($1.0

trillion) and China ($0.4 trillion).


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- The shadow banking system’s share of total financial intermediation has decreased since the onset of the crisis and has been recently stable at a level around 25% of the total financial system (Exhibit 2-2), after

having peaked at 27% in 2007. In aggregate, the size of the shadow banking system in a broad sense is around half the size of banking system assets.


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- The size of the shadow banking system (or NBFIs), as conservatively

proxied by assets of OFIs, was equivalent to 111% of GDP in aggregate for 20 jurisdictions and the euro area at end-2011 (Exhibit 2-3), after having peaked at 128% of GDP in 2007.


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- The US has the largest shadow banking system, with assets of $23 trillion in 2011 on this proxy measure, followed by the euro area ($22

trillion) and the UK ($9 trillion). However, its share of the total shadow banking system for 20 jurisdictions and the euro area has declined from 44% in 2005 to 35%

in 2011 (Exhibit 2-4). The decline of the US share has been mirrored by an increase in the shares of the UK and the euro area.

These aggregates count as a conservative estimate of the size of the shadow banking system, across a number of dimensions. Firstly, the category “other financial intermediaries” may include entities

that are not engaged in credit intermediation. The range of entities included in this category can vary from one jurisdiction to another.


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Secondly, “financial assets” include non-credit instruments that may constitute part of the long credit intermediation “chain”.

Third, in some cases total assets are used rather than financial assets, because of data limitations.

The remainder of this report examines the composition and growth of the shadow banking system in more detail. - Section 3 offers a more detailed cross-jurisdiction analysis of the size

of the shadow banking system, and growth trends since the onset of the crisis. It shows a considerable divergence among jurisdictions in terms of:

-

(i) The importance of NBFIs in the overall financial system (% share within the financial system); (ii) Size relative to real economy (GDP); and

(iii) Growth trends, especially after the crisis. Jurisdictions where NBFIs are large relative to the financial system

and have experienced robust growth since 2007 may deserve more in-depth investigation (e.g. the UK). For emerging market and developing economies where the NBFI

sector is growing at a strong pace but remains small overall, the challenge consists in striking an appropriate balance between the need for increasing financial inclusion and broadening access to finance, including through NBFIs, and the importance of preserving

financial stability.

- Section 4 provides a detailed analysis of the components of the shadow banking system, as conservatively proxied by OFIs, and

growth trends since the onset of the crisis.


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Investment funds other than MMFs seem to constitute the largest share (35% of OFIs in 2011), followed by structured finance vehicles

(10%). The size of all sub-sectors of OFIs is, on aggregate, either stable or declining since 2007, with the largest declines affecting MMFs and

structured finance vehicles.

- Thanks to improvements in the granularity of data provided by certain countries, the share of the unidentified component (“others”) within

the OFI sector has been reduced from 36% last year (with data from 11 jurisdictions) to 18% this year (with data for 25 jurisdictions) and 33% (with data for 20 jurisdictions and the euro area).

However, since other jurisdictions with a large shadow banking system (e.g. the euro area and the UK) lack granular data for NBFIs, further improvement in the Flow of Funds statistics or adjustments by other data sources is essential to obtain a better picture of this sector.

- Systemic risks stemming from interconnectedness between banks

and shadow banking entities are examined in Section 5.

Among the various measures to capture such risks, (i) Direct credit exposures and

(ii) Funding dependence across sectors are assessed based on data submitted from some jurisdictions. A cross-jurisdiction comparison of jurisdictions where data is

available shows that there is wide variation in the degree of interconnectedness between the two sectors in different financial systems.

However, in most jurisdictions, interconnectedness risk tends to be higher for shadow banking entities than for banks.


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Shadow banking entities seem to be more dependent on bank funding and are more heavily invested in bank assets, than vice versa.

This assessment may be improved with wider data coverage, more granular data, and supplementing the assessment by additional information, for instance sourced from prudential regulators.

- Finally, a brief summary of responses to the additional survey

questionnaire on finance companies is set out in Section 6.

The responses from 25 participating jurisdictions suggest the existence of a wide range of businesses covered under the category “finance companies”, a term that broadly refers to non-banks that provide loans to other entities.

While the composition of this sector varies across jurisdictions, the responses underlined the importance of finance companies in providing credit to the real economy especially to fill credit voids that

are not covered by other financial institutions. A few jurisdictions have also emphasised the need to enhance monitoring of the sector as finance companies may be liable to

specific risk factors and/or regulatory arbitrage. However, since the size of the sector is limited, participating jurisdictions do not see significant risks at present from a systemic

point of view.

3. Cross-jurisdiction analysis Flow of Funds data allow for cross-jurisdiction comparisons of the structure of financial systems and of the importance and growth of NBFIs as conservatively proxied by OFIs (see template in Annex 1).


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3.1 Structure of financial systems Three main groups of jurisdictions emerge when analysing the structure of financial systems based on the share of banks, insurance companies

and pension funds, other NBFIs/OFIs, public financial institutions and central banks in the total (see Annex 2 and Exhibit 3-1): - A first group includes advanced economies characterised by a

dominant share of banks combined with a limited share of OFIs that does not exceed 20%. Jurisdictions such as Australia, Canada, France, Germany, Japan,

Spain fall in this category.

- A second group includes economies where the share of OFIs is above 20% of the total financial system and relatively similar, or higher, to

that of banks.

For instance, the Netherlands, the UK, the US, fall in this category. - A third group includes emerging market and developing economies

where the share of public financial institutions or the central bank is significant, often on account of high foreign exchange reserves or sovereign wealth funds, and where the share of OFIs is relatively low.

This group includes jurisdictions such as Argentina, China, Indonesia, Russia and Saudi Arabia.


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Globally, the shadow banking system, as conservatively proxied by OFIs, represents on average 25% of financial system assets and 111% of the aggregated GDP, for the sample of 20 participating jurisdictions and the

euro area.


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As shown in Exhibit 3-2, these aggregate numbers mask wide disparities between jurisdictions.

Five jurisdictions (Hong Kong, the Netherlands, the UK, Singapore and Switzerland) are characterised by a large size of NBFIs relative to GDP, which is partly attributable to the fact that these countries also have large

banking systems relative to GDP. Part of this concentration is attributable to these jurisdictions’ role as financial centres or host to financial activities carried out by

foreign-owned institutions.

3.2 Growth trends of non-bank financial intermediaries across jurisdictions Before the crisis, the shadow banking system had registered very high rates of growth across all jurisdictions (Exhibit 3-3).

In this period characterised by low interest rates and a general under-pricing of risk, the increase in leverage in the banking and shadow banking systems, combined with excessive levels of maturity and

liquidity transformation in both systems, precipitated the collapse in financial intermediation.


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Post-crisis, the growth of the shadow banking system decelerated

significantly in all jurisdictions (Exhibit 3-3). Nine jurisdictions (Australia, Canada, France, Italy, the Netherlands, Saudi Arabia, Spain, Turkey, the US) out of twenty five experienced

declines of their NBFIs for the period 2007-2011, albeit at moderate pace. In particular, securitisation markets remained impaired in most regions and segments, and MMFs suffered from the prolonged period of very low

interest rates which put their business model at risk. Out of the seventeen jurisdictions whose NBFI sector continued to grow, half of them were emerging economies where financial deepening is a

significant structural driver of change in the financial system. India and Indonesia stand out with annual growth rates of above 20% since 2007 which may require closer monitoring.


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Two advanced economies experienced relatively robust rates of growth of their NBFIs since 2007: the UK (10% a year) and to a lesser extent

Switzerland (6%). In the UK, a significant part of this growth is associated with an increase in derivative assets of NBFIs, which is matched by a commensurate

increase in derivative liabilities, and is in line with trends in the gross market value of global OTC derivatives and London’s large share of this market. Further work would be needed to understand why similar increases were not recorded in other jurisdictions active in derivative

dealing and the potential role of different accounting regimes.

