Monday April 16 2012 - Top 10 risk and compliance management related news stories and world events

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_____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and Compliance Professionals (IARCP)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.com

Monday, April 16, 2012 - Top 10 risk and compliance management related news stories and world events that (for

better or for worse) shaped the week's agenda, and what is next

George Lekatis President of the IARCP

Dear Member, Crying is not a sign of weakness. You may let out your tears! Assuming full implementation of the Basel III requirements as of 30 June 2011, including changes to the definition of capital and risk-weighted assets, and ignoring phase-in arrangements, Group 1 banks would have an overall shortfall of €38.8 billion for the CET1 minimum capital requirement of 4.5%, which rises to €485.6 billion for a CET1 target level of 7.0% (ie including the capital conservation buffer); the latter shortfall already includes the G-SIB surcharge where applicable. As a point of reference, the sum of profits after tax prior to distributions across the same sample of Group 1 banks in the second half of 2010 and the first half of 2011 was €356.6 billion. Under the same assumptions, the capital shortfall for Group 2 banks included in the Basel III monitoring sample is estimated at €8.6 billion for the CET1 minimum of 4.5% and €32.4 billion for a CET1 target level of 7.0%.

The sum of Group 2 bank profits after tax prior to distributions in the second half of 2010 and the first half of 2011 was €35.6 billion.

Welcome to the Top 10 list.

http://www.risk-compliance-association.com/

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Number 1 (Page 4)

The Basel Committee published the results of its Basel III monitoring exercise. The study is based on rigorous reporting processes set up by the Committee to periodically review the implications of the Basel III standards for financial markets. Number 2 (Page 40) Study on the Cross-Border Scope of the Private Right of Action Under Section 10(b) of the Securities Exchange Act of 1934 As Required by Section 929Y of the Dodd-Frank Wall Street Reform and Consumer Protection Act Number 3 (Page 52)

12 April 2012 - The European Banking Authority (EBA) publishes today the results of the survey on the implementation of CEBS Guidelines on remuneration policies and practices. Number 4 (Page 96)

Jumpstart Our Business Startups Act: Frequently Asked Questions.

The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012.

Number 5 (Page 101)

EBA, ESMA and EIOPA publish two reports on Money Laundering. The Joint Committee of the three European Supervisory Authorities (EBA, ESMA and EIOPA) has published two reports on the implementation of the third Money Laundering Directive [2005/60/EC] (3MLD).

http://www.eba.europa.eu/Publications/Guidelines/CEBS-Guidelines-on-Remuneration-Policies-and-Pract.aspx



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Number 6 (Page 105)

BIS - Peer review of supervisory authorities' implementation of stress testing principles. Stress testing is an important tool used by banks to identify the potential for unexpected adverse outcomes across a range of risks and scenarios. Number 7 (Page 136) The Hong Kong Monetary Authority (HKMA) announced (Thursday) that investigation of over 99% of a total of 21,851 Lehman-Brothers-related complaint cases received has been completed.

Number 8 (Page 138)

DARPA seeks robot enthusiasts Hardware, software, modeling and gaming developers sought to link with emergency response and science communities to design robots capable of supervised autonomous response to simulated disaster Number 9 (Page 141)

The Securities and Exchange Commission announced the formation of a new Investor Advisory Committee required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Number 10 (Page 144) EIOPA - Report on Good Practices for Disclosure and Selling of Variable Annuities

This Report summarises the findings of an Expert Group, set up in May 2011 under the auspices of EIOPA’s Committee on Consumer Protection and Financial Innovation (CCPFI) with the aim of establishing good disclosure and selling practices for variable annuities (VA).

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NUMBER 1

Quantitative impact study results published by the Basel Committee, 12 April 2012

The Basel Committee published the results of its Basel III monitoring exercise. The study is based on rigorous reporting processes set up by the Committee to periodically review the implications of the Basel III standards for financial markets. A total of 212 banks participated in the study, including 103 Group 1 banks (ie those that have Tier 1 capital in excess of €3 billion and are internationally active) and 109 Group 2 banks (ie all other banks). While the Basel III framework sets out transitional arrangements to implement the new standards, the monitoring exercise results assume full implementation of the final Basel III package based on data as of 30 June 2011 (ie they do not take account of the transitional arrangements such as the phase in of deductions). No assumptions were made about bank profitability or behavioural responses, such as changes in bank capital or balance sheet composition. For that reason the results of the study are not comparable to industry estimates. Based on data as of 30 June 2011 and applying the changes to the definition of capital and risk-weighted assets, the average common equity Tier 1 capital ratio (CET1) of Group 1 banks was 7.1%, as compared with the Basel III minimum requirement of 4.5%. In order for all Group 1 banks to reach the 4.5% minimum, an increase of

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€38.8 billion CET1 would be required. The overall shortfall increases to €485.6 billion to achieve a CET1 target level of 7.0% (ie including the capital conservation buffer); this amount includes the surcharge for global systemically important banks where applicable. As a point of reference, the sum of profits after tax and prior to distributions across the same sample of Group 1 banks in the second half of 2010 and the first half of 2011 was €356.6 billion. For Group 2 banks, the average CET1 ratio stood at 8.3%. In order for all Group 2 banks in the sample to meet the new 4.5% CET1 ratio, the additional capital needed is estimated to be €8.6 billion. They would have required an additional €32.4 billion to reach a CET1 target 7.0%; the sum of these banks' profits after tax and prior to distributions in the second half of 2010 and the first half of 2011 was €35.6 billion. The Committee also assessed the estimated impact of the liquidity standards. Assuming banks were to make no changes to their liquidity risk profile or funding structure, as of June 2011, the weighted average Liquidity Coverage Ratio (LCR) for Group 1 banks would have been 90% while the weighted average LCR for Group 2 banks was 83%. The aggregate LCR shortfall is €1.76 trillion which represents approximately 3% of the €58.5 trillion total assets of the aggregate sample. The weighted average Net Stable Funding Ratio (NSFR) is 94% for both Group 1 and Group 2 banks. The aggregate shortfall of required stable funding is €2.78 trillion. Banks have until 2015 to meet the LCR standard and until 2018 to meet

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the NSFR standard, which will reflect any revisions following each standard's observation period. As noted in a January 2012 press statement issued by the Group of Governors and Heads of Supervision, the Basel Committee's oversight body, modifications to a few key aspects of the LCR are currently under investigation but will not materially change the framework's underlying approach. The Committee will finalise and subsequently publish its recommendations in these areas by the end of 2012. Banks that are below the 100% required minimum thresholds can meet these standards by, for example, lengthening the term of their funding or restructuring business models which are most vulnerable to liquidity risk in periods of stress. It should be noted that the shortfalls in the LCR and the NSFR are not additive, as reducing the shortfall in one standard may also reduce the shortfall in the other standard.

Results of the Basel III monitoring exercise as of 30 June 2011 April 2012 Executive summary In 2010, the Basel Committee on Banking Supervision conducted a comprehensive quantitative impact study (C-QIS) using data as of 31 December 2009 to ascertain the impact on banks of the Basel III framework, published in December 2010. The Committee intends to continue monitoring the impact of the Basel III framework in order to gather full evidence on its dynamics. To serve this purpose, a semi-annual monitoring framework has been set up on the risk-based capital ratio, the leverage ratio and the liquidity

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metrics using data collected by national supervisors on a representative sample of institutions in each jurisdiction. This report summarises the aggregate results of the latest Basel III monitoring exercise, using data as of 30 June 2011. The Committee believes that the information contained in the report will provide the relevant stakeholders with a useful benchmark for analysis. Information for this report was submitted by individual banks to their national supervisors on a voluntary and confidential basis. A total of 212 banks participated in the study, including 103 Group 1 banks and 109 Group 2 banks. Members’ coverage of their banking sector is very high for Group 1 banks, reaching 100% coverage for some jurisdictions, while coverage is comparatively lower for Group 2 banks and varied across jurisdictions. The Committee appreciates the significant efforts contributed by both banks and national supervisors to this ongoing data collection exercise. The report focuses on the following items:

- Changes to bank capital ratios under the new requirements, and estimates of any capital deficiencies relative to fully phased-in minimum and target capital requirements (to include capital charges for global systemically important banks – G-SIBs);

- Changes to the definition of capital that result from the new capital

standard, referred to as common equity Tier 1 (CET1), including a reallocation of deductions to CET1, and changes to the eligibility criteria for Additional Tier 1 and Tier 2 capital;

- Increases in risk-weighted assets resulting from changes to the

definition of capital, securitisation, trading book and counterparty credit risk requirements;

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- The international leverage ratio; and - Two international liquidity standards – the liquidity coverage ratio

(LCR) and the net stable funding ratio (NSFR). With the exception of the transitional arrangements for non-correlation trading securitisation positions in the trading book, this report does not take into account any transitional arrangements such as phase-in of deductions and grandfathering arrangements.

Rather, the estimates presented assume full implementation of the final Basel III requirements based on data as of 30 June 2011.

No assumptions have been made about banks’ profitability or behavioural responses, such as changes in bank capital or balance sheet composition, since this date or in the future.

For this reason the results are not comparable to current industry estimates, which tend to be based on forecasts and consider management actions to mitigate the impact, and incorporate estimates where information is not publicly available.

The results presented in this report are also not comparable to the prior C-QIS, which evaluated the impact of policy questions that differ in certain key respects from the finalised Basel III framework.

As one example, the C-QIS did not consider the impact of capital surcharges for global systemically important banks.

Capital shortfalls Assuming full implementation of the Basel III requirements as of 30 June 2011, including changes to the definition of capital and risk-weighted assets, and ignoring phase-in arrangements, Group 1 banks would have an overall shortfall of €38.8 billion for the CET1 minimum capital requirement of 4.5%, which rises to €485.6 billion for a CET1 target level of 7.0% (ie including the capital conservation buffer); the latter shortfall already includes the G-SIB surcharge where applicable.

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As a point of reference, the sum of profits after tax prior to distributions across the same sample of Group 1 banks in the second half of 2010 and the first half of 2011 was €356.6 billion. Under the same assumptions, the capital shortfall for Group 2 banks included in the Basel III monitoring sample is estimated at €8.6 billion for the CET1 minimum of 4.5% and €32.4 billion for a CET1 target level of 7.0%.

The sum of Group 2 bank profits after tax prior to distributions in the second half of 2010 and the first half of 2011 was €35.6 billion.

Further details on additional capital needs to meet the Basel III requirements are included in Section 2.

Capital ratios The average CET1 ratio under the Basel III framework would decline from 10.2% to 7.1% for Group 1 banks and from 10.1% to 8.3% for Group 2 banks.

The Tier 1 capital ratios of Group 1 banks would decline, on average from 11.5% to 7.4% and total capital ratios would decline from 14.2% to 8.6%.

As with the CET1 ratios, the decline in other capital ratios is comparatively less pronounced for Group 2 banks; Tier 1 capital ratios would decline on average from 10.9% to 8.6% and total capital ratios would decline on average from 14.3% to 10.6%.

Changes in risk-weighted assets As compared to current risk-weighted assets, total risk-weighted assets increase on average by 19.4% for Group 1 banks under the Basel III framework. This increase is driven largely by charges against counterparty credit risk and trading book exposures.

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Securitisation exposures, principally those risk-weighted at 1250% under the Basel III framework (which were previously 50/50 deductions under Basel II), are also a significant contributor to the increase. Banks that have significant exposures in these areas influence the average increase in risk-weighted assets heavily. As Group 2 banks are less affected by the revised counterparty credit risk and trading book rules, these banks experience a comparatively smaller increase in risk-weighted assets of only 6.3%. Even within this sample, higher risk-weighted assets are attributed largely to Group 2 banks with counterparty and securitisation exposures (ie those subject to a 1250% risk weighting).

Leverage ratio The weighted average current Tier 1 leverage ratio for all banks is 4.5%. For Group 1 banks, it is somewhat lower at 4.4% while it is 5.0% for Group 2 banks.

The average Basel III Tier 1 leverage ratio for all banks is 3.5%. The Basel III average for Group 1 banks is 3.4%, and the average for Group 2 banks is 4.2%.

Liquidity standards Both liquidity standards are currently subject to an observation period which includes a review clause to address any unintended consequences prior to their respective implementation dates of 1 January 2015 for the LCR and 1 January 2018 for the NSFR.