4. Composition of non-bank financial intermediaries An important step in assessing the importance and the trends in the shadow banking sector is to more precisely identify the sub-components

of the NBFI/OFI sector and their degree of risk. As data from the five largest euro area jurisdictions is more granular than aggregate data at the euro area level, the analysis in this section is,

contrary to the rest of the report, mostly based on data for 25 jurisdictions, instead of 20 jurisdictions and the euro area, in order to provide more precise breakdowns and trends.

4.1 Breakdown by sub-sectors of NBFIs at end-2011 The OFI sector can be split into nine sub-sectors23 of varying importance (Exhibit 4-1 left-hand panel): - The largest sub-sector, representing $19 trillion and 35% of assets of

NBFIs in 2011, is that of “other investment funds”, i.e. funds other than MMFs.


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This sub-sector is very diverse in its risk characteristics and includes equity funds, bond funds of varying degrees of credit risk, mixed

funds as well as Exchange-Traded Funds (ETFs). It may also include hedge funds in some jurisdictions if they cannot separate data on hedge funds from other investment funds.

The lack of granularity of flow of funds statistics across jurisdictions does not allow for a further decomposition, but a crossing with data from other sources such as the Investment Company Institute (ICI)

provides an approximation (Exhibit 4-1 right hand panel).

- Non-equity funds, which may include funds involved in credit intermediation and operating with some degree of maturity and/or

liquidity transformation, would broadly correspond to $9 trillion using ICI estimates.


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While providing a useful order of magnitude, this number should be taken with some caution as there are differences in coverage and

measurement between Flow of Funds and ICI statistics. Further improvement in the Flow of Funds statistics to separate the different type of investment funds is essential.

- Structured finance vehicles are the second largest identified

sub-sector with $5 trillion of assets corresponding to 10% of NBFIs. It includes securitization vehicles, which are created for the purpose

of warehousing assets and issuing securities backed by these assets. Given the differences in accounting and statistical methodologies across jurisdictions, this may include vehicles that are owned by

banks and consolidated in bank’s balance sheet from a prudential perspective, including “self-securitisations” that are created for the purpose of using the related securities as collateral in central bank liquidity operations.

Further work would be needed to determine more precisely how much of this sub-sector remains outside of the regulatory perimeter from a prudential perspective.

- Broker-dealers, finance companies, financial holding companies and

MMFs are roughly of equal size, each representing 7% of total NBFIs and around $4 trillion in assets.

The broker-dealer sector is essentially concentrated in the US (52%) and Japan (42%), which also reflects the fact that other jurisdictions with large financial sectors (e.g. the euro area, the UK) do not single

out broker-dealers in their Flow of Funds statistics. Finance companies are also concentrated in US (43%), Japan (18%) and China (11%).


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They are covered in more details in section 6 of the report. MMFs are mainly concentrated in the US and the euro area, which together

represent 90% of MMFs globally (Exhibit 4-2). Within the euro area, a large part of the outstanding amounts for the region originate from France and from non-FSB member jurisdictions

(e.g. Ireland and Luxembourg).

- The rest of the OFI sector is represented by jurisdiction-specific entities such as Dutch Special Financial Institutions (SFIs) and US

Funding corporations, each at 4%-5% of total OFIs, and hedge funds (0.4%). Dutch SFIs are the subject of a separate case study included in this

report. At 0.4% of OFIs, the share of hedge funds is likely to be significantly underestimated.


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This is due to several factors, including the residency of hedge funds in off-shore jurisdictions not covered in the FSB exercise, and the lack

of granularity of UK and US flow of fund statistics that do not track them due to lack of data. Surveys such as the one by the UK FSA as well as estimates from

industry databases constitute at the moment a more reliable tool for monitoring this sector than the macro-mapping exercise. According to Hedge Fund Research (HFR) data, hedge funds held

globally more than $2 trillions of Assets Under Management in Q1 2012. This represents 14% more than the 2007 peak and 50% more than the

2008 deleveraging-trough. - The share of the unaccounted residual component (“others”29)

within the overall NBFI sector has been reduced to 18% with the

expanded set of data on 25 jurisdictions, significantly down from the 36% level observed in the October 2011 Shadow Banking report with 11 jurisdictions, thanks to the improvements in the granularity of certain jurisdictions’ statistics.

However, the still sizeable portion of “others” mostly reflects the relative lack of granularity of some jurisdictions’ flow of funds (e.g. euro area wide flow of funds, the UK).


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4.2 Recent trends in sub-sectors Turning to the growth rate of sub-sectors globally over the past year, and taking as a sample 25 jurisdictions, structured finance vehicles and

MMFs contracted by 12% and 5% respectively. The other sub-sectors were broadly stable (Exhibit 4-4). The trends in 2011 appear to be a continuation of the stagnating or

declining patterns observed since the crisis in an environment of elevated risk aversion and muted financial innovation. However, this picture masks considerable differences across jurisdictions

in the growth of the different sub-sectors. A simple way to illustrate this dispersion is to look at the jurisdictions for which some sub-sectors experienced an annual average growth rate of

more than 10% in the post-crisis period of 2007-2011 (Exhibit 4-5). This method entails some judgement regarding the level of the significance threshold and may also capture strong increases from a very

low base that do not constitute immediate risk.


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Notwithstanding the caveats of this approach, it shows that certain emerging markets (Argentina, Brazil, China, Indonesia, Korea) have experienced strong growth in several non-bank sub-sectors since 2007, which could be partly explained by financial deepening.

Other more specific areas of strong growth, often from a low base, include investment funds in Canada, finance companies in Hong Kong and India, and MMFs in Russia.


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5. Interconnectedness between banks and shadow banking entities (non-bank financial intermediaries) 5.1 Analysing interconnectedness between banks and shadow banking entities Systemic risks can arise not only from shadow banking entities but also from interconnectedness between banks and shadow banking entities (or

NBFIs). Banks and shadow banking entities are highly interlinked, with banks often being part of the shadow banking credit intermediation chain or

providing (explicit or implicit) support (e.g. guarantees) to the shadow banking entities to enable cheap financing and maturity/liquidity transformation.

Furthermore, banks and shadow banking entities provide funds to each other through loans and investment in financial products. Finally, banks may be owners of shadow banking entities such as finance companies or broker-dealers.


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This interconnectedness between the two systems can create systemic risks as distress in a shadow banking entity (or a bank) may easily spill

over to a bank (or a shadow banking entity). Also, such interconnectedness may exacerbate the pro-cyclical build-up of leverage and thus heighten the risks of asset price bubbles, especially

when entities in both systems invest in the same (or correlated) assets. Systemic risks can also build up when banks and shadow banking entities have common exposures to certain sectors or financial instruments.

Moreover, interconnectedness can amplify market reactions when market liquidity is scarce in the financial markets – indeed such reactions can themselves intensify the loss of liquidity.

Banks are thus likely to be significantly affected by developments in the shadow banking system and vice versa. There are a number of useful measures to capture potential risks

stemming from the interconnectedness between banks and shadow banking entities. Two such measures are direct credit exposures and funding dependence

on each other. Conceptually, both banks and shadow banking entities pose credit and funding risks to each other that depend on the size and maturity

structures of their assets and liabilities, concentration levels by sub-sector, and type of collateralisation (if any) of the lending instruments (Exhibit 5-1).

Currently a breakdown by these categories is not available in most of the participating jurisdictions, but some jurisdictions have data on an aggregated sector-to-sector basis between banks and shadow banking entities (or NBFIs) as conservatively proxied by OFIs.


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The rest of this section summarises high-level analysis of interconnectedness between the two sectors through looking at the two

measures based on the data available.

5.2 High-level analysis of interconnectedness - A cross-jurisdiction comparison shows that there is wide variation in

the degree of interconnectedness between banks and shadow banking

entities or NBFIs in different financial systems. For instance, there are a few jurisdictions where banks’ credit exposure to NBFIs is relatively large in terms of banks’ balance sheet

size: the Netherlands and the UK have ratios of banks’ assets to NBFIs above 10% of banks’ total assets. Interestingly, for these jurisdictions, banks’ dependence on funding

from NBFIs is also relatively large, thus creating an interdependence


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(bi-directional connection) via which stress could be rapidly transmitted across the two sectors.

Note also that there are jurisdictions where banks depend disproportionately more on funding from NBFIs than vice versa (e.g. Brazil, Chile, and to a lesser extent Switzerland).

- The risk associated with interconnectedness between the two sectors is larger for NBFIs in relative terms than for banks in most jurisdictions, as revealed by the higher ratios on the right-hand chart, compared to the left-hand chart.

For instance, NBFIs’ dependence on bank funding is large in Indonesia , the UK (each around 27% of NBFIs’ assets), and Italy (28%).

Other jurisdictions where NBFIs obtain substantial funding from banks (around 20% of NBFIs’ assets) include Australia, Canada, and Singapore.

Regarding credit risk, in some jurisdictions NBFIs’ assets are heavily concentrated in the banking sector: over 30% of assets are invested in banks in Brazil, Chile, and Indonesia.

However, these measures of interconnectedness provide a first assessment of the potential risks that interconnection poses and are best used as a starting point for deciding if further analysis is

warranted.


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- In terms of the recent evolution of interconnectedness between the two sectors, the monitoring exercise identified a few jurisdictions

where interconnectedness between banks and NBFIs has changed substantially over the period 2006-2011. Specifically the relative weight of banks’ assets to NBFIs increased at

a good pace in the Netherlands. On the other hand, the UK has witnessed a reduction in the level of funding that banks provide to NBFIs since 2002 (i.e., from 19% in

2002 to 12% in 2011), and to a lesser degree in the amount of funding that banks obtain from NBFIs (from around 14% in 2002 to around 10% in 2011).


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- From the perspective of NBFIs, there are also some noteworthy trends during the period 2002 to 2011. In Australia and the Netherlands, OFIs increased the funding they

obtain from banks (Exhibit 5-4). On the other hand, the liabilities of banks to NBFIs (i.e., funding provided from OFIs to banks) increased in France.

Conversely, in the UK, NBFIs have reduced the relative weight of their interconnectedness with banks. It would be useful to supplement analysis of such changes in

interconnectedness so as to understand why the changes have occurred and what risks they might pose.


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5.3 Data Issues for further enhancement of monitoring A number of important data shortcomings were identified during the monitoring exercise.

The resolution of these shortcomings would improve the analysis in the previous section and further enhance the monitoring of risks stemming from the interconnectedness between the banking and shadow banking sectors.


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- Data availability: numerous jurisdictions, including those with large shadow banking systems, do not have a breakdown of the assets and

liabilities of banks vis-à-vis NBFIs. Thus, it is essential for all jurisdictions to collect such data and at least conduct high-level analysis.

In addition, further breakdowns by maturity structure of assets and liabilities, concentration, and collateralization would help the analysis by obtaining a more precise assessment of risks.

- Domestic consolidation issues: several jurisdictions reported that

there could be substantial differences between the figures used by prudential authorities (which typically consolidate all domestic and

overseas bank-related entities) and national accounts (Flow of Funds) data (which are basically on a domestic solo entity-basis). These inconsistencies could lead to an overestimation of the share of

the financial system that is beyond the scope of bank prudential regulation. The potential size of these inconsistencies varies across jurisdictions.

For instance, Canadian Flow of Funds data consolidates bank-owned SPVs into banks, whereas in most euro area jurisdictions SPVs are accounted for as NBFIs/OFIs in the Flow of Funds statistics.

It should be noted that the existence of this potential overestimation does not necessarily equate to an overestimation of potential risks, as the non-traditional activities of banks need to be monitored carefully.

- Cross-border consolidation issues: consolidation issues may become

more complicated when a non-bank financial intermediary has its parent bank in a different jurisdiction.


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In this case, home authorities of the parent bank have to ensure that the relevant information on the non-bank financial subsidiary abroad

is obtained and incorporated into the consolidated risk analysis. Going forward, an appropriate assessment of the potential risks derived from the interconnectedness between banks and non-bank

financial intermediaries may also require more granular breakdowns of the maturity structure of the assets and liabilities of banks vis-à-vis non-bank financial intermediaries and vice versa.

6. Finance Companies - Overview of Survey Responses In addition to the overall monitoring exercise, additional information on finance companies was collected from all 25 participating jurisdictions based on a survey questionnaire.

The questionnaire comprised of eight questions covering three broad areas: (i) Definition and types of finance companies across jurisdictions;

(ii) Regulatory regimes, policy tools and monitoring; and (iii) Business models and potential risks. This section summarises the

results of the responses received on the survey on finance companies.

6.1 Definition and types of finance companies The definition and types of finance companies seem to vary across jurisdictions.

However, most jurisdictions broadly define finance companies as “non-bank financial entities that provide loans to other entities”.


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This definition covers a wide spectrum of business models that vary across and within countries.

Nevertheless, virtually all jurisdictions reported that finance companies include non-bank financial entities that are involved in leasing, factoring, consumer finance (e.g. credit card, automobile, and mortgage loans), as

well as business finance. An additional definitional element in most jurisdictions is the prohibition for finance companies to raise deposits from the public, although there

are few jurisdictions where certain types of finance companies are in fact allowed to accept deposits (e.g. India, Mexico, Singapore, and the UK).

6.2 Regulatory frameworks Jurisdictions reported three main approaches to regulating finance

companies: (i) In most jurisdictions finance companies must obtain a license from the business conduct bureau and comply with consumer protection rules

(e.g. caps on the interest rate charged to consumers); (ii) Some jurisdictions have additional investor protection regulations, as finance companies often raise funds in capital markets and via debt

issuance; and (iii) A few jurisdictions have bank-like prudential regulations (typically, but not exclusively, those jurisdictions where finance companies are

allowed to raise deposits). Finance companies must also adhere to disclosure requirements intended to provide information to both consumers and investors.

Some jurisdictions also reported that there is sub-national regulation (e.g. provinces in Canada and states in the US) or sub-national supervision (e.g. prefectures in Japan) for finance companies.


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There are also some non-regulated finance companies in several jurisdictions, such as certain types of mortgage lenders in Canada and

business finance companies in the UK. As for consolidation within a banking group, there seems to be a wide range of practices.

6.3 Policy tools and monitoring frameworks to address shadow banking risks The 25 participating jurisdictions were also asked to briefly explain the policy tools available to address the systemic risks associated with the activities of finance companies (in particular, maturity transformation,

liquidity transformation and leverage). Most jurisdictions do not have policy instruments that were specifically designed for dealing with such systemic risks.

Instead, they tend to be dealt with by policy tools derived from the general regulatory regime applicable to finance companies in each jurisdiction.

For example, consumer protection rules for finance companies will have an indirect effect in addressing systemic risks by imposing limits on certain activities (e.g. strict limits on related-party lending) and/or types of risks.

Additionally, some jurisdictions also rely on prudential (and macroprudential) tools provided for banks.

In addition to the regulatory framework for finance companies, some jurisdictions have established a macroprudential framework to address build-up of systemic risks in this sector.

For instance, in Australia, the Reserve Bank (RBA) conducts an annual monitoring exercise of shadow banking entities, including finance


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companies, and would highlight any risks to the Council of Financial Regulators for policy action by Council agencies, were that to be

necessary; the Canadian government determines which mortgages qualify for government insurance, thus limiting the activities in securitisation markets; in the US, the Financial Stability Oversight Council (FSOC) can require the Federal Reserve to regulate specific

finance companies when they are deemed to be “systemical ly important” based on the Dodd-Frank Act. In terms of monitoring the activities of finance companies especially for

those that are not consolidated with banks, existing frameworks are generally less intrusive and intense than for banks, and tend to be focused mostly on compliance with business conduct or consumer/investor protection requirements at the entity level, rather than being based on a

sector-wide monitoring approach, where aggregated trends and risk metrics are tracked and analysed at the sector level. In some cases, however, macro-monitoring seems to be conducted based

on data provided by respective industry associations (e.g. Germany). In Australia, in addition to the annual review of shadow banking risks noted above, there are also additional registering and reporting

requirements for finance companies surpassing certain size thresholds.