Basel III monitoring results for the end-June 2011 reporting period give an indication of the impact of the calibration of the standards and highlight several key observations:

A total of 103 Group 1 and 102 Group 2 banks participated in the liquidity monitoring exercise for the end-June 2011 reference period.

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The weighted average LCR for Group 1 banks is 90% while the weighted average LCR for Group 2 banks is 83%.

The aggregate LCR shortfall is €1.76 trillion which represents approximately 3% of the €58.5 trillion total assets of the aggregate sample.

The weighted average NSFR is 94% for both Group 1 and Group 2 banks.

The aggregate shortfall of required stable funding is €2.78 trillion.

General remarks At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision (GHOS), the Committee’s oversight body, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.

These capital reforms together with the introduction of two international liquidity standards, delivered on the core of the global financial reform agenda presented to the Seoul G20 Leaders summit in November 2010.

Subsequent to the initial comprehensive quantitative impact study published in December 2010, the Committee continues to monitor and evaluate the impact of these capital and liquidity requirements (collectively referred to as “Basel III”) on a semi-annual basis.

This report summarises results of the latest Basel III monitoring exercise using 30 June 2011 data.

Scope of the impact study All but one of the 27 Committee member jurisdictions participated in Basel III monitoring exercise as of 30 June 2011. The estimates presented are based on data submitted by the participating banks to national supervisors in reporting questionnaires in accordance with the instructions prepared by the Committee in September 2011. The questionnaire covered components of eligible capital, the calculation

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of risk-weighted assets (RWA), the calculation of a leverage ratio, and components of the liquidity metrics. The results were initially submitted to the Secretariat of the Committee in October 2011.

The purpose of the exercise is to provide the Committee with an ongoing assessment of the impact on participating banks of the capital and liquidity proposals set out in the following documents:

- Revisions to the Basel II market risk framework and Guidelines for computing capital for incremental risk in the trading book;

- Enhancements to the Basel II framework which include the revised risk weights for re-securitisations held in the banking book;

- Basel III: A global framework for more resilient banks and the banking system as well as the Committee’s 13 January 2011 press release on loss absorbency at the point of non-viability;

- International framework for liquidity risk measurement, standards

and monitoring; and - Global systemically important banks: Assessment methodology and

the additional loss absorbency requirement.

Sample of participating banks A total of 212 banks participated in the study, including 103 Group 1 banks and 109 Group 2 banks. Group 1 banks are those that have Tier 1 capital in excess of €3 billion and are internationally active. All other banks are considered Group 2 banks. Banks were asked to provide data as of 30 June 2011 at the consolidated level. Subsidiaries of other banks are not included in the analyses to avoid double counting.

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Table 1 shows the distribution of participation by jurisdiction.

For Group 1 banks members’ coverage of their banking sector was very high reaching 100% coverage for some jurisdictions.

Coverage for Group 2 banks was comparatively lower and varied across jurisdictions.

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Not all banks provided data relating to all parts of the Basel III framework.

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Accordingly, a small number of banks are excluded from individual sections of the Basel III monitoring analysis due to incomplete data.

Methodology The impact assessment was carried out by comparing banks’ capital positions under Basel III to the current regulatory framework implemented by the national supervisor. With the exception of transitional arrangements for non-correlation trading securitisation positions in the trading book, Basel III results are calculated without considering transitional arrangements pertaining to the phase-in of deductions and grandfathering arrangements. Reported average amounts in this document have been calculated by creating a composite bank at a total sample level, which effectively means that the total sample averages are weighted. For example, the average common equity Tier 1 capital ratio is the sum of all banks’ common equity Tier 1 capital for the total sample divided by the sum of all banks’ risk-weighted assets for the total sample.

To maintain confidentiality, many of the results shown in this report are presented using box plots charts.

These charts show the distribution of results as described by the median values (the thin red horizontal line) and the 75th and 25th percentile values (defined by the blue box).

The upper and lower end points of the thin blue vertical lines show the values which are 1.5 times the range between the 25th and the 75th percentile above the 75th percentile or below the 25th percentile, respectively.

This would correspond to approximately 99.3% coverage if the data were normally distributed.

The red crosses indicate outliers.

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To estimate the impact of implementing the Basel III framework on capital, comparisons are made between those elements of Tier 1 capital which are not subject to a limit under the national implementation of Basel I or Basel II, and CET1 under Basel III.

Data quality For this monitoring exercise, participating banks submitted comprehensive and detailed non-public data on a voluntary and best-efforts basis. As with the C-QIS, national supervisors worked extensively with banks to ensure data quality, completeness and consistency with the published reporting instructions. Banks are included in the various analyses that follow only to the extent they were able to provide sufficient quality data to complete the analyses. For the liquidity elements, data quality has improved significantly throughout the iterations of the Basel III monitoring exercise, although it is still the case that some differences in banks’ reported liquidity risk positions could be attributed to differing interpretations of the rules, rather than underlying differences in risk. Most notably individual banks appear to be using different methodologies to identify operational wholesale deposits and exclusions of liquid assets due to failure to meet the operational requirements.

Interpretation of results The following caveats apply to the interpretation of results shown in this report: These results are not comparable to those shown in the C-QIS, which evaluated the impact of policy questions that differ in certain key respects from the finalised Basel III framework. As one example, the C-QIS did not consider the impact of capital surcharges for G-SIBs based on the

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initial list of G-SIBs announced by the Financial Stability Board in November 2011. One member country, Switzerland, has already implemented certain elements of the Basel III framework pertaining to new rules for market risk and enhancements to the treatment of securitisations held in the banking book (often referred to collectively as “Basel 2.5”). For banks in this country, the results included in this report reflect the impact of adopting the Basel III requirements relative to the Basel II and Basel 2.5 frameworks already in place. The new rules for counterparty credit risk are not fully accounted for in the report, as data for capital charges for exposures to central counterparties (CCPs) and stressed effective expected positive exposure (EEPE) could not be collected. The actual impact of the new requirements will likely be lower than shown in this report given the phased-in implementation of the rules and interim adjustments made by the banking sector to changing economic conditions and the regulatory environment. For example, the results do not consider bank profitability, changes in capital or portfolio composition, or other management responses to the policy changes since 30 June 2011 or in the future. For this reason, the results are not comparable to industry estimates, which tend to be based on forecasts and consider management actions to mitigate the impact, as well as incorporate estimates where information is not publicly available. The Basel III capital amounts shown in this report assume that all common equity deductions are fully phased in and all non-qualifying capital instruments are fully phased out. As such, these amounts underestimate the amount of Tier 1 capital and Tier 2 capital held by a bank as they do not give any recognition for non-qualifying instruments that are actually phased out over nine years.

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The treatment of deductions and non-qualifying capital instruments also affects figures reported in the leverage ratio section. The underestimation of Tier 1 capital will become less of an issue as the implementation date of the leverage ratio nears. In particular, in 2013, the capital amounts based on the capital requirements in place on the Basel III monitoring reporting date will reflect the amount of non-qualifying capital instruments included in capital at that time. These amounts will therefore be more representative of the capital held by banks at the implementation date of the leverage ratio.

Capital shortfalls and overall changes in regulatory capital ratios Table 2 shows the aggregate capital ratios under the current and Basel III frameworks and the capital shortfalls if Basel III were fully implemented, both for the definition of capital and the calculation of risk-weighted assets as of 30 June 2011.

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As compared to current CET1, the average CET1 capital ratio of Group 1 banks would have fallen by nearly one-third from 10.2% to 7.1% (a decline of 3.1 percentage points) when Basel III deductions and risk-weighted assets are taken into account.

The reduction in the CET1 capital ratio of Group 2 banks is smaller (from 10.1% to 8.3%), which indicates that the new framework has greater impact on larger banks.

Results show significant variation across banks as shown in Chart 1.

The reduction in CET1 ratios is driven by the new definition of eligible capital, by deductions that were not previously applied at the common equity level of Tier 1 capital in most jurisdictions (numerator) and by increases in risk-weighted assets (denominator).

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Banks engaged heavily in trading or counterparty credit activities tend to show the largest denominator effects as these activities attract substantively higher capital charges under the new framework.

Tier 1 capital ratios of Group 1 banks would on average decline 4.1 percentage points from 11.5% to 7.4%, and total capital ratios of this same group would decline on average by 5.6 percentage points from 14.2% to 8.6%.

As with CET1, Group 2 banks show a more moderate decline in Tier 1 capital ratios from 10.9% to 8.6%, and a decline in total capital ratios from 14.3% to 10.6%.

The Basel III framework includes the following phase-in provisions for capital ratios:

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For CET1, the highest form of loss absorbing capital, the minimum requirement will be raised to 4.5% and will be phased-in by 1 January 2015;

For Tier 1 capital, the minimum requirement will be raised to 6.0% and will be phased-in by 1 January 2015;

For total capital, the minimum requirement remains at 8.0%;

Regulatory adjustments (ie possibly stricter sets of deductions that apply under Basel III) will be fully phased-in by 1 January 2018;

An additional 2.5% capital conservation buffer above the regulatory minimum capital ratios, which must be met with CET1, will be phased-in by 1 January 2019; and

The additional loss absorbency requirement for G-SIBs, which ranges from 1.0% to 2.5%, will be phased in by 1 January 2019.

It will be applied as the extension of the capital conservation buffer and must be met with CET1.

The Annex includes a detailed overview of all relevant phase-in arrangements.

Chart 2 and Table 2 provide estimates of the amount of capital that Group 1 and Group 2 banks would need between 30 June 2011 and 1 January 2019 in addition to the capital they already held at the reporting date, in order to meet the target CET1, Tier 1, and total capital ratios under Basel III assuming fully phased-in target requirements and deductions as of 30 June 2011.

Under these assumptions, the CET1 capital shortfall for Group 1 banks with respect to the 4.5% CET1 minimum requirement is €38.8 billion.

The CET1 shortfall with respect to the 4.5% requirement for Group 2 banks, where coverage of the sector is considerably smaller, is estimated at €8.6 billion.

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For a CET1 target of 7.0% (ie the 4.5% CET1 minimum plus the 2.5% capital conservation buffer, plus any capital surcharge for G-SIBs as applicable), Group 1 banks’ shortfall is €485.6 billion and Group 2 banks’ shortfall is €32.4 billion.

The surcharges for G-SIBs are a binding constraint on 24 of the 28 G-SIBs included in this Basel III monitoring exercise.

As a point of reference, the aggregate sum of after-tax profits prior to distributions for Group 1 and Group 2 banks in the same sample was €356.6 billion and €35.6 billion, respectively in the second half of 2010 and the first half of 2011.

Assuming the 4.5% CET1 minimum capital requirements were fully met (ie, there were no CET1 shortfall), Group 1 banks would need an additional €66.6 billion to meet the minimum Tier 1 capital ratio requirement of 6.0%.

Assuming banks already hold 7.0% CET1 capital, Group 1 banks would need and an additional €221.4 billion to meet the Tier 1 capital target ratio of 8.5% (ie the 6.0% Tier 1 minimum plus the 2.5% CET1 capital conservation buffer), respectively.

Group 2 banks would need an additional €7.3 billion and an additional €16.6 billion to meet these respective Tier 1 capital minimum and target ratio requirements.

Assuming CET1 and Tier 1 capital requirements were fully met (ie, there were no shortfalls in either CET1 or Tier 1 capital), Group 1 banks would need an additional €119.3 billion to meet the minimum total capital ratio requirement of 8.0% and an additional €223.2 billion to meet the total capital target ratio of 10.5% (ie the 8.0% Tier 1 minimum plus the 2.5% CET1 capital conservation buffer), respectively.

Group 2 banks would need an additional €5.5 billion and an additional €11.6 billion to meet these respective total capital minimum and target ratio requirements.

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As indicated above, no assumptions have been made about bank profits or behavioural responses, such as changes balance sheet composition, that will serve to ameliorate the impact of capital shortfalls over time.