6.4 Business models As explained earlier, it is very difficult to discern a standard business model for finance companies from the responses.

Indeed, some jurisdictions reported very varied funding structures for finance companies, some of which are very dependent on bank funding (e.g. Indonesia), while other jurisdictions rely more on alternative

funding sources, including debt issuances and securitisations (e.g. Canada, the Netherlands and the US), as well as deposits or deposit-like products (e.g. Mexico, India, Singapore, and the UK).


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Regarding assets, structures tend to be very specialised along product niches (for instance, companies specialising in automobile finance,

mortgages, or securities trading), as well as geographical area (in some emerging markets and developing economies such as India and Mexico, there are finance companies that specialise in providing credit in rural and semi-rural areas).

Lending to banks seems to be negligible (in terms of banks’ liabilities) in all reporting jurisdictions but careful analysis may be needed at the entity-level.

In terms of profitability, many jurisdictions regarded finance companies to be profitable, often commensurate to profitability levels in the banking industry.

6.5 Risks Finance companies play an important role in the credit chain by filling credit voids not covered by other types of financial intermediaries (particularly in some emerging markets and developing economies).

However, despite the importance of this role, the share of finance companies’ assets in the total financial system is small in all jurisdictions.

In global terms, for instance, their total estimated size amounts to around $4 trillion (equivalent to 8% of the total assets of NBFIs/OFIs). Virtually all jurisdictions found difficulties providing specific measures of

the maturity and liquidity transformation in the activities of finance companies. On leverage, however, several jurisdictions seem to have imposed

regulatory caps (e.g. leverage ratio requirements) on the balance-sheet leverage finance companies can build. Regarding imperfect credit risk transfers, most jurisdictions reported these to be small or non-existent for finance companies.


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Given the small relative size of the sector, participating jurisdictions at

present do not see these risks to be of serious concern from a systemic point of view. In addition, a few jurisdictions also reported that risks have decreased

since the crisis, particularly those relating to securitisation markets, which remain very subdued. Thus, finance companies appear to be more vulnerable to distress

stemming from other sectors than likely to cause it. Nevertheless, a few jurisdictions have emphasised the need to enhance monitoring of this sector as finance companies may be liable to specific

risk factors and/or regulatory arbitrage as they are often under less rigorous prudential regulation compared to banks. For example in Turkey, 67% of the liabilities of Turkish leasing companies are in foreign currency.

In addition, there are examples of crises affecting the finance company sector, such as in New Zealand from 2006 to 2011.

In some jurisdictions, finance companies play a crucial role in providing credit to small and medium enterprises (SMEs), giving rise to potential feedback effects between finance companies and banks via common exposures to SMEs.

Banks or industry group often set up finance companies in foreign jurisdictions that provide services which they usually do not provide in their home jurisdictions (e.g. automobile company setting up finance

companies in certain jurisdictions that provide mortgages).


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Guidelines on the assessment of the suitability of members of the management body and key function holders

Executive Summary

The Guidelines set out the process, criteria and minimum requirements for assessing the suitability of members of the management body and key function holders of a credit institution.

Article 11(1) of Directive 2006/48/EC provides that a credit institution shall only be authorised when there are at least two suitable persons who effectively direct the business and asks the EBA to develop guidelines for the assessment of the suitability of the persons who effectively direct the

business of a credit institution. Weaknesses in corporate governance, including inadequate oversight by and challenge from the supervisory function of the management body in a

number of credit institutions, have contributed to excessive and imprudent risk-taking in the banking sector which has led in turn to the failure of individual credit institutions and systemic problems.

Hence the scope of these Guidelines is not limited to members of the management body acting in its management function, but extends to the members of the supervisory function in order to ensure appropriate oversight over the management of a credit institution, including its risk

taking decisions. This is consistent with the EU Commission’s proposal of 20 July 2011 for a Directive on the access to the activity of credit institutions and the

prudential supervision of credit institutions and investment firms (CRD IV).


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The ongoing suitability of all members of the management body is crucial for the proper functioning of a credit institution.

The Guidelines also specify requirements for the assessment of key function holders, who have a crucial role in the day to day management of the business.

These measures are considered to be necessary and proportionate to ensure robust governance arrangements in credit institutions, as required by Article 22 of Directive 2006/48/EC.

As financial and mixed financial holding companies are also required to have suitable persons who direct the business and those companies have a significant influence over credit institutions, the scope of the Guidelines

encompasses them as well. Credit institutions should assess the suitability of members of the management body prior to or immediately after their appointment and

notify the competent authority of appointments. Some competent authorities may require prior approval.

Competent authorities will themselves assess the suitability of proposed or appointed members of the management body. The Guidelines set out several criteria which should be considered in this

assessment. In cases where a member of the management body is not suitable, the credit institution and, if necessary, the competent authority should take

appropriate action. The EBA has conducted a high-level impact assessment of the proposals included in the guidelines.


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This impact assessment should be read together with the impact assessment done by the European Commission in the context of the

proposed Directive of the European Parliament and of the Council on the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (proposed CRD IV, published 20/07/2011).

The proposal of the European Commission contains the requirement that the suitability of all members of the management body shall be assessed.

The Commission analysed the impact of an assessment process for all board members and concluded that although such a requirement would trigger costs, such costs would be insignificant compared to the benefits.

The guidelines proposed in this document will not create any significant additional costs and help to realise the benefits identified in the European Commission’s impact assessment.

The Guidelines should be complied with by competent authorities and credit institutions by 22 May 2013.

Definitions For the purposes of these Guidelines, the following definitions apply:

a. Management body means the governing body (or bodies) of a credit institution, comprising the supervisory and the management function, which has ultimate decision-making authority and is empowered to set the credit institution’s strategy, objectives and overall direction;

b. Management body in its supervisory function means the management body acting in its supervisory function and overseeing and monitoring management decision-making;

c. Member means a proposed or appointed member of the management body;


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d. Key function holders are those staff members whose positions give them significant influence over the direction of the credit institution, but

who are not members of the management body. Key function holders might include heads of significant business lines, EEA branches, third country subsidiaries, support and internal control functions.

Requirements regarding the assessment of the suitability Chapter I - Responsibilities & general assessment criteria 4. Responsibilities 4.1. Assessing the initial and ongoing suitability of members of the management body and key function holders should primarily be the responsibility of the credit institution.

4.2. If a nomination committee or equivalent exists, it should actively contribute to fulfilling the credit institution's responsibility for adopting appropriate internal policies on the assessment of the suitability of members of the management body and key function holders.

5. General assessment criteria 5.1. The assessment of the experience of members of the management body and key function holders should take into account the nature, scale and complexity of the business of the credit institution as well as the

responsibilities of the position concerned. The level and nature of the experience required from a member of the management body in its management function may differ from that

required from a member of the management body in its supervisory function.


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5.2. Members of the management body and key function holders should in any event be of good repute, regardless of the nature, scale and

complexity of the business of the credit institution. 5.3. Where there is a matter which casts doubt on the experience or good repute of a member of the management body and key function holders, an

assessment of how this will or might impinge on that person’s suitability should be undertaken. All matters relevant to and available for the assessment should be taken

into account, regardless of where and when they occurred.

Chapter II - Assessment by credit institutions 6. Credit institutions’ suitability assessment 6.1. Credit institutions should assess the suitability of members of the management body on the basis of the criteria set out in paragraphs 13 to

15 and in accordance with the EBA’s Guidelines on Internal Governance at Chapter B.2 and record the assessment and the results. Whenever possible the assessment should be done before the member

takes up his or her position. If this is not possible the assessment should be completed as soon as practicable, but in any event within six weeks.

6.2. Credit institutions should re-assess the suitability of a member of the management body when events make a re-assessment necessary in order

to verify the person’s ongoing suitability.

This can be limited to examining whether the member remains suitable

taking into account the relevant event.


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6.3. When assessing the suitability of members of the management body, credit institutions should assess whether the management body is

suitable collectively. Weaknesses within the overall composition of the management body or its committees should not necessarily lead to the conclusion that a

particular member is not suitable. 6.4. The credit institution should assess the suitability of key function holders before they are appointed, re-assess their suitability as

appropriate and record the assessments and their results.


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Aruoba-Diebold-Scotti Business Conditions Index The Aruoba-Diebold-Scotti business conditions index is designed to

track real business conditions at high frequency.

Its underlying (seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment, industrial production,

personal income less transfer payments, manufacturing and trade sales; and quarterly real GDP) blend high- and low-frequency information and stock and flow data.

The average value of the ADS index is zero. Progressively bigger positive values indicate progressively better-than-average conditions, whereas


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progressively more negative values indicate progressively worse-than-average conditions.

The ADS index may be used to compare business conditions at different times.

A value of -3.0, for example, would indicate business conditions significantly worse than at any time in either the 1990-91 or the 2001 recession, during which the ADS index never dropped below -2.0.

The vertical lines on the figure provide information as to which indicators are available for which dates. For dates to the left of the left line, the ADS index is based on observed

data for all six underlying indicators. For dates between the left and right lines, the ADS index is based on at least two monthly indicators (typically employment and industrial

production) and initial jobless claims. For dates to the right of the right line, the ADS index is based on initial jobless claims and possibly one monthly indicator.


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The Australian banking system under stress – again? John F Laker, APRA Chairman AB+F Randstad Leaders Lecture 2012

Introduction I am pleased to have this opportunity to take part again in the AB+F Leaders Lecture series, this time in Brisbane.

Two years ago, in front of a different audience, I posed a question. Would the Australian banking system cope if it were to be confronted

with much greater adversity than it had weathered to that point in the global financial crisis? As I said then, for our banking institutions the crisis had not been the

‘near death’ experience that many banks abroad had faced, and to which some succumbed. I answered my question by releasing the results of a macroeconomic

stress test that APRA had conducted, built on the hypothetical scenario of a substantial economic downturn in Australia driven by a marked slowdown in China.

The stress test results were reassuring, and reinforced our confidence in the resilience of the Australian banking system. Two years on, the crisis is still with us. Global market confidence may

have been boosted recently by additional monetary policy measures in major advanced economies, but fundamental economic concerns remain. Tangible progress in the resolution of the eurozone’s sovereign debt and

banking problems has been slow to materialise, the United States is


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approaching a ‘fiscal cliff’ and the trajectory of the US and Chinese economies is unclear.

The IMF has recently concluded that downside risks to global economic forecasts have increased and are considerable. The Australian economy has continued to perform strongly but it, too, is

facing a softer growth outlook. What more opportune time to pose the question, again.

Would the Australian banking system cope if the global and domestic economic environment were to turn much gloomier? The answer, again, can be found in the results of another macroeconomic

stress test that APRA has recently completed. And this time the hypothetical was tougher than our 2010 test — it involved a much sharper slowdown in China and a disorderly resolution

of eurozone problems leading to a freeze in global funding markets. Exercises of this type confirm the growing importance of stress testing in the toolkit of prudential supervisors.

Admittedly, the technique has had something of a chequered history. Stress tests undertaken by global banks, supervisory authorities and

international organisations before the crisis largely failed to send the right warnings. No more so than in Iceland, where stress tests confirmed the solvency of

the Icelandic banking system not long before it collapsed. Since the crisis began, a substantial intellectual, IT and resource effort has been made to strengthen the rigour and the credibility of stress tests .


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And we now see highly publicised stress tests being employed in a number of major jurisdictions to help restore market confidence in

individual banks and banking systems. My talk today focuses on two particular dimensions of stress testing. The first is the use of stress testing by regulated institutions to identify

vulnerabilities in their operations or solvency. My remarks will address:

- the benefits and challenges of stress testing as a risk management tool; and

- some ‘best practice’ aspirations for regulated institutions in further

developing their stress-testing capabilities. The second dimension is the use of supervisor-led stress tests to analyse system-wide vulnerabilities.

To put our own work into an international context, I will provide a brief overview of recent industry-wide or macroeconomic stress tests conducted in the United States, Europe and Spain.

And then the punchline — the results of APRA’s recent macroeconomic stress test!

Stress testing as a risk management tool Stress testing is a quantitative ‘what if’ exercise aimed at assessing vulnerabilities and resilience in the face of ‘severe but plausible’ shocks, to use the accepted parlance.

That is, severe enough to be meaningful yet plausible enough to be taken seriously.


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At the level of a regulated institution, stress testing can be used to estimate the impact of shocks on cash flows, profits and capital positions.

APRA views stress testing as a critical risk management tool for regulated institutions and we have embedded this view in the recent strengthening of our capital adequacy framework.

New prudential standards are now in place for authorised deposit-taking institutions (ADIs), implementing the Basel III reforms, and for life and general insurers.

Central to this framework are expanded requirements for capital planning and management in institutions, which are encapsulated in the ‘Internal Capital Adequacy Assessment Process’ or ICAAP.

An ICAAP involves an integrated and documented approach to risk management and capital management.

Properly developed, an ICAAP should assess the level of, and appetite for, risk in the institution and establish the level and quality of capital that is appropriate to support that risk profile.

The ICAAP must be approved by the board and must include a strategy for ensuring adequate capital is maintained over time. The ICAAP must also include stress testing and scenario analysis.

To assist institutions in developing their ICAAPS, APRA has released for consultation a draft prudential practice guide on this topic.

As we make clear in the guidance, stress testing is a core part of the ICAAP process and can be used in the formulation of capital targets and trigger levels.

Capital targets should be in line with the board’s risk appetite and should ensure that the institution has a sufficient capital buffer to be able to


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absorb losses in stressed conditions, without breaching minimum prudential requirements.

Capital adequacy cannot be demonstrated by ‘just meeting’ prudential requirements; institutions need to hold an adequate buffer above those requirements to minimise the risk of a breach in normal and stressed

circumstances. In its ICAAP, an institution should use its own stress tests, as well as any led by APRA, to help set appropriate capital targets and buffers.

There should be a clear explanation for the board, and supervisors, of how stress tests have been factored into capital planning.

Of course, stress testing is not limited to assessing capital adequacy — it also has a wider role. Its value can and should stretch far beyond showing that capital levels are

sufficient. It can be applied at an enterprise-wide level, portfolio-specific or risk-specific level to inform risk appetite, set risk limits, provide early

warning indicators and identify potential mitigating actions. For APRA supervisors, the results of stress tests are used to anchor expectations for the level of capital that an institution should hold in

normal times, to provide a sufficient buffer to withstand a challenging environment. The results are also used to inform our risk assessment of institutions and

as part of the development of supervisory action plans. Where issues or concerns are identified, supervisors follow-up to ensure rectification action is taken.


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This can include steps to strengthen capital positions but is not limited to capital initiatives.

Stress testing is not a panacea. Stress testing is often described as an art, not a science. It is the

combination of statistical modelling and expert judgement, based necessarily on simplifying assumptions. Hence, stress testing should not be relied upon in isolation and without

recognition of the margin for error. It is part of the risk manager’s and supervisor’s toolkit, but not the only tool.

It is a component of, but not a replacement for, robust and comprehensive risk management and supervision. To quote a recent International Monetary Fund (IMF) paper on

stress-testing principles and practice: ‘No matter how much a stress tester tries, stress tests always have margins of error.

Their results will almost always turn out to be optimistic or pessimistic ex post.

In addition, there will always be model risk, imperfect data access, or underestimation of the severity of the shock. One should therefore set stress test results in a broader context.’

This is not to dismiss stress testing as a critical tool because it is not exact.

No forward-looking analysis can be.


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As Keynes is reputed to have said, it is better to be roughly right than precisely wrong.

But to be most effective, stress testing in an institution should be used in concert with other forms of financial analysis, informed discussion and risk assessment.