Impact of the definition of capital on Common Equity Tier 1 capital As noted above, reductions in capital ratios under the Basel III framework are attributed in part to capital deductions not previously applied at the common equity level of Tier 1 capital in most jurisdictions. Table 3 shows the impact of various deduction categories on the gross CET1 capital (ie, CET1 before deductions) of Group 1 and Group 2 banks. In the aggregate, deductions reduce the gross CET1 of Group 1 banks under the Basel III framework by 32.0%. The largest driver of Group 1 bank deductions is goodwill, followed by combined deferred tax assets (DTAs) deductions, and intangibles other than mortgage servicing rights.

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These deductions reduce Group 1 bank gross CET1 by 15.4%, 4.9%, and 3.6%, respectively.

The category described as other deductions reduces Group 1 bank gross CET1 by 3.0% and pertain mainly to deductions for provision shortfalls relative to expected credit losses and deductions related to defined benefit pension fund schemes.

Holdings of capital of other financial companies reduce the CET1 of Group 1 banks by 2.9%.

The category “Excess above 15%” refers to the deduction of the amount by which the aggregate of the three items subject to the 10% limit for inclusion in CET1 capital exceeds 15% of a bank’s CET1, calculated after all deductions from CET1.

These 15% threshold bucket deductions reduce Group 1 bank gross CET1 by 2.1%. Deductions for MSRs exceeding the 10% limit have a minor impact on Group 1 CET1.

Deductions reduce the CET1 of Group 2 banks by 26.9%. Goodwill is the largest driver of deductions for Group 2 banks, followed by holdings of the capital of other financial companies, and combined DTAs deductions.

These deductions reduce Group 2 bank CET1 by 10.5%, 4.4%, and 4.3%, respectively.

Other deductions, which are driven significantly by deductions for provision shortfalls relative to expected credit losses, result in a 3.5% reduction in Group 2 bank gross CET1.

Deductions for intangibles other than mortgage servicing rights and deductions for items in excess of the aggregate 15% threshold basket reduce Group 2 bank gross CET1 by 2.5% and 1.8%, respectively.

Deductions for mortgage servicing rights above the 10% limit have no impact on Group 2 banks.

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Changes in risk-weighted assets Overall results Reductions in capital ratios under the Basel III framework are also attributed to increases in risk-weighted assets. Table 4 provides additional detail on the contributors to these increases, to include the following categories:

Definition of capital: These columns measure the change in risk-weighted assets as a result of proposed changes to the definition of capital. The column heading “other” includes the effects of lower risk-weighted assets for exposures that are currently included in risk-weighted assets but receive a deduction treatment under Basel III.

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The column heading “50/50” measures the increase in risk-weighted assets applied to securitisation exposures currently deducted under the Basel II framework that are risk-weighted at 1250% under Basel III. The column heading “threshold” measures the increase in risk-weighted assets for exposures that fall below the 10% and 15% limits for CET1 deduction;

Counterparty credit risk (CCR):

This column measures the increased capital charge for counterparty credit risk and the higher capital charge that results from applying a higher asset value correlation parameter against exposures to financial institutions under the IRB approaches to credit risk. Not included in CCR are risk-weighted asset effects of capital charges for exposures to central counterparties (CCPs) or any impact of incorporating stressed parameters for effective expected positive exposure (EEPE);

Securitisation in the banking book:

This column measures the increase in the capital charges for certain types of securitisations (eg, resecuritisations) in the banking book; and

Trading book:

This column measures the increased capital charges for exposures held in the trading book to include capital requirements against stressed value-at-risk, incremental default risk, and securitisation exposures in the trading book. Risk-weighted assets for Group 1 banks increase overall by 19.4% for Group 1 banks.

This increase is to a large extent attributed to higher risk-weighted assets for counterparty credit risk exposures, which result in an overall increase in total Group 1 bank risk-weighted assets of 6.6%.

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The predominant driver behind this figure is capital charges for counterparty credit risk as the higher asset value correlation parameter results in an increase in overall risk-weighted assets of only 1.0%.

Trading book exposures and securitisation exposures currently subject to deduction under Basel II, also contribute significantly to higher risk-weighted assets at Group 1 banks at 5.2% for each category.

Securitisation exposures currently subject to deduction, counterparty credit risk exposures, and exposures that fall below the 10% and 15% CET1 eligibility limits are significant contributors to changes in risk-weighted assets for Group 2 banks.

Changes in risk-weighted assets show significant variation across banks as shown in Chart 3. Again, these differences are explained in large part by the extent of banks’ counterparty credit risk and trading book exposures, which attract significantly higher capital charges under Basel III as compared to current rules.

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Impact of the revisions to the Basel II market risk framework Table 5 shows further detail on the impact of the revised trading book capital charges on overall risk-weighted assets for Group 1 banks. The sample analysed here is smaller than the one in Table 4 as not all the Group 1 banks provided data on market risk exposures. For this reduced sample of banks, trading book exposures resulted in a 6.1% increase in total risk-weighted assets. The main contributors to this increase are stressed value-at-risk (stressed VaR), non-correlation trading securitisation exposures subject the standardised measurement method (column heading “SMM non-CTP”), and the incremental risk capital charge (IRC), which contribute 2.2%,

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1.7%, and 1.4%. Less significant contributors to the increase in overall risk-weighted assets are capital charges for correlation trading exposures. Increases in risk-weighted assets are partially offset by effects related to previous capital charges24 and changes to the standardised measurement method (SMM).

Impact of the rules on counterparty credit risk (CVA only) Credit valuation adjustment (CVA) risk capital charges lead to a 7.3% increase in total RWA for the subsample of 77 banks which provided the relevant data (6.6% on the full Group 1 sample). A larger fraction of the total effect is attributable to the application of the standardised method than to the advanced method. The impacts on Group 2 banks are smaller but still significant, adding up to an overall 2.9% increase in RWA over a subsample of 63 banks (2.2% for the full Group 2 sample), totally attributable to the standardised method. Further detailed are provided in Table 6.

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Findings regarding the leverage ratio The results regarding the leverage ratio are provided using two alternative measures of Tier 1 capital in the numerator: Basel III Tier 1, which is the fully phased-in Basel III definition of Tier 1 capital, and Current Tier 1, which is Tier 1 capital eligible under the Basel II agreement (the phase-in period of Basel III begins in 2013). Total exposures of Group 1 banks according to the definition of the denominator of the leverage ratio were €59.2 trillion while total exposures for Group 2 banks were €5.6 trillion.

One important element in understanding the results of the leverage ratio section is the terminology used to describe a bank’s leverage.

Generally, when a bank is referred to as having more leverage, or being more leveraged, this refers to a multiple (eg 33 times) as opposed to a ratio (eg 3%).

Therefore, a bank with a high level of leverage will have a low leverage ratio.

Chart 4 presents leverage ratios based on Basel III Tier 1 and current Tier 1 capital. The chart provides this information for all banks, Group 1 banks and Group 2 banks.

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The weighted average current Tier 1 leverage ratio for all banks is 4.5%.

For Group 1 banks, it is somewhat lower at 4.4% while it is 5.0% for Group 2 banks.

The average Basel III Tier 1 leverage ratio for all banks is 3.5%. The Basel III average for Group 1 banks is 3.4%, and the average for Group 2 banks is 4.2%.

The analysis shows that Group 2 banks are generally less leveraged than Group 1 banks, and this difference increases under Basel III when the requirements are fully phased in.

It is likely that a portion of this effect is due to the changes in the definition of capital, which, as seen in Section 2, are likely to affect Group 1 banks to a greater extent than Group 2 banks.

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Under the current Tier 1 leverage ratio, 17 banks would not meet the 3% Tier 1 leverage ratio level, including six Group 1 banks and 11 Group 2 banks.

Under the Basel III Tier 1 leverage ratio, 63 banks would not meet the 3% Tier 1 leverage ratio level, including 36 Group 1 banks and 27 Group 2 banks.

Liquidity Liquidity coverage ratio One of the two standards introduced by the Committee is a 30-day liquidity coverage ratio (LCR) which is intended to promote short-term resilience to potential liquidity disruptions. The LCR has been designed to require global banks to have sufficient high-quality liquid assets to withstand a stressed 30-day funding scenario specified by supervisors. The LCR numerator consists of a stock of unencumbered, high quality liquid assets that must be available to cover any net outflow, while the denominator is comprised of cash outflows less cash inflows (subject to a cap at 75% of outflows) that are expected to occur in a severe stress scenario. 103 Group 1 and 102 Group 2 banks provided sufficient data in the 30 June 2011 Basel III monitoring exercise to calculate the LCR according to the Basel III liquidity framework. The weighted average LCR was 90% for Group 1 banks and 83% for Group 2 banks. These aggregate numbers do not speak to the range of results across the banks. Chart 5 below gives an indication of the distribution of bank results; the thick red line indicates the 100% minimum requirement, the thin red horizontal lines indicate the median for the respective bank group. 45% of the banks in the Basel III monitoring sample already meet or

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exceed the minimum LCR requirement and 60% have LCRs that are at or above 75%.

For the banks in the sample, Basel III monitoring results show a shortfall of liquid assets of €1.76 trillion (which represents approximately 3% of the €58.5 trillion total assets of the aggregate sample) as of 30 June 2011, if banks were to make no changes whatsoever to their liquidity risk profile.

This number is only reflective of the aggregate shortfall for banks that are below the 100% requirement and does not reflect surplus liquid assets at banks above the 100% requirement.

Banks that are below the 100% required minimum have until 2015 to meet the standard by scaling back business activities which are most vulnerable to a significant short-term liquidity shock or by lengthening the term of their funding beyond 30 days.

Banks may also increase their holdings of liquid assets.

The key components of outflows and inflows are shown in Table 7.

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Group 1 banks show a notably larger percentage of total outflows, when compared to balance sheet liabilities, than Group 2 banks. This can be explained by the relatively greater contribution of wholesale funding activities and commitments within the Group 1 sample, whereas, for Group 2 banks, retail activities, which attract much lower stress factors, comprise a greater share of funding activities.

Cap on inflows No Group 1 and 19 Group 2 banks reported inflows that exceeded the cap. Of these, six fail to meet the LCR, so the cap is binding on them.

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Of the banks impacted by the cap on inflows, 18 have inflows from other financial institutions that are in excess of the excluded portion of inflows.

The composition of high quality assets currently held at banks is depicted in Chart 6. The majority of Group 1 and Group 2 banks’ holdings, in aggregate, are comprised of Level 1 assets; however the sample, on whole, shows diversity in their holdings of eligible liquid assets. Within Level 1 assets, 0% risk-weighted securities issued or guaranteed by sovereigns, central banks and PSEs, and cash and central bank reserves comprising significant portions of the qualifying pool. Comparatively, within the Level 2 asset class, the majority of holdings is comprised of 20% risk-weighted securities issued or guaranteed by sovereigns, central banks or PSEs, and qualifying covered bonds.

Cap on Level 2 assets €121 billion of Level 2 liquid assets were excluded because reported Level 2 assets were in excess of the 40% cap as currently operationalised.

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34 banks currently reported assets excluded, of which 24 (11% of the total sample) had LCRs below 100%. Chart 7 combines the above LCR components by comparing liquidity resources (buffer assets and inflows) to outflows. Note that the €800 billion difference between the amount of liquid assets and inflows and the amount of outflows and impact of the cap displayed in the chart is smaller than the €1.76 trillion gross shortfall noted above as it is assumed here that surpluses at one bank can offset shortfalls at other banks. In practice the aggregate shortfall in the industry is likely to lie somewhere between these two numbers depending on how efficiently banks redistribute liquidity around the system.

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Net stable funding ratio The second standard is the net stable funding ratio (NSFR), a longer-term structural ratio to address liquidity mismatches and provide incentives for banks to use stable sources to fund their activities. 103 Group 1 and 102 Group 2 banks provided sufficient data in the 30 June 2011 Basel III monitoring exercise to calculate the NSFR according to the Basel III liquidity framework. 46% of these banks already meet or exceed the minimum NSFR requirement, with three-quarters at an NSFR of 85% or higher. The weighted average NSFR for each of the Group 1 bank and Group 2 samples is 94%. Chart 8 shows the distribution of results for Group 1 and Group 2 banks; the thick red line indicates the 100% minimum requirement, the thin red horizontal lines indicate the median for the respective bank group.

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The results show that banks in the sample had a shortfall of stable funding of €2.78 trillion at the end of June 2011, if banks were to make no changes whatsoever to their funding structure.

This number is only reflective of the aggregate shortfall for banks that are below the 100% NSFR requirement and does not reflect any surplus stable funding at banks above the 100% requirement.

Banks that are below the 100% required minimum have until 2018 to meet the standard and can take a number of measures to do so, including by lengthening the term of their funding or reducing maturity mismatch.

It should be noted that the shortfalls in the LCR and the NSFR are not necessarily additive, as decreasing the shortfall in one standard may result in a similar decrease in the shortfall of the other standard, depending on the steps taken to decrease the shortfall.

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NUMBER 2

Study on the Cross-Border Scope of the Private Right of Action Under Section 10(b) of the Securities Exchange Act of 1934 As Required by Section 929Y of the Dodd-Frank Wall Street Reform and Consumer Protection Act

April 2012

This study has been prepared by the Staff of the U.S. Securities and Exchange Commission. The Commission has expressed no view regarding the analysis, findings, or conclusions contained herein.

Executive Summary

This study stems from two significant legal developments in the Summer of 2010 regarding the application of Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) to transnational securities frauds. Section 10(b) is an antifraud provision designed to combat a wide variety of manipulative and deceptive activities that can occur in connection with the purchase or sale of a security. The Securities and Exchange Commission (“Commission”) has civil enforcement authority under Section 10(b) and the Department of Justice (“DOJ”) has criminal enforcement authority. Further, injured investors can pursue a private right of action under Section 10(b); meritorious private actions have long been recognized as an important supplement to civil and criminal law-enforcement actions. On June 24, 2010, the Supreme Court in Morrison v. National Australia Bank concluded that there is no “affirmative indication” in the Exchange Act that Section 10(b) applies extraterritorially.

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Finding no affirmative indication of an extraterritorial reach, the Supreme Court adopted a new transactional test under which: Section 10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States. Congress promptly responded to the Morrison decision by adding Section 929P(b)(2) of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). Section 929P(b)(2) provided the necessary affirmative indication of extraterritoriality for Section 10(b) actions involving transnational securities frauds brought by the Commission and DOJ. Specifically, Section 929P(b)(2) provides the district courts of the United States with jurisdiction over Commission and DOJ enforcement actions if the fraud involves: (1) conduct within the United States that constitutes a significant step in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States. With respect to private actions under Section 10(b), Section 929Y of the Dodd-Frank Act directed the Commission to solicit public comment and then conduct a study to consider the extension of the cross-border scope of private actions in a similar fashion, or in some narrower manner. Additionally, Section 929Y provided that the study shall consider and analyze the potential implications on international comity and the potential economic costs and benefits of extending the cross-border scope of private actions.

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Background Conduct and Effects Tests. Prior to the Supreme Court’s Morrison decision, the lower federal courts had applied two tests to determine the cross-border reach of Section 10(b): the conduct test and the effects test. Under the conduct test, Section 10(b) applied if a sufficient level of conduct comprising the transnational fraud occurred in the United States, even if the victims or the purchases and sales were overseas. Although the courts had adopted a range of approaches to defining when the level of domestic conduct was sufficient, courts generally found the conduct test satisfied where: (1) the mastermind of the fraud operated from the United States in a scheme to sell shares in a foreign entity to overseas investors; (2) much of the important efforts such as the underwriting, drafting of prospectuses, and accounting work that led to the fraudulent offering of a U.S. issuer’s securities to overseas investors occurred in the United States; or (3) the United States was used as a base of operations for meetings, phone calls, and bank accounts to receive overseas investors’ funds. Under the effects test, Section 10(b) applied to transnational securities frauds when conduct occurring in foreign countries caused foreseeable and substantial harm to U.S. interests. Among other situations, the effects test applied where either overseas fraudulent conduct or a predominantly foreign transaction resulted in a direct injury to: (1) Investors resident in the United States (even if the U.S. investors are relatively small in number);

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(2) Securities traded on a U.S. exchange or otherwise issued by a U.S. entity; or (3) U.S. domestic markets, at least where a reasonably particularized harm occurred. Morrison Litigation. Morrison involved a so-called “foreign-cubed” class action – a class action on behalf of foreign investors who had acquired the common stock of a foreign corporation through purchases effected on foreign securities exchanges. The plaintiffs alleged that the foreign corporation made false and misleading statements outside the United States to the plaintiff-investors that were based on false financial figures that had been generated in the United States by a wholly-owned U.S. subsidiary. The federal district court dismissed the case, holding that the conduct test had not been satisfied. The court of appeals affirmed the dismissal. At the Supreme Court, many of the arguments raised by the parties and the various amici curiae (i.e., non-parties who voluntarily submitted their views and analysis to assist the Court) centered on policy arguments supporting or opposing the conduct and effects tests in comparison to a bright-line test that would restrict the cross-border reach of Section 10(b). The plaintiffs and their supporting amici argued, among other things, that: (1) there is an inherent U.S. interest in ensuring that even foreign purchasers of globally traded securities are not defrauded, because the prices that they pay for their securities will ultimately impact the prices at which the securities are sold in the United States; (2) foreign issuers that cross-list in the United States benefit from the prestige and increased investor confidence that results from a U.S. listing, and thus it is reasonable to hold these foreign issuers to the full force of the U.S. securities laws regardless of where the particular transaction occurs;

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(3) without the cross-border application of Section 10(b) afforded by the conduct and effects tests, there generally would be no legal options for redress open to the foreign victims of frauds committed by persons residing in the United States; and (4) eliminating the conduct and effects tests could be a significant factor weighing against further or continued foreign investment in the United States. The defendants and their supporting amici (excluding foreign governments) argued, among other things, that: (1) the uncertainty and lack of predictability resulting from the conduct and effects tests discourage investment in the United States and capital raising in the United States, which would not occur with a bright-line test limiting Section 10(b) only to transactions within the United States; (2) application of Section 10(b) private liability to frauds resulting in transactions on foreign exchanges would result in wasteful and abusive litigation, cause the United States to become a leading venue for global securities class actions, and subject foreign issuers to the burdens and uncertainty of extensive U.S. discovery, pre-trial litigation, and perhaps trial before plaintiffs’ claims can be dismissed under the conduct and effects tests; and (3) different nations have reached different conclusions about what constitutes fraud, how to deter it, and when to prosecute it, and the cross-border application of U.S. securities law would interfere with those sovereign policy choices. The U.S. Solicitor General, joined by the Commission, recommended to the Supreme Court a standard that would permit a private plaintiff who suffered a loss overseas as part of a transnational securities fraud to pursue redress under Section 10(b) if the U.S. component of the fraud directly caused the plaintiff’s injury. Although the Solicitor General acknowledged the potential for private securities actions brought under U.S. law to conflict with the procedures

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and remedies afforded by foreign nations, the Solicitor General opposed a transactional test that would permit a Section 10(b) private action only if the securities transaction occurred in the United States. A transactional test, the Solicitor General explained, would produce arbitrary outcomes, including denying a Section 10(b) private action even when the fraud was hatched and executed entirely in the United States and the injured investors were in the United States if the transactions induced by the fraud were executed abroad. The British, French, and Australian Governments opposed to varying degrees the cross-border scope of private rights of action under Section 10(b). Each argued that it had made different policy choices about the prevention of fraud and enforcement of antifraud rules based on its own sovereign interests, and asserted that each choice deserved respect. The British and French Governments expressly supported a bright-line test. Morrison Decision. As noted above, the Supreme Court adopted a new transactional test under which Section 10(b) applies only to frauds in connection with the “the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” In rejecting the conduct and effects tests, the Court expressly identified the potential threat of regulatory conflict and international discord that private securities class actions can pose in the context of transnational securities frauds. Justice Stevens filed a concurrence in which he argued in favor of the conduct and effects tests, and criticized the transactional test as unduly excluding from private redress under Section 10(b) frauds that transpire in the United States or directly target U.S. citizens.

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Post-Morrison Legal Developments Following the Morrison decision, the lower federal courts have addressed a number of questions regarding the interpretation and application of the transactional test. To date, the courts have issued decisions holding that: 1) Although the Supreme Court stated in Morrison that Section 10(b) applies to the “purchase or sale of a security listed on an American stock exchange,” an investor in a U.S. and foreign cross-listed security cannot maintain a Section 10(b) private action if he or she acquired the security on the foreign stock exchange. 2) An investor who acquires an exchange-traded American depositary receipt (ADR), which is a type of security that represents an ownership interest in a specified amount of a foreign security, can maintain a Section 10(b) private action. 3) The purchase or sale of a security on a foreign exchange by a U.S. investor is not within the reach of Section 10(b) even if the transaction was initiated in the United States (e.g., the purchase or sale order was placed with a U.S. broker-dealer by a U.S. investor). 4) A Section 10(b) private action is not available for a U.S. counter-party to a security-based swap that references a foreign security, at least to the extent that the counter-party is suing a third party (i.e., a non-party to the swap) for fraudulent conduct related to the foreign-referenced security. 5) Section 10(b) applies where a defendant engages in insider trading overseas with respect to a U.S. exchange-traded corporation by acquiring contracts for difference, which are a type of security in which the purchaser acquires the future movement of the underlying company’s common stock without taking formal ownership of the company’s shares. 6) A Section 10(b) private action is not available against a securities intermediary such as a broker-dealer, investment adviser, or underwriter

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if the transaction for which the investor suffered a loss occurred on a foreign exchange or otherwise outside the United States, even if (i) the intermediary resided in the United States and primarily engaged in the fraudulent conduct here, or (ii) the intermediary traveled to the United States frequently to meet with the U.S. investor-client. 7) Investors who purchase shares of an off-shore feeder fund that holds itself out as investing exclusively or predominantly in a U.S. fund cannot maintain a Section 10(b) private action unless the purchase of the feeder fund’s shares occurred in the United States. Courts are divided on the issue of how to determine whether a purchase or sale of securities not listed on a U.S. or foreign exchange takes place in the United States, setting forth a number of competing approaches that include looking to: (a) whether either the offer or the acceptance of the off-exchange transaction occurred in the United States; (b) whether the event resulting in “irrevocable liability” occurred in the United States; or (c) whether the issuance of the securities occurred in the United States.

Responses to Request for Public Comment In response to the Commission’s request for public comments, as of January 1, 2012 the Commission received 72 comment letters (excluding duplicate and follow-up letters) – 30 from institutional investors; 19 from law firms and accounting firms; 8 from foreign governments; 7 from public companies and associations representing them; 7 from academics; and 1 from an individual investor.

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Of these, 44 supported enactment of the conduct and effects tests or some modified version of the tests, while 23 supported retention of the Morrison transactional test. Arguments in Favor of the Transactional Test. The comment letters in support of the transactional test asserted that cross-border extension of Section 10(b) private actions would create significant conflicts with other nations’ laws, interfere with the important and legitimate policy choices that these nations have made, and result in wasteful and abusive litigation involving transactions that occur on foreign securities exchanges. Those comment letters argue that, by contrast, retention of the transactional test would foster market growth because the test provides a bright-line standard for issuers to reasonably predict their liability exposure in private Section 10(b) actions. Arguments Against the Transactional Test. The comment letters opposed to the transactional test argued, among other things, that: whether an exchange-traded securities transaction executed through a broker-dealer occurs in the United States or overseas may not be either apparent to U.S. investors or within their control; the transactional test impairs the ability of U.S. investment funds to achieve a diversified portfolio that includes foreign securities because the funds will have to either trade in the less liquid and potentially more costly ADR market in the United States or, alternatively, forgo Section 10(b) private remedies to trade overseas or pursue foreign litigation; and the transactional test fails to provide a private action in situations where U.S. investors are induced within the United States to purchase securities overseas. Arguments in Favor of the Conducts and Effects Tests. The comment letters supporting enactment of the conduct and effects tests argued that doing so would promote investor protection because private actions would be available to supplement Commission enforcement actions involving transnational securities frauds. These comment letters also argued that the conduct and effects tests reflect the economic reality that although a company’s shares may trade on a foreign exchange and the company may be incorporated overseas,

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the entity may have an extensive U.S. presence justifying application of U.S. securities laws. Further, comment letters also argued that the conduct and effects tests ensure that fraudsters operating in the United States or targeting investors in the United States cannot easily avoid the reach of Section 10(b) private liability, and facilitates international comity by balancing the interests of the United States and foreign jurisdictions. Arguments Against the Conduct and Effects Tests. The arguments against the conduct and effects tests largely mirrored those set forth above in favor of the transactional test. In addition, these comment letters argued that: investor protection and deterrence of fraud are sufficiently achieved in the context of transnational securities fraud by Congress having enacted the conduct and effects tests for cases brought by the Commission and DOJ; small U.S. investors do not need the heightened protection of the conduct and effects tests because they generally do not directly invest overseas; the conduct and effects tests’ fact-specific analysis bears little relationship to investors’ expectations about whether they are protected by U.S. securities laws; and foreign legal regimes already provide sufficient remedies for investors who engage in transactions abroad. Alternative Approaches that Commenters Proposed. Several comment letters argued in support of conduct and effects tests limited to U.S. resident investors. According to these comment letters, such an approach would minimize many of the international comity concerns associated with the conduct and effects tests because foreign nations recognize that the United States has a strong interest in protecting its own citizens. Another option that the comment letters suggested was a fraud-in-the-inducement standard under which an investor could maintain a Section 10(b) private action if the investor was induced to purchase or sell the security in reliance on materially false or misleading material provided to the investor in the United States.