Some ‘best practices’ in stress testing In 2009, the Basel Committee on Banking Supervision reviewed the performance of stress testing practices before and during the crisis and

was, frankly, less than impressed. To encourage global banking institutions to lift their game, the Basel Committee released its Principles for sound stress testing practices and

supervision. APRA requested that the five Australian banks using the ‘advanced’ Basel II approaches (‘advanced banks’) conduct a self-assessment of their

compliance against these Principles, and I discussed the learnings in my earlier speech. Over 2011, a working group of the Basel Committee undertook a peer

review of the implementation of the Principles by supervisory authorities, via an off-site survey. A senior APRA executive coordinated this survey.

The review found the Principles to be generally effective, although countries were at various stages of maturity in implementing them.

While not a primary focus of the review, many countries provided views on areas for improvement in stress-testing practices in banking institutions.


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I would rather turn the language around and describe these areas in terms of ‘best practice’ aspirations.

The aspirations are equally relevant to ADIs and to insurers. Five key areas of ‘best practice’ can be highlighted.

Firstly, stress test results should be integrated into decision-making within the institution. In APRA’s view, this is not only obvious but fundamental, and the theme is enshrined in our ICAAP requirements.

Stress testing should directly inform business and strategic decisions and, where necessary, trigger action.

It should be an integral part of risk management, assisting in understanding the institution’s risk profile and testing its risk appetite, not seen as some sort of regulatory compliance exercise.

The board should be clear on how the results of internal and supervisor-led stress tests have been factored into risk settings, such as the planning of appropriate capital buffers.

In our view, this has not always been the case and we will be closely monitoring the use of stress tests in our ongoing reviews of capital plans and capital management.

Secondly, and notwithstanding the important role of stress testing, boards and senior management, as well as other users, need to have a strong understanding of the limitations, assumptions and uncertainties associated with stress tests.

APRA expects that enterprise-wide stress test results would be routinely reported to board risk committees, and be challenged by them.


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If the challenges are to be effective, there needs to be an adequate level of detail in the stress test results reported and an appropriate coverage of

critical assumptions. Documentation should include, for example, the key macroeconomic parameters of the stress test scenarios, the impact on capital and

profitability, and discussion of key modelling assumptions. Sensitivity analysis can help to highlight particular central assumptions or specific vulnerabilities, and communicate the range of uncertainty

around the results. The limitations of models should also be recognised, with a significant additional margin for uncertainty built into the analysis of stress test

results. Where mitigating actions are factored in, stress test results should be presented both before and after such actions.

This enables a clear view on the ‘worst case’ outcome and the value of proposed management responses. Relevant feedback from APRA on internal and supervisor-led stress tests

should also be reported to and considered by the board, and issues addressed where relevant. Thirdly, stress tests need to confront the institution with realistic

adversity. The 'what if’, particularly the underlying economic scenario, must be demanding.

Common scenarios set by APRA are one way of guaranteeing severity and they enable peer comparisons to be easily drawn.


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But institutions should also routinely design scenarios that are particularly relevant to their specific risk profile, updated and refreshed as

that profile shifts over time. The global financial crisis has redefined the ‘severe but plausible’ benchmark.

It has shown that the Golden Decade that preceded the crisis is no guide to plausibility; the scale of recent financial system shocks in many countries is now a better guide.

Institutions should not be boxed in by history in designing suitably challenging stress tests.

This is a particularly important issue for regulated institutions in Australia, given the good performance of the Australian economy over a long period, including through most of the crisis.

It may be tempting for these institutions to succumb to what has been described as ‘disaster myopia’ — that is, the difficulty of imagining appropriately severe economic conditions after a long period of stability.

The lack of severe stress experience can lead to reluctance by institutions to contemplate their own mortality and a willingness to dismiss as implausible scenarios that would drive financial losses.

Scenarios built on benign experience will under-estimate potential stress and provide false confidence. A couple of years ago, a senior Bank of England official aptly highlighted

the constraints of history. He commented that the worst GDP growth outcome in the United Kingdom over the preceding 25-year period leading up to 2007 was a

decline of 1.4 per cent.


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In Australia, the equivalent worst case GDP outcome for a 1-in-25 year stress, based on the last 25-year period, would be even less than this.

This is in stark contrast with the experience of major economies in the global financial crisis, where the decline in GDP for the G7 countries in 2009 averaged around four per cent.

Great care is necessary, therefore, in drawing conclusions about longer-term risks based on recent history.

As with other parts of stress testing, scenario development is as much about judgement as it is statistics. There is also a secondary but equally critical challenge for regulated

institutions in Australia after a long period of relative stability: viz., a lack of meaningful historical data in downturn economic conditions on which to base stress-testing models.

Institutions have to look beyond recent history and beyond domestic precedent. Beware a failure of imagination! The fourth area of best practice relates to data and IT infrastructure.

Stress tests are a technical challenge, requiring co-ordination across a range of different teams within an institution.

Risk, finance, treasury and strategy teams all need to be engaged. Enterprise-wide stress test exercises will typically rely on a number of different models, projecting forward the balance sheet, profitability and

capital position at a granular level. To give you a sense of this, APRA’s macroeconomic stress test this year involved financial and regulatory capital information from the five

advanced banks covering nine different credit portfolios and many


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thousands of cells of data — and they are just the outputs from the process.

Naturally, the reliability of the data is paramount. As stress testing becomes a regular and routine process, IT systems need

to be sufficiently flexible and integrated to ensure information can be aggregated across the institution, and produce quick and reliable results. Aggregation is very important to providing a complete picture of the

stress test. There needs to be appropriate checks and oversight to ensure the results are accurate and intuitive.

The final area of ‘best practice’ relates to modelling issues. Translating the scenarios into stressed losses is often seen as a black box

but it is the critical part of the process. Weaknesses in modelling reduce the credibility of the exercise, but these weaknesses can often be hidden beneath the surface of the results.

APRA supervisors, supported by our risk specialists, will be spending more time understanding institutions’ stress-testing models, peering into the black box to better understand the methodologies and assumptions it

contains. In the recent APRA macroeconomic stress test, the wide range of estimates from institutions’ own stress test models indicated that there is

still some way to go in developing the required technology and capabilities in this area. For example, the default rates projected on lower-rated corporate

exposures varied from 50 per cent to 90 per cent over the stress test period, contributing to a wide range of loss outcomes.


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This was a consequence of different modelling practices rather than differences in underlying risk.

Given the use of a common scenario, similarities in the composition of loan books and relative credit quality, it would be reasonable to expect a much narrower range in default rates than the individual models implied.

This underlines the importance both of internal governance of the stress-testing process and of supervisory challenge. Before APRA finalised its stress test results, the banks involved were

asked to apply common APRA-determined credit risk factors to estimate loan losses. This helped to remove, or at least quieten, some model ling noise from the

process. The modelling challenge is not restricted to forecasting loan losses, although this is where stress-testing techniques are now being applied

more intensely. Projecting changes in interest income, trading income and funding costs is also important.

Differences in the ability to generate income in stressed conditions to offset loan losses can be a key driver of stressed losses across different institutions.

Over-optimistic or unrealistic forecasts for stressed income can lead to inflated estimates of capital. Caution is required here. The assumed ratings migration of assets in stressed conditions is another

topic where careful analysis is required. The five areas of ‘best practice’ that I have outlined provide a high-level ‘to do’ list for our regulated institutions.

In each area, of course, there is considerable detailed work to be done.


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In reviewing progress, APRA will be looking for a combination of investment in the supporting infrastructure, and effective oversight,

judgment and challenge.

International context Often building on exercises within regulated institutions, stress testing by

supervisory authorities is gaining greater prominence as a tool for analysing system-wide risks. These stress tests are sometimes described as macroprudential stress

tests but I have used the more familiar ‘macroeconomic’ term. These sorts of stress tests have become much more rigorous than some Pollyannaish pre-crisis tests and, in some major jurisdictions, the results

of industry-wide stress tests have been eagerly anticipated by policymakers, analysts and investors as confirmation (or otherwise) of bank soundness.