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Comment letters supporting this alternative argued that it would be consistent with investors’ expectations, because investors generally believe that they will be protected by the legal regime that applies in the locations where they are subjected to fraudulent information or conduct.

Options Regarding the Cross-Border Reach of Section 10(b) Private Actions The Staff advances the following options for consideration: Options Regarding the Conduct and Effects Tests. Enactment of conduct and effects tests for Section 10(b) private actions similar to the test enacted for Commission and DOJ enforcement actions is one potential option. Consideration might also be given to alternative approaches focusing on narrowing the conduct test’s scope to ameliorate those concerns that have been voiced about the negative consequences of a broad conduct test. One such approach (which the Solicitor General and the Commission recommended in the Morrison litigation) would be to require the plaintiff to demonstrate that the plaintiff’s injury resulted directly from conduct within the United States. Among other things, requiring private plaintiffs to establish that their losses were a direct result of conduct in the United States could mitigate the risk of potential conflict with foreign nations’ laws by limiting the availability of a Section 10(b) private remedy to situations in which the domestic conduct is closely linked to the overseas injury. The Commission has not altered its view in support of this standard. Another option is to enact conduct and effects tests only for U.S. resident investors.

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Such an approach could limit the potential conflict between U.S. and foreign law, while still potentially furthering two of the principal regulatory interests of the U.S. securities laws – i.e., protection of U.S. investors and U.S. markets. Options to Supplement and Clarify the Transactional Test. In addition to possible enactment of some form of conduct and effects tests, the Study sets forth four options for consideration to supplement and clarify the transactional test. One option is to permit investors to pursue a Section 10(b) private action for the purchase or sale of any security that is of the same class of securities registered in the United States, irrespective of the actual location of the transaction. A second option, which is not exclusive of other options, is to authorize Section 10(b) private actions against securities intermediaries such as broker-dealers and investment advisers that engage in securities fraud while purchasing or selling securities overseas for U.S. investors or providing other services related to overseas securities transactions to U.S. investors. A third option is to permit investors to pursue a Section 10(b) private action if they can demonstrate that they were fraudulently induced while in the United States to engage in the transaction, irrespective of where the actual transaction takes place. A final option is to clarify that an off-exchange transaction takes place in the United States if either party made the offer to sell or purchase, or accepted the offer to sell or purchase, while in the United States

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NUMBER 3

Survey on the implementation of the CEBS Guidelines on Remuneration Policies and Practices 12 April 2012 - The European Banking Authority (EBA) publishes today the results of the survey on the implementation of CEBS Guidelines on remuneration policies and practices. The survey findings indicate that in most countries the Guidelines came into force on 1 January 2011 and that supervisors have actively assessed remuneration policies requiring, where needed, interventions in the remuneration structures and payouts of the variable component. While considerable progress has been reported with respect to the governance of remuneration, some areas of concern remain. Further supervisory guidance is needed in setting up the criteria for identifying risk takers as well as in the application of the proportionality principle and of the risk alignment practices. The findings of the survey have showed a satisfactory implementation of the Guidelines into the respective legal and supervisory frameworks and good progress by the industry has been reported namely as to the practices in the governance of remuneration.

However, the scope of the Guidelines is one of the areas for concern as considerable variations exist in the extent to which the remuneration requirements are applied beyond the scope of the CRD.



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With regard to the identification of risk takers, the survey has highlighted inconsistencies across institutions in the criteria used to identify staff that have a material impact on the firm’s risk profile.

Furthermore, such criteria have not always proved to sufficiently grasp the risk impact aspect of the exercise.

Inconsistencies have also emerged in the application of the proportionality principle with practices varying from predetermined fixed criteria to open case-by-case approaches to determine if the set of specific remuneration rules should be applied to identified staff.

Finally, the survey has showed that risk alignment practices across the industry remain underdeveloped namely with regard to the interaction of parameters used for risk management and the structure of bonus pools.

In light of the shortcomings identified by the survey, it is welcomed that the Danish Presidency, in its January compromise text on the CRD IV package, has proposed to widen the scope of the mandate for the EBA to elaborate criteria to identify categories of staff whose professional activities have a material impact on the institution’s risk profile.

CONTEXT FOR THE SURVEY This report presents the results of an EBA survey on the implementation of the CEBS Guidelines on Remuneration Policies and Practices (hereafter: the Guidelines) amongst European banking supervisors, conducted in Q 4 2011. The Guidelines were published on 10 December 2010. The aim of the survey was twofold i.e. to get an overview of - how legislators and supervisors have implemented the Guidelines in

their legislative frameworks and/or their supervisory policies, focusing on possible differences between these implementations and the Guidelines;

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- more importantly, how the requirements of the Guidelines have been supervised in practice, what progress has been made by institutions and which areas need further development.

This aim is set off against a level playing field concern that was raised when adopting the Guidelines, both by the sector and between supervisors. Although the Guidelines provide an extensive supporting framework to interpret the CRD III requirements on remuneration, they include numerous open aspects where judgment by institutions and by supervisors is required. The concern was that this judgment would lead to different implementations within the EU, further intensified by the fact that prudential supervision over remuneration policies has been since the crisis a completely new field of supervisory competence in most EU countries. Through this report the EBA wants to encourage greater regulatory consistency across the EU jurisdictions. The survey benchmarks progress and further work to be done against the Guidelines, and consequently has a European context, with no direct link to level playing field concerns between Europe and other members of the FSB. In this respect, the FSB published in October 2011 a Thematic Review on Compensation that included this kind of level playing concerns, amongst other implementation survey work on the FSB Principles and Implementation Standards. As a follow-up, the FSB has launched a detailed ongoing monitoring program. In the European Union, this survey is not the only tool through which EBA monitors remuneration practices and levels in institutions across the Member States.

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A benchmark exercise based on remuneration data collected in accordance with the criteria for disclosure established in point 15(f) of part 2 Annex XII of CRD III, will be launched by EBA. Twenty-one supervisors have participated in the survey; questions in the survey were mainly open and qualitative of nature, but for some aspects, numerical information was asked for a sample of institutions that represents 60 % of total assets in the banking sector or at least the 20 largest institutions in a particular Member State. Answers about practices in institutions relate mainly to the 2010 remuneration cycle (i.e. for performances in 2010), the first year of application of the CRD III requirements. The intention of this implementation report is not to repeat the requirements of the Guidelines. Where necessary, references will be made to the numbers of the relevant paragraphs of the Guidelines in footnotes. Words or expressions used in this report which are also used in the Guidelines shall have the meaning in this report as in the Guidelines.

Executive Summary The CRD III remuneration requirements sought to develop risk-based remuneration policies and practices, aligned with the long term interests of the institution and avoiding short-term incentives that could lead to excessive risk-taking. This was seen as a key contributory reform in restoring overall financial stability after the 2007-2008 financial crisis. In most countries, the Guidelines came into force on 1 January 2011, with some countries suffering from delays in the legislative process.

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The CRD III combination of articles and annexes, with the Guidelines on top of these, is often mirrored in the countries as a combination of legislative acts, regulation, circulars and/or explanatory memoranda. The balance between legally prescriptive and supervisory regulatory approaches differs between the respondents. Supervisors have actively assessed remuneration policies, imposing - where needed - amendments to the policy and consequently intervening in the remuneration structures and actual payouts of variable remuneration. In all countries, the Guidelines are part of the supervisory review over institutions.

The scope of the Guidelines is an area of significant concern.

Regarding the scope of institutions, there are effectively no substantive exemptions at national level to the application of the remuneration requirements to institutions covered by CRD III. Considerable variations exist in the extent to which the remuneration requirements are applied beyond the scope of CRD III e.g. in some countries this extends to the financial sector as a whole. While these findings are reassuring or at least not problematic at first sight, they need further nuancing when put in the context of groups or when taken together with the proportionality CRD III allows. Groups with non-EEA entities or groups with non-regulated subsidiaries or regulated subsidiaries that are not subject to CRD III do not always obtain the standard of group-wide application of the remuneration policy. Differences in how the Guidelines apply beyond the EEA borders often have their origin in different implementation of the FSB Principles and Implementing Standards by third countries.

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Proportionality regimes, sometimes based on predetermined fixed criteria, other times based on an open case-by-case approach, can lead to significant variation in the net degree by which institutions are subject to the CRD III requirements. Regarding staff under scope of the specific risk alignment requirements, CRD III requires that institutions identify the categories of staff that have a material impact on the risk profile of the institution (hereafter: the Identified Staff). Institutions use a large variety of criteria for this internal exercise but these are not always sufficient to grasp the risk impact aspect of this exercise or to take into account less quantifiable risks such as reputational risk. The numbers of Identified Staff differ considerably between Member States, but there is a clear tendency of institutions to select very low numbers. This affects the core of the CRD III requirements and undermines the effectiveness of EU supervisory reforms on remuneration. The process to determine the Identified Staff in a group can be applied differently between parent undertaking and subsidiaries. There is a genuine concern on supervisory differences regarding the identification process, within and outside the EEA. These differences can lead to regulatory arbitrage and competitive disadvantages. Many supervisors express the need for clear criteria and a process to identify risk takers in a single entity and within groups. More guidance is also needed on the application of the proportionality principle and the neutralization of requirements. Further harmonisation of the identification process is essential for a level playing field.

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In order to be able to align with the risk profile of institutions, a balance should be found between clarity and flexibility.

The governance of remuneration has shown considerable progress.

This may be explained by the fact that remuneration governance is part of broader governance reforms after the financial crisis. There is a widespread good implementation of the Guidelines with regard to the general principles on corporate governance, the role of the management body in its supervisory and management function and the setting up of a Remuneration Committee (hereafter: Rem Co). If weaknesses occur, those mainly stem from the group governance context: differences in the implementation of the Guidelines across jurisdictions often have their origin in different corporate laws and practices; another source may be the difficult balance between the coherent application of the group policy and the local responsibilities, based on local risks profiles and regulatory environment, that subsidiaries may have in the field of remuneration.

The risk alignment of remuneration policies and practices remain underdeveloped.

In the first cycle of application of CRD III, it appears that too many supervisory resources often have been spent to discussions with institutions regarding the numbers of Identified Staff rather than focusing more on risk alignment principles. Hardly any supervisory guidance, additional to the Guidelines, has been developed at national level. Changes are perceptible in risk alignment during performance measurement of employees and in the parameters used ex ante for setting bonus pools.

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Net profits and to a certain extent also risk-adjusted performance parameters are now more in use for setting bonus pools, but much more experience needs to be gained here on the credibility of the parameters and on their simultaneous internal use for risk management purposes outside remuneration so that they can really become embedded in the organisation's risk management framework. The interaction of such risk-adjusted parameters and discretionary judgment needs more transparency and the level at which the ex ante adjustment is applied is still restricted too much to the highest levels of the organisation. Also it is particularly important to ensure that the level of variable remuneration is consistent with the need to maintain, strengthen and restore a sound capital base. Regarding ex post risk alignment, more improvements seem to be desirable with a view to establishing sufficiently sensitive malus criteria which trigger forfeiture of deferred, i. e. unvested, variable remuneration. The malus criteria used do not always reflect the back testing character, which is inherent in the idea of a malus, with regard to the initially measured performance. In light of the underdevelopment of risk adjustment techniques, the ratios of variable to fixed that institutions have set in their remuneration policies and that were used in this first CRD III cycle do not appear to signal a breach with practices from the past and tend to be high. The criteria by which institutions decide on the ratios in practice are not always clear. Progress can however be observed in setting up multi-year frameworks, with deferral periods now being widespread. National requirements on the different elements of the multi-year framework (e.g. proportion being deferred, time horizon, vesting process,

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time span between end of accrual and vesting of deferred amount) show some minor variance or divergence from the Guidelines.