Not surprisingly, stress testing has become a key feature of supervisory activity in Europe, where the European Banking Authority (EBA) conducts EU-wide stress tests.

Its 2011 stress test was coordinated on an impressive scale, with 90 banks involved in 21 different countries. A common scenario was used to enable benchmarking and peer

comparisons, supported by a common methodology and underpinning assumptions. The stress test was praised for its risk coverage and detailed disclosure of

results, but also criticised for its treatment of sovereign debt exposures and the muted severity of the common scenario. Following the publication of the stress-test results, the EBA issued a

recommendation that national supervisory authorities should ensure that


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capital positions were strengthened at specific banks where shortfalls or concerns were identified.

Later in 2011, as the eurozone sovereign debt crisis escalated, the EBA followed up with the EU ‘capital exercise’, in which it recommended that all large European banks build a temporary capital buffer to reach a nine

per cent Core Tier 1 ratio. Earlier this year, the US Federal Reserve conducted stress tests involving 19 large US bank holding companies as part of its Comprehensive Capital

Analysis and Review (CCAR) process. Since the unprecedented Supervisory Capital Assessment Program (SCAP) in 2009, stress testing of major US banks has been a regular and

critical part of the US supervisory process; it is central to the US Federal Reserve’s assessment of capital adequacy and its evaluation of major US banks’ proposals to make capital distributions.

In the 2012 CCAR exercise, the aggregate Tier 1 common ratio was assessed to be higher in the stress test after hypothetical losses than actual capital levels held in 2008, testament to the steps taken to strengthen capital positions of US banks since the crisis began.

The most recent major stress test was that of the Spanish banking system in mid 2012, conducted on behalf of the authorities by independent consultants.

This was a thorough and very detailed evaluation of the risks and capital needs of the main banking groups in Spain.

The stress test program combined top-down model-based approaches with a forensic bottom-up bank-by-bank assessment. Given the importance of the exercise, it was in effect a full financial audit,

involving the analysis of some 36 million loans and 8 million guarantees.


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Data quality was verified by more than 400 auditors.

The process identified capital shortfalls at several banks under both baseline and adverse scenarios; in the adverse scenario, additional capital needs were estimated at around €60 billion for the system overall.

These industry-wide stress tests share several key characteristics. They are supervisor-led exercises carried out at a granular level of detail in the context of significant uncertainty, at a time when the domestic banking systems involved have been undergoing substantial

restructuring. They are what have been termed ‘crisis management stress tests’, with a very distinct purpose in mind: to assess whether key banking institutions

need to be recapitalised and, if so, by how much. As such, they focus on a critical capital ratio benchmark to assess capital adequacy, backed by recapitalisation plans where needed.

Given their objective and context, public disclosure of the stress tests has been extensive.

In addition to aggregate results, detailed results have been provided for individual banks and for specific outcomes, such as loss rates by portfolio.

The context for macroeconomic stress testing in Australia is a different one. The economic environment stands in marked contrast to that of the

United States and Europe and the Australian banking system is not facing fundamental restructuring or needing reinforcement. Like many other prudential supervisors, APRA does not publish its stress

test results for individual institutions.


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All this, however, does not make stress testing any less important. Indeed, as the Basel Committee noted in its Principles for sound stress testing

practices and supervision: “Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative

conditions can lead to complacency and the underpricing of risk.”

Stress testing by APRA Let me turn now to the results of the macroeconomic stress test that

APRA conducted this year for the five advanced banks. These banks account for around 80 per cent of total banking system assets in Australia.

The three-year macroeconomic scenario for the stress test was developed in conjunction with the Reserve Bank of Australia and the Reserve Bank of New Zealand.

As with the 2010 exercise, coverage of the stress test extended to the New Zealand operations of the major banks.

The ‘what if’ scenario was built around a further deterioration of global economic conditions, with a disorderly resolution of the fiscal problems in Europe triggering a dislocation in global debt markets and a sharp downturn in the North Atlantic economies.

China is assumed to be unable to fully offset the decline in its exports with domestic spending and, as a result, the rate of growth of the Chinese economy slows sharply.

The implied reduction in Chinese demand for minerals lowers commodity prices significantly, with a consequent deterioration in the exchange rate for the Australian dollar.


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Domestically, households and businesses respond to the external shock by reducing consumption and investment expenditure.

As a result, GDP falls and unemployment rises substantially, which feeds back into rising defaults and sharp falls in house prices and commercial property prices.

In this scenario, the key macroeconomic parameters for Australia used as the basis for the stress test were:

- a sharp (5 per cent) contraction in real GDP in the first year; - a rapid rise in the unemployment rate to a peak of 12 per cent;

- a peak-to-trough fall in house prices of 35 per cent; and

- a fall in commercial property prices of 40 per cent.

This is a tougher stress test than the one APRA undertook in 2010. The projected economic contraction is deeper and more prolonged, with a weaker recovery and a longer period before return to growth.

The rise in unemployment is higher and the impact on the housing market therefore more pronounced; there is a greater peak-to-trough fall in house prices.

This time, the stress test also addressed liquidity consequences. The dislocation in global debt markets results in the largest banks being

unable to access global funding markets for six months. The consequence is more intense competition for deposit funding and an increase in funding costs, weighing on lending margins and acting as a

drag on revenues.


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Remember, this is a hypothetical.

It is in no way a forecast or a central expectation for the course of the Australian economy. Rather, the stress test was intended to test the boundaries of ‘severe but

plausible’, especially given the current relatively strong position of the Australian economy. Benchmarked against recent industry-wide stress tests in other countries,

the severity is confirmed by the fact that the GDP shock is more than four standard deviations based on the annual volatility of GDP in Australia since 1960; the shock was one-to-three standard deviations in other major tests.

As a test of plausibility, the macroeconomic scenario would be comparable with the actual experience of the United Kingdom, United States and some European countries during the global financial crisis.

Although the macroeconomic scenario was tougher than in the 2010 exercise, the actual mechanics of the stress test were largely the same.

The advanced banks were asked to apply the macroeconomic scenario in their own models and provide their assessment, in quite granular detail, of the impact on the ratings migration of assets, default behaviour, profitability and capital.

After analysing this information, APRA then determined a common set of portfolio-specific risk measures that were applied to the banks’ loan portfolios.

Reflecting the severity of the scenario, the advanced banks all reported significant losses, driven by much higher bad debt expenses.

Credit loss rates in aggregate were comparable with the experience in the early 1990s, although not quite as high as the peaks then reached.


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As expected, total losses were larger than in the 2010 exercise.

Despite the deterioration in labour market conditions and the projected stress on the housing market, residential mortgages, which account for nearly half of the advanced banks’ credit exposures, contributed only a fifth of total losses.

The mortgage portfolio alone was not the principal driver of losses, a reflection of the structure of the domestic mortgage market as well as the general tightening in lending standards following the crisis.

Losses were realised across a range of loan portfolios, particularly corporate, SME and commercial property portfolios.

Losses on these business portfolios were more frontloaded, materialising earlier in the scenario than losses on residential mortgage portfolios, which tended to lag the increase in unemployment.

The main results of the stress test for the five advanced banks, taken as a group, are as follows: - None of the banks would have failed under the downturn

macroecnomic scenario; - None of the banks would have breached the four per cent minimum

Tier 1 capital requirement of the Basel II Framework in any year of the

stress test; and - The weighted average reduction in Tier 1 capital ratios over the

three-year stress period was 3.8 percentage points.

This is a very positive result. It reflects the efforts of the advanced banks to strengthen their Tier 1

capital positions since the crisis began through ordinary equity issues and profit retention.


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It leaves these banks well positioned to transition to the new Basel III

capital regime. The weighted average reduction in Total Capital ratios over the three-year stress period was 4.1 percentage points.

This took the five advanced banks, as a group, marginally below the eight per cent minimum Total Capital requirement of the Basel II Framework by the end of the stress period.