The use of instruments as part of variable remuneration suffers from a feasibility gap.

CRD III introduced a requirement to pay at least 50% of the variable component of remuneration in instruments. Because the wording used for this requirement includes an "appropriate balance" of different types of instruments, there was some room for institutions to tailor this requirement to their own needs and possibilities. In some countries, there is delay in complying with this CRD III requirement because banks have difficulties in finding suitable instruments. Listed institutions in several jurisdictions do not use common shares due to practical and dilution problems, even though based on the CRD III text there were expectations that such shares would be used by listed institutions. So-called "phantom shares plans" (equivalent non cash instruments) are more frequently used by both listed and non-listed institutions, although their development is still subject to many open issues. The main open issue concerns the valuation of these plans: by whom should the value be determined and what kind of method should be used to that end? Further practical experience is needed in this respect, especially to develop these instruments for non-listed companies. Still, some strong practices are emerging which may help to shape further policy. Hybrid tier 1 instruments, part of the "appropriate balance" that CRD III envisaged, are so far in practice not used.

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Disclosure of remuneration policies and practices deserves greater attention.

Greater attention on disclosure of remuneration policies and practices could enhance the implementation. The tandem between public disclosure and supervisory reporting, once the EBA Guidelines 46 and Guidelines 47 on remuneration data collection exercises are implemented, should be helpful in this respect. Effective disclosure in fact allows the market's awareness on remuneration to increase. At the same time, it increases monitoring by the markets and regulators on the relation between pay, risk-taking and performance and can facilitate the emergence of best practices that address both financial stability concerns and the institutions' need for competitive pay schemes. It is therefore important to ensure an equal level of application of the disclosure requirements. Today, this is still hampered mainly by the fact that disclosure requirements relate to those categories of staff selected as Identified Staff, whose number can differ considerably between Member States, as already mentioned.

Analysis of the Implementation Scope Scope issues are structured as follows: first the report discusses the institutions in scope, then the report examines how the concept of Identified Staff has been implemented. These two subsections have three parts: a general discussion and then an elaboration of how (1) the group context and

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(2) neutralization influence implementation. The Guidelines distinguish between proportionality between institutions and proportionality between staff, with neutralization being the most far-reaching form of these types of proportionality.

INSTITUTIONS WITHIN SCOPE General The CRD III remuneration requirements apply to credit institutions as defined under art. 4(1) of Directive 2006/48 and investment firms as defined under Directive 2006/49/EC, which in turn refers to Directive 2004/39/EC on markets in financial instruments (MiFID) (article 4 (1)(1)). It is clear that the implementation of the remuneration requirements has ensured comprehensive coverage of these institutions. Overall, jurisdictions have in place no substantive exemptions to the application of the requirements. However there were considerable divergences in two important areas: - The extent to which the CRD III remuneration requirements were

applied to sectors not within the scope of CRD III; and - The approach which individual markets have taken to proportionality

and the degree to which the remuneration requirements may be neutralized.

(In this context neutralization means the decision not to apply certain of the remuneration requirements to certain covered institutions dependent upon nationally determined criteria).

Many jurisdictions apply the remuneration requirements solely to those institutions covered by CRD III.

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However, some others extend the application in relatively modest ways including, for example, the utilisation of broader definitions of credit institutions or extension to settlement and clearing institutions. Some authorities, though, have chosen to apply the requirements much more widely including in some cases to the whole of the financial services sector or to a significant number of additional sub-sectors, for example to insurance and reinsurance companies, investment management companies and private pension funds, asset management and finance leasing firms. The key positive outcome is that the remuneration requirements are comprehensively being applied to CRD III institutions and some jurisdictions have used national discretion to apply the requirements more widely. Future EU legislation for other financial services sectors e.g. Solvency II, will lead to more harmonisation.

Neutralization at the level of institutions However, although all firms within scope are covered, there are very wide divergences across jurisdictions in the extent to which the remuneration provisions can be neutralized and the ways in which that neutralization is achieved. In a few cases there was little or no neutralization. Three jurisdictions operate tiered proportionality regimes. Whilst these have some differences in structure and detail, the proportionality regimes apply neutralization primarily in relation to the size, scope, complexity and nature of firms’ businesses with the most significant firms unable to neutralize any of the provisions.

Germany Germany has a very heterogeneous banking market with many smaller institutions that have a conservative business model, esp. with a focus on local retail and smaller to medium corporate client business.

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For this reason the Remuneration Regulation for Institutions (Instituts-Vergütungsverordnung, in short InstitutsVergV) makes a distinction between general requirements applying to all institutions and all employees (sections 3, 4 and 7 InstitutsVergV), and additional more demanding requirements (sections 5, 6 and 8 InstitutsVergV) that are relevant for “major institutions” and the remuneration schemes of their management board and identified staff. Institutions that are not "major" may neutralize the following requirements listed in Annex 2 of the Guidelines ("major institutions" cannot neutralize the following requirements): - (g) on performance criteria, - (h) on the multi-year framework, except for the management body of

every institution, - (o) on instruments, - (p) on deferral, - (q) on risk adjustments, - (r) on pension policy as “discretionary pension benefits” play no role

in the German institutions - the establishment of a Rem Co.

The general requirements of the InstitutsVergV (sections 3, 4 and 7) implement all other requirements listed in Annex 2 of the Guidelines (including Annex 2 (l) on the ratio variable/fix). Qualification as a "major institution" depends on total assets and a risk analysis which the institution is required to perform itself. This risk analysis is relevant for all institutions whose total assets on the respective balance sheet dates for the last three completed financial years reached or exceeded an average of €10 billion. The risk analysis shall take particular account of the institution’s size, its remuneration structure and the nature, scope, complexity, risk content and international scale of the business activities conducted.

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In this regard, particular significance will be attached to an institution’s business activities. Institutions with total assets of at least €40 billion are generally considered to be "major". Institutions with total assets under €10 billion are not considered to be "major" unless these institutions deem themselves to be major.

Italy Italy operates a proportionality regime based on three categories of institutions: (a) ‘major’ banking groups with total consolidated assets of over €40 billion are required to adopt all the general and stricter requirements of the CRD III and the Guidelines; (b) ‘medium’ banks and banking groups with total consolidated assets between €3.5 and €40 billion are required to apply all the general requirements and may consider not to apply the stricter requirements on a case by case basis; (c) ‘minor’ banks with total consolidated assets lower than €3.5 billion are required to comply with the general requirements but not with the stricter provisions. Stricter requirements are: (i) the payment of at least 50% of variable remuneration in shares/other financial instruments; (ii) the deferral of at least 40% to 60% of the variable remuneration for at least 3 to 5 years; (iii) the appointment of a Rem Co. All the other CRD III provisions have to be intended as "general requirements". As a result of such proportionate approach, all Italian institutions must therefore comply with all the CRD III provisions and the Guidelines.

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Medium and minor institutions might neutralize only the stricter requirements. A Rem Co shall be however appointed in all listed institutions regardless of size.

Group context In the case of groups, the remuneration requirements are generally implemented worldwide and in relation to all regulated and non-regulated subsidiaries. The responses received reveal that national regulations in all countries completely reflect the minimum requirements of the Guidelines with regard to the application of remuneration policies on a consolidated basis. In many jurisdictions, the group Rem Co has a role in ensuring that remuneration provisions are applied at both group and subsidiary level. In practice, the balance between the requirement of the parent company to have the group remuneration policy applied coherently and the requirement of subsidiaries to take into account local responsibilities, based on local risk profile and regulatory environment, proves to be difficult to obtain. Some supervisors faced practices where the parent company determined group wide policies which did not sufficiently respect the subsidiary’s local responsibilities. Divergences occurred in the extent to which national regulations might take into account local non-EEA regulations (since within the EU there is a harmonised framework), practices or culture. In certain cases local regulations prevailed or were taken into account but in one case only if local regulation was tighter than national regulation. In those circumstances local requirements took precedence.

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In certain other jurisdictions home regulation automatically applied regardless of where the business was carried out. Sometimes institutions use (the absence of) local non-EEA regulations, practices or culture as an argument to implement less stringent remuneration policies in relation to activity in those third country markets. A supervisory response noted in that case was to bring activity in those markets at least within scope of the group policy, to ensure transparency towards and oversight by the management body. There are similarly differences in the application of proportionality principles ranging from the full application of home country proportionality regimes to application on a case by case basis to no scope for proportionality. There is thus the potential here for Member States to operate different regimes for their institutions in the same third country markets. The possible impact of this would be greatest where local jurisdictions operated markedly less restrictive remuneration regimes than those applicable in the EEA.

STAFF WITHIN SCOPE CRD III requires that institutions identify the categories of staff that have a material impact on the risk profile of the institution. The scope of the Identified Staff determines the scope of the specific risk alignment requirements. Therefore the identification of staff is the essential starting point for the effective management of risks. It is clear from the implementation report that the selection of Identified Staff has been the most important subject of discussion between institutions and supervisors.

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Because of the impact on the scope of the remuneration policies and on the competition between institutions, discussions between supervisors and institutions 'stuck' at this phase of the implementation of sound remuneration policies. The differentiation in the number of Identified Staff hinders the creation of a level playing field.

Institutional practices CRD III and the CEBS Guidelines state the categories of staff which should be selected. The CEBS Guidelines provide some guidance on the selection of Identified Staff. However, it is clear from the implementation report that more guidance is needed. Varying practices lead to differences in the criteria used to identify staff and in the number of Identified Staff within jurisdictions and internationally. Those differences can lead to regulatory arbitrage and competitive disadvantages. The result is that institutions have tended to select low numbers of Identified Staff, which is contrary to the objective of managing effectively risks resulting from remuneration policies and practices. Institutions use different processes to select Identified Staff. Some institutions first identify the relevant types of activity and then select the Identified Staff within these activities. Others base their selection on a risk analysis.

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Within the different categories of Identified Staff, mentioned in CRD III and the Guidelines, the category 'other risk takers' has proved to be the most challenging. The implementation report also provides some information on the selection criteria. Institutions use a variety of criteria to select the 'other risk takers'; often more than one. The criteria are quantitative as well as qualitative. The good practices identified in the implementation report are mainly quantitative metrics which are based on responsibilities or are linked to the risk impact of the employee's activity. Examples which were mentioned are: credit competence; trading limits; bounded economic capital on business unit level; Value at Risk, Risk Weighted Assets-, revenue- or Profit&Loss impact; risk capital, total remuneration, ratio fixed to variable remuneration, and various thresholds (threshold above which staff are allowed to operate; amounts of revenue; assets under management). Qualitative criteria which are used by the institutions are the seniority of staff; hierarchy in the institution; type of responsibility of staff members; type of activity; and employee rating. Most of these criteria are applied at individual level. In one jurisdiction institutions are required to use also criteria at institutional level. The implementation report also provides information per jurisdiction on the percentage of the total number of employees which institutions have selected as Identified Staff. These percentages should be treated with some care, because they are not always comparable. One reason for this is the different sizes of institutions.

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Although the absolute number of Identified Staff of a big institution will usually be higher than the number of a small institution, the percentage of the total number of staff can be lower. Also national regulation on proportionality or proportionality practices may impact the percentage of Identified Staff. Nevertheless, the clear conclusion can been drawn that the numbers of Identified Staff which institutions have selected vary considerably per jurisdiction. This conclusion applies to all three categories of banks on which the Implementation report requested data: 'all institutions', 'investment banks', and 'retail banks'. For example, in the category 'all institutions' there are 6 jurisdictions with an average Identified Staff < 1% of total number of employees; in 5 jurisdictions the average Identified Staff is between 1-5 %; in 3 jurisdictions the average is between 5-10 %; and in 2 jurisdictions the average is more than 10%. Institutions tend to identify lower numbers of Identified Staff, especially the bigger institutions. In the view of supervisors this is inadequate for effective risk management. Five supervisors have provided information on investment banks. Although one would expect investment banks consistently to have a higher percentage of Identified Staff than retail banks due to the higher risk profile, this is not the case in practice. In three jurisdictions investment banks have a higher percentage of Identified Staff than retail banks. However, in the other two jurisdictions the investment banks have a lower percentage.

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In the majority of jurisdictions the management body is involved in the identification process. Often the board has the responsibility to set the criteria for the selection of Identified Staff. In a few jurisdictions the supervisory board has a role. More often the Rem Co is involved, but its responsibilities vary between jurisdictions. Among the control functions, the human resources function is the most commonly involved in the identification process. The risk management function is clearly less often involved, although the aim of sound remuneration policies is the management of risks. The compliance function and the audit function appear to have only a minor role in the identification process.

Supervisory practices and guidance Almost all supervisors have indicated that they apply the institution-wide rules of CRD III and that the regulation covers all staff. In three jurisdictions, the regulations apply to a wider group of people, such as consultants, intermediaries, and persons to whom the institution has outsourced certain activities. The aim of covering this wider group is to avoid circumvention of the regulation. Almost all jurisdictions indicated that every institution covered by CRD has to select Identified staff. The determination of Identified Staff (especially in the category ‘other risk takers’, at lower level of the hierarchy) proves to be difficult, because a process and clear criteria are lacking. One supervisor has developed further guidance on ‘material impact’.

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Other supervisors have published guidance on the functions which should be appointed as Identified Staff and on the category ‘remuneration bracket’.

The Netherlands The Dutch supervisor has published a Q&A concerning Identified staff. With regard to the category "other risk takers"' the Dutch Q&A gives criteria related to the most common financial risks. Depending on a bank’s or investment firm’s business, the relative importance of risk types may vary. It is up to the firm to demonstrate which are most important. For banks that engage in (mortgage) lending, credit risk may generally be expected to be among the principal risk types. Where a firm (also) does significant business in the wholesale or financial markets, market risk will be a prominent financial risk. For most banks, funding and liquidity risk will also be of importance. Where credit, market, capital and liquidity risk are concerned, the Dutch supervisor regards a (non-additive) combination of three criteria as a starting point for gauging the materiality of staff activities.

Taken individually, every one of these tests have their limitations (e.g.: trading business is relatively immaterial in capital terms; taking capital as the sole criterion will provide inconclusive evidence). Thus a combination of all three tests provides the fullest overview of ‘material activities’.

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Note that the test results are non-additive. Where a test score ‘sticks out’, the associated activity is assumed to materially affect the firm’s risk profile. Next, relevant staff members may be identified within the scope of the selected activities. Functions which have a material influence on the risk profile are not limited to management functions (hierarchical positions), but also contain operational and controlling functions. With regard to nonfinancial risks (e.g. reputation, legal, or IT risks) the Dutch Q&A states that it is difficult to lay down a single or a small number of quantitative measures. Therefore, institutions should primarily select staff responsible for decisions with strong impact on a firm’s operational risk profile.

Denmark The Danish order on remuneration includes the following criteria on which persons should be appointed as identified staff: 1) the management of the part of the institution that deals with or approves financial instruments, 2) the management of the part of the institution that invests the institution's own book, 3) employees in the part of the institution as mentioned in 1 and 2 who via financial instruments can take a material risk on behalf of the institution on the institutions own book (proprietary trading), 4) the management of the actuary function and the reassurance function who can take a material risk on behalf of the institution on the institution's own book,

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5) managers of the part of the institution who control compliance of thresholds for risk taking, and 6) other employees that can cause the institution a material credit risk.

The UK The UK FSA Handbook states that the first three categories of Identified Staff ("Code staff" in the Handbook) (senior management, risk takers and staff engaged in control functions) should include persons who perform a significant influence function for the firm, or is a senior manager; individuals holding key positions, including heads of significant business lines and support and control functions; and other risk takers, which firms may identify through setting their own metrics. Many supervisors express the need for clear criteria and a process to select Identified Staff in a single entity and within groups. Further harmonisation of the identification process is essential for alevel playing field to operate. In view of this it is also suggested to set appropriate quantitative and qualitative criteria for the number of Identified Staff. In order to be able to align with the risk profile of institutions, a balance should be found between clarity and flexibility. Specific issues on which more guidance is needed are: (i) the definition of the term ‘material’, with regard to activities /subsidiaries /business lines as well as to 'other risk takers'. Without a better definition, institutions interpret functions (such as CFO and control functions) differently. (ii) the material impact of operating staff.

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This proves to be more difficult to determine than staff in hierarchical positions. (iii) the relevant level in the organisation. Some supervisors mention that it is not clear how far down in the organisation institutions have to select Identified Staff. Although low in hierarchy, certain activities of staff in lower positions can have an impact on the risk profile. (iv) the measurement of reputational risk and other not – easy – to – measure - risks when assessing the impact on the risk profile. (v) determination of the category of ‘risk takers who have collectively impact on the risk profile’. Clear criteria for the identification of this category are lacking. (vi) the identification of Identified Staff within a group. Especially there are questions about the level within subsidiaries at which staff have to be identified (e.g. only the highest control function in a subsidiary or also the level below), and whether a further difference should be made between regulated and non-regulated subsidiaries. (vii) the application of the proportionality principle and the neutralization of requirements. Diverging regulation or supervisory guidance on this point could have impact on the level playing field.

Neutralization at the level of Identified Staff Annex 2 of the CEBS Guidelines provides a table which shows the applicability and the possibility of neutralization of requirements for Identified Staff. In three jurisdictions neutralization is not possible.

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In all other jurisdictions neutralization is allowed for the requirements (o), (p) and (q): pay out in financial instruments (combined with retention) and deferral (including ex post adjustment). In a few jurisdictions institutions have made use of this. Reasons given for the neutralization of the requirements are: the business model in combination with the total (limited) number of employees; low ratio variable to fixed remuneration; the size of the group of persons which has collectively material impact; maximum threshold of total variable remuneration; the relative level of seniority of staff members; the size of the possible obligation entered into on behalf of the institution.

GOVERNANCE Much progress has been made in the field of governance of remuneration. Both institutions and supervisors have increased their awareness in this respect and have taken concrete actions to strengthen the governance arrangements. This may be explained by the fact that governance of remuneration is part of broader governance reforms undertaken after the financial crisis. The degree of compliance of national regulations with the Guidelines is therefore high. However, while many countries have proved themselves to be fully compliant from a regulatory point of view, many have pointed out that more time is still needed to complete an exhaustive assessment of good and bad practices. In a few circumstances, institutions claimed that the regulations were too recent to be fully and properly implemented. The Guidelines on corporate governance have been generally well implemented, in particular in respect of: the role and compensation of the

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management body in its supervisory and management functions5; the setting up, role and composition of the Rem Co and the definition, role and composition of the control functions. However, problems still persist in few limited areas; in these cases, supervisors have often expressly required institutions to rectify the practices and non-compliance (i.e. institutions have been asked to limit the role of the CEO, improve the formalisation and functioning of all the reporting lines, ensure adequate discussion among all corporate bodies etc.). The effective involvement of the control functions in the design, oversight and review of the overall remuneration policy is of paramount importance in order to achieve the prudential goals of CRD III and the Guidelines; nonetheless in many countries neither direct contact of the control functions with the bodies responsible for the design and approval of the compensation policy, nor access to the information needed to fully participate in the decision-making process seem to be guaranteed. There is room for further regulatory convergence across EU jurisdictions on some detailed aspect of the governance Guidelines. However, some other differences can not be removed, as they stem from national corporate governance legislative frameworks (e.g. some specificities may derive from the different allocation of roles and responsibilities within the management and supervisory boards). Despite significant progress, many countries raised specific concerns with regard to group-wide remuneration policies and the structural relationship between the parent company and its subsidiaries (from a governance point of view). This increases diversity across Member States. The most frequent concerns mentioned are: the identification of the Identified Staff (see above in section 3.1.B - group context); clear documentation of the remuneration decision making process and the relationship between the subsidiaries and their parent company in that

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respect; the timely allocation of bonus pools at the subsidiary levels; too little or only an unbalanced interaction between the control functions (compliance, internal audit, HR) at parent and subsidiary level. There are good practices that may help in solving problems arising in the field of the group context. For example: 1) the human resources function at the subsidiary level receives a yearly local inspection of its remuneration policy performed by group control functions; 2) the internal audit function of the parent company reports to the home supervisory authority about the remuneration policy of the whole group; 3) a clear documentation on which local specificities (activities and risks of a subsidiary, local regulatory environment etc.) apply and how they are integrated in the group policy. Besides encouraging these good practices, some supervisors have also required from parent institutions to provide them detailed data and information on the compensation schemes adopted at the subsidiary levels. Another good evolution is that cooperation and coordination initiatives amongst supervisory authorities have been activated, to ensure the effective compliance with regulation in cross-border groups.

France French supervisors have required main banking institutions to report several months in advance their forecasting on the global pool of compensation that their business units and subsidiaries will submit to their control and supervisory functions.

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This practice has provided the French supervisor with both information and tools for 1. ensuring institutions’ ability to comply in real time with the requirement that compensation pools are effectively aligned with institutions’ risk profile and results; 2. testing the time needed for supervisory and control functions to perform in a group context an assessment of the amount and computation modalities of compensation pools which are submitted by management functions.

RISK ALIGNMENT: UNDERDEVELOPED TECHNIQUES The need for risk aligned variable remuneration was a core issue raised in the wake of the financial crisis. However, institutions and supervisors also had to focus on more supporting but important questions related to this risk alignment, such as the scope of remuneration requirements on institutions and staff. Therefore the issue of the actual risk alignment itself has to be given considerably more attention by institutions and supervisors. In this context, it is also important thatvariable remuneration is reduced where necessary to maintain, strengthen and restore a sound capital base.

OVERALL RISK ALIGNMENT Risk alignment of variable remuneration has many different aspects that are reflected in CRD III and the Guidelines. The idea of risk alignment is embodied in several requirements like the alignment of remuneration systems with the institutions’ strategies, the prohibition of guaranteed bonuses, personal hedging strategies and golden parachutes, the implementation of minimum ratios fixed to variable remuneration, the limits to the variable compensation when

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inconsistent with a sound capital base as well as the use of risk adjusted performance parameters in the accrual period and of deferred variable remuneration with malus or clawback arrangements. Most of the reporting Member States stated that the national provisions with regard to risk alignment of the variable remuneration show no identifiable differences to the Guidelines. Often Member States keep the national provisions on a more abstract and compacted level than the Guidelines. Nevertheless the Guidelines are at least used for interpretation and are sometimes even directly referred to. Some Member States seem to accentuate certain aspects with regard to risk alignment in their regulation and their supervisory practices. In some Member States the supervisory practice or regulation reached more prescriptive outcomes with regard to the scope or the maximum ratios of variable to fixed remuneration.

Alignment with strategies Institutions’ remuneration system and especially the variable part of the remuneration influence employees’ behaviour with regard to (inappropriate) risk taking. Thus remuneration systems – intentionally or not – also serve as a management tool. As such remuneration systems could be aligned with institutions’ business and risk strategies as well as in the risk management system. The link between strategies and especially between risk strategies and the remuneration system is not always well developed or documented.

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In some cases this may also have to do with underdeveloped business and risk strategies that make it difficult to derive operational objectives from these strategies. Also remuneration systems are not always sufficiently embedded in the strategy planning, transposition, assessment and modification process. Thus, performance parameters used for risk management purposes are still underrepresented in remuneration systems. A good practice is to link the remuneration-related processes to the institutions’ business and risk strategy process. This ensures that the remuneration system is aligned with the strategies and the operational objectives derived from these strategies. Furthermore those functions that are in charge of the strategy process including the risk management function should formally be involved in the process of development, implementation and modification of a remuneration system especially with a view to the objectives set out at the different levels of an institution’s remuneration system.