This result was not unexpected and nor does it raise undue concern on our part.

These banks had been running down their Tier 2 capital levels ahead of finalisation of the Basel III capital standards, which impose stricter eligibility criteria for Tier 2 capital instruments.

APRA has now released these eligibility criteria in final form and APRA supervisors will be monitoring plans to replenish Tier 2 capital holdings. The reduction in capital ratios in the stress test is calculated gross, before

consideration of any mitigating actions that management could take to respond to the stressed conditions. This enables APRA and the boards concerned to understand the ‘raw’

outcome and ensures that stress test results are not clouded by actions that may or may not be achievable, depending on market conditions. There were a range of mitigating actions proposed by the banks.

These included repricing of risk, tighter underwriting standards, cost-cutting, cutbacks in the provision of credit and the issuance of new capital.


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Some of these actions would have second-round effects on economic activity, although a further iterative phase was not factored into the stress

test. After allowing for mitigating actions, the weighted average capital position of the advanced banks as a group returned to pre-stress levels.

APRA has provided feedback to the banks concerned where it felt there was an element of over-optimism built into some of the proposed mitigating actions.

The liquidity consequences of the freeze in global funding markets did not, in the stress test, prove to be systemically challenging.

Net interest margins narrowed before partially recovering towards the end of the stress period and this, combined with subdued credit demand, dampened income growth. Liquidity was also put under pressure.

However, cash outflows from wholesale funding maturities were largely offset by growth in domestic deposits, while collateral flows associated with the projected weakening in the Australian dollar also alleviated funding pressure.

The stress test set a benchmark that there be no reliance on the Reserve Bank of Australia for ongoing liquidity support beyond its current repo arrangements (including self-securitisations) by the end of the stress

period. That benchmark was met.

This result is testament, in part, to the stronger funding positions that the advanced banks have adopted since the crisis. However, it is also an illustration of the difficulty in testing both capital

and liquidity through a single macroeconomic scenario.


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Liquidity shocks tend to be most concerning when prompted by a deposit run, a relatively short sharp crisis event often measured in days. Shocks to

solvency can build up over a longer horizon. Nonetheless, an integrated and comprehensive approach to stress testing that covers liquidity and solvency impacts remains an important objective

for supervisor-led stress tests. APRA’s macroeconomic stress test was a ‘bottom up’ stress test. In other words, the exercise was implemented by the individual banks involved

using their advanced modelling and internal data, but based on a common set of risk estimates determined by APRA. A bottom-up approach builds on granular detail, particularly on credit

risk exposures to which loss outcomes can be very sensitive. It can also consider institution-specific management responses to scenarios.

However, it is a very resource-intensive exercise and the results can be affected by differences in modelling practices between institutions.

A ‘top-down’ stress test, in contrast, is one implemented fully by a supervisory authority on the basis of a uniform methodology and consistent modelling.

Top-down stress testing is more flexible and enables greater scope for sensitivity analysis, alternative scenarios and different assumptions on risk.

It also avoids variations in modelling across institutions. However, the approach lacks richness of detail and the results are contingent on a single model, or suite of models, and the data set that

supports them.


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A sensible approach, where it can be done, is to run both a bottom-up and a top-down stress test in parallel, providing validation and analysis

through the process. This is, indeed, what has happened in Australia. As part of its 2012 Financial Sector Assessment Program (FSAP) review of Australia, the

IMF conducted a systematic top-down stress test for the five advanced banks, based on the macroeconomic scenario used by APRA. The results will be published by the IMF shortly.

Suffice to say that, despite the differences in approach, the IMF’s results are consistent with the more granular approach of APRA’s stress test.

This is a reassuring cross-check of our conclusions.

Concluding comments APRA’s recent macroeconomic stress test, together with the IMF’s

assessment, provides further confirmation that the Australian banking system has the capital strength to cope not just with the real -world stress test of the crisis, now stretching beyond five years, but with much greater adversity.

This was APRA’s view in my first speech on stress testing. It remains APRA’s view today.

However, nothing stands still. Risk profiles of regulated institutions are dynamic, not static. Management strategies and risk appetites constantly evolve.

The operating environment will always be clouded with uncertainties.


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Perhaps the only certainly in this whole area is that the hypothetical shocks in stress testing exercises will not be the shocks that materialise in

fact! In my first speech, I emphasised that both APRA and our regulated institutions are on a journey to improve stress-testing capabilities.

That journey continues. APRA is expanding its commitment to, and resourcing for, stress testing as a core area of frontline supervision.

Though there is still much work to be done, we welcome improvements made by institutions to advance their stress-testing programs and their plans for further investment.

We also welcome the greater engagement of boards and senior management. That engagement is a key element in the development and use of stress

testing as an integrated part of risk management. And, be assured, APRA will return to the question in the title of my speech, again and again!


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Financial services supervision: Commission requests Belgium, France, Greece, Luxembourg, Poland and Portugal to implement EU rules

The Commission has requested Belgium, France, Greece, Luxembourg, Poland and Portugal to notify within two months measures to implement

EU rules in the financial sector (Directive 2010/78/EU) concerning the powers of the three new European supervisory authorities for banks (European Banking Authority), insurance and occupational pensions (European Insurance and Occupational Pensions Authority) and

securities (European Securities and Markets Authority). The Directive aims at adapting the provisions of key financial services Directives to the new supervisory framework.

This will make sure that European Supervisory authorities will be fully allowed to carry out all the tasks conferred upon them.

Member States were due to implement the Directive, no later than 31 December 2011. The Commission's requests take the form of reasoned opinions under EU

infringement procedures. If the Member States fail to notify measures to implement the Directive within two months, the Commission may decide to refer them to the EU

Court of Justice.

Electronic money: Commission asks Court of Justice to fine Belgium for not implementing EU rules The European Commission has decided to refer Belgium to the Court of Justice of the EU for failing to implement the Directive on the taking up,


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pursuit and prudential supervision of the business of electronic money institutions.

The Commission has also decided to ask the Court to impose daily penalty payments on Belgium, until it fully implements the Directive.

The Commission proposes a daily fine of € 59 212,80 which would be paid as from the date of the Court's ruling until Belgium notified the Commission that it had fully implemented the rules into national law.


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The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business

unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.

Basel III Speakers Bureau

The Basel iii Compliance Professionals Association (BiiiCPA) has established the Basel III Speakers Bureau for firms and organizations that want to access the Basel iii expertise of Certified Basel iii Professionals (CBiiiPros).

The BiiiCPA will be the liaison between our certified professionals and these organizations, at no cost. We strongly believe that this can be a great opportunity for both, our certified professionals and the organizers.

To learn more: www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html

http://www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html


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Certified Basel iii Professional (CBiiiPro) Distance Learning and Online Certification Program

The all-inclusive cost is $297

What is included in this price:

A. The official presentations we use in our instructor-led classes (1426 slides) You can find the course synopsis at:

www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Professional.html

B. Up to 3 Online Exams

There is only one exam you need to pass, in order to become a Certified Basel iii Professional (CBiiiPro). If you fail, you must study again the official presentations, but you do not need to spend money to try again. Up to 3 exams are included in the price.

To learn more you may visit: www.basel-iii-association.com/Questions_About_The_Certification_An

d_The_Exams_1.pdf www.basel-iii-association.com/Certification_Steps_CBiiiPro.pdf

C. Personalized Certificate printed in full color. Processing, printing and posting to your office or home. To become a Certified Basel iii Professional (CBiiiPro) you must follow

the steps described at: www.basel-iii-association.com/Basel_III_Distance_Learning_Online_Certification.html

http://www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Professional.html

http://www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Professional.html

http://www.basel-iii-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.basel-iii-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.basel-iii-association.com/Certification_Steps_CBiiiPro.pdf

http://www.basel-iii-association.com/Basel_III_Distance_Learning_Online_Certification.html

http://www.basel-iii-association.com/Basel_III_Distance_Learning_Online_Certification.html


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Basel iii News December 2012

Career

Transcript of Basel iii News December 2012