Prohibitions CRD III and the Guidelines disallow guaranteed bonuses (except when hiring new staff and limited to the first year of employment), personal hedging strategies to undermine the risk alignment effects as well as “golden parachutes” that would reward for failure, are not allowed. All responding Member States adopted these requirements in their national jurisdictions. Most institutions incorporated the aforementioned prohibitions in their remuneration policies. Good progress has been made with a view to guaranteed bonuses. Except when hiring new staff and limited to the first year of employment guaranteed bonuses seem to play no relevant role in the remuneration practices of Member States' institutions.

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However, in practice also the classification of payments as guaranteed bonuses may not always be obvious. Supervisors notice cases where certain payments are presented as fixed payments, but where further examination of the characteristics of these payments leads to re-assessment of that qualification. A similar observation can be made with regard to golden parachutes. Their use is claimed to be nonexistent by institutions. Nevertheless, the classification of certain arrangements under "payments related to the early termination of a contract that do not reward for failure" may be questionable, e.g. in cases where persons have an entitlement to their fixed remuneration for the residual period of a fixed term contract in case the performance under that contract has been terminated before the originally anticipated term. With a view to the prohibition of hedging strategies and liability-related insurance it is good practice if institutions require a commitment of their employees to adhere to this requirement.

RATIOS VARIABLE TO FIXED Overall national regulations are in line with the Guidelines' requirements to have an appropriately balanced ratio of variable to fixed remuneration to ensure a fully flexible bonus that could be zero. In some Member States this provision has to be applied by all institutions and for all employees and is not limited to Identified Staff. Most Member States leave it to the institutions to set an internal maximum ratio. This ratio can differ internally between business lines of an institution. The criteria by which institutions decide on the ratios in practice are not yet well known.

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This may have to do with the fact that the use of ratios has a certain tradition and is therefore not always explainable. Another factor is market usages with a view to benchmarking among peer groups. However, it seems questionable whether institutions really use sophisticated approaches to determine such ratios. Only few Member States introduced maximum ratios. With the implementation of more detailed requirements for the variable part of the remuneration, industry shifted parts of the variable pay into the fixed part of the remuneration. Some Member States found it opportune to prevent this unintended consequence of CRD III and introduced a requirement to keep the variable part of the remuneration sufficiently high so that risk adjustment requirement can have sufficient impact on that part when needed. The ratios of variable to fixed remuneration for executive members of the management body (executives) and the other Identified Staff varied among Member States. Through the implementation report, data have been collected on the average and maximum ratios of variable to fixed remuneration paid in the different Member States to executives and other Identified Staff. National competent authorities were asked to base their data collection on a representative sample of institutions in their jurisdiction, comprising either 60% of total domestic banking assets or the 20 largest institutions. Aggregate information on fixed to variable remuneration ratios was reported as minimum and maximum and average among all observations on an individual bank basis.

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For the purpose of this report, Member State figures have then been aggregated at Union level. The data show that the median of the average ratios among MS is 122% for executives and 139% for the other identified staff. The highest value of the average ratios that were reported by the MS was 220% for executives and 313% for the other identified staff. Furthermore, looking at the maximum ratios reported by the MS, the median of this is 225% for executives and 324% for the other identified staff. The highest reported values of these maximum ratios were 429% for executives and 940% for the other identified staff. Because of the differences in the degree to which Identified Staff are determined by the institutions (see above in this report in section 3.1.B) and because the sample of institutions for which data have been collected may include very different types of institutions depending on the Member State concerned, the level of detail of these data did not allow numerical conclusions to be drawn from them. However, the general conclusion is that in all Member States, the variable part of the remuneration exceeds the fixed remuneration considerably for all Identified Staff. Moreover, in all Member States, this ratio is generally higher for the category "other risk takers" than for the category "executive members" (for the categories, see paragraph 16 of the Guidelines). Taking into account the nominal pay levels for the fixed component for executives and the other risk takers, the ratios observed can lead to very high variable remuneration components. If the potential variable remuneration is the dominating part of the total remuneration, this could incentivise staff to take too much risk in order to assure a certain minimum pay level.

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Some supervisors informally communicate to their institutions a certain numerical maximum ratio of variable to fixed that they consider as appropriate; this allows them to obtain a clear level playing field in the whole sector under their supervision. In this context, observed practices within institutions are: - The remuneration policy determines in a detailed way the underlying

reasons why for a particular business unit or person, it is considered appropriate to have a ratio variable to fixed remuneration above a certain level.

- High ratios above a certain threshold are approved by the management body in its supervisory function.

- Approval for ratios inside a division that exceed the average of the

ratios inside this division considerably.

- Higher ratios result in a higher part of the variable payment deferred as well as in longer deferral and retention periods.

RISK ALIGNMENT TECHNIQUES EX ANTE AND EX POST Risk alignment of variable remuneration has two main perspectives. Risks already have to play a prominent role in the performance measurement or accrual period and the award process when a certain pool of variable remuneration is determined and then allocated to divisional subpools, business units and individuals (ex ante perspective). As this forward-looking ex ante perspective may not identify all risks that later may emerge , risks also have to be considered retrospectively similar to a back testing of the initially measured performance (ex post perspective).

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The ex post perspective of risk alignment is subject to those requirements that cover the pay out process of variable remuneration, especially in the deferral and malus or clawback arrangements. Although these two perspectives cannot be mixed, they can not be seen separately either. A more conservative approach in one perspective may allow for a more flexible approach in the other perspective. For example institutions that apply longer accrual periods with risk adjusted performance parameters may only apply the minimum deferral period of three years or use shorter retention periods for instruments like shares. The CRD III and the Guidelines require that the total variable remuneration does not limit the ability of institutions to maintain a sound capital base. In this respect, Member States shall have the power to impose corrective measures (e.g. limits to the variable remuneration, capital add-ons) and institutions shall have in place well-functioning ex ante (potential reduction of the bonus pool) and ex post risk alignment mechanisms. The responses received reveal that national regulations in the majority of Member States completely reflect the CRD III and Guidelines requirements. As regard practices carried out by institutions, the level of capital seems to be taken into account among the risk-adjustment indicators, but there is no evidence as to if and how it operated to reduce, when necessary, the overall variable remuneration. Risk alignment of variable remuneration is the most challenging aspect of a sound remuneration system. The practices in institutions and experiences of supervisors are still nascent.

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Ex ante perspective An important way to incorporate risks in the system of measuring remuneration-related performance is the use of risk adjusted performance parameters. Risk adjusted parameters are still underrepresented among the quantitative performance parameters used by institutions to determine and allocate the bonus pools. This may be partly due to the limitations of existing measures for different types of risk and assets. Rather, performance criteria used by banks tend to include measures (such as revenues, profit, RoE, business volume, earnings per share,...) that may be subject to financial manipulation or do not provide employees with sufficient incentives to consider the quality of the business undertaken. Common techniques used to adjust profits and capital for risks are based on the calculation of economic profit or economic capital (VaR, RAROC, RORAC). Accounting profits do not capture adequately future risks and may imply a certain degree of judgment in decisions on the performance-related part of remuneration is necessary. Adjusting remuneration for risk over a multi-year period, seems also to be quite difficult to achieve in practice for an institution. However, if compensation schemes rely on imperfect risk measures, they run the risk of becoming ineffective and, more importantly, of creating arbitrage-like opportunities for employees to take on risks that are not fully recognized by the measures. It is therefore important for institutions not to rely blindly on their risk models but to make qualitative judgments as well.

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Institutions often also use discretion to adjust the bonus pools, e. g. to reflect external or unexpected events. However, discretion is also used for upward adjustments which makes the measurement and award process less transparent and susceptible to possible manipulations. In this context a very important factor that is considered when bonus pools - not only on institutional level but also on divisional and business unit level - are adjusted by discretion is the competitive environment in which institutions have to retain or attract their staff. Therefore even a bonus pool which is calculated predominantly on the basis of conservative performance parameters is often dominated by the need to grant competitive remuneration packages and especially variable remuneration. This has an overriding effect on the risk adjusted performance parameters used. Many institutions determine and allocate their variable remuneration in more or less modified top-down approaches. A top-down approach starts by setting a bonus pool on the level of the institution, which is then allocated to business units and to individuals. Bigger institutions often have additional divisional sub pools under the bonus pool at the level of institution, which are then further distributed. On each of the aforementioned levels ex ante risk adjustment can be exercised. Furthermore institutions seem to use risk adjusted parameters more at higher bonus pool levels, i. e. at the level of institution and at divisional level.

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At the level of the business unit, but especially at individual level, consideration of risk metrics by institutions seems to be rarely used. Real risk adjustments at these levels are more based on red flags raised e. g. in case of breaches of compliance. The other performance parameters used at business unit and individual level seem to be based more on operating results and some qualitative parameters like customer satisfaction etc. Some jurisdictions have more detailed expectations with a view to the ratio of institution wide, business unit and individual performance parameters (e. g. management board: 50% institution wide, 50% individual; others: in principle 1/3 on each level). The use of more risk adjusted performance parameters also at lower levels, i. e. business unit and individual level, should be a key future objective. This is because the behaviour of an employee in his specific job function will primarily be influenced by those parameters he can affect through his performance etc. It is good practice to use a combination of appropriate quantitative and qualitative parameters on each level of performance measurement, i. e. on institutional, divisional and business unit level as well as on individual level. Quantitative parameters that refer to the annual performance of the institutions should refer to a multi-year period to avoid a high volatility of these metrics, which could lead to inappropriate risk taking. There should also be a formalized process and predefined criteria for a possible discretionary adjustment of these parameters, especially to reflect the adjustment of profits. The Rem Co and risk management function should formally be involved in this process.

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Possible adjustments and their rationale should be documented and be part of the reporting to the management body in its supervisory function. Supervisors should ask for the full calculations behind variable remuneration, checking the traceability of the different decisions. Furthermore it is good practice to use the aforementioned performance parameters in combination with a secondary risk adjusted metric, which should coincide with the risk metrics used for risk management purposes at the respective level of performance measurement. For example, if the allocation of a divisional bonus pool to a business unit depends on operating results of a business unit, an existing VaR limit for this business unit could also serve as a performance cap. This performance cap would reduce the incentive to take higher risks in order to increase operative results. For supervisors, it is important to monitor the strength of the incentives given by remuneration to executives and identified staff, by looking, for instance, at how much executives and other identified staff are insulated from downside risks.

Ex post perspective More improvements seem to be desirable with a view to sufficient sensitive malus criteria which trigger forfeiture of deferred, i. e. unvested, variable remuneration. Malus criteria used do not always reflect the back testing character, which is inherent in the idea of a malus, with regard to the initially measured performance. Often, the ex post risk adjustment is only qualitative in nature, or where it is quantitative in nature, it is not sufficiently defined.

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For example, institutions often use a “significant downturn” as a parameter for ex post risk adjustment, without giving any details on what a “significant downturn” means. Also the malus trigger should be applied at lower levels, i.e. business unit and individual level, as this has a more substantial effect on the employees’ behaviour (see above). Often malus triggers at lower levels do not take full account of negative operational performance and risk profiles of the business unit. At individual level a malus is often only triggered in the case of severe compliance breaches or when an employee leaves the firm voluntarily. It is good practice if malus or clawback arrangements include a performance forfeiture on each level where the performance initially was assessed, i.e. on the institutional, divisional and business unit level as well as on individual level. This performance forfeiture should revert to those performance parameters that were already used in the ex ante accrual process to assess the initial performance on the respective level.

SETTING UP MULTI YEAR FRAMEWORKS Performance measurement periods, deferral schedules with malus or clawback arrangements attached to them and retention periods in case instruments are used to pay out variable remuneration introduce a multi-year element, linking the employees' compensation schemes to the long term performance of the institutions. This is by now a widespread practice in institutions. There are no major differences in the national regulation with respect to the requirements of the CRD and Guidelines for the different components of the multi year framework.

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In some countries longer accrual periods of at least two years are expected for members of the management body. The portion of variable remuneration to be deferred varies between minimum 40% and 60%, as prescribed in CRD, while the deferral period varies between minimum 3 and 5 years. Some countries fixed a threshold of variable remuneration below which there is no requirement for deferral to take place. Another country fixed a threshold of variable remuneration for which 60% needs to be deferred. The payment is in general on a pro-rata basis, with yearly vesting periods after the end of the accrual period, as prescribed in the Guidelines. In general, no specific retention period has been fixed, an issue also left open in the Guidelines. Several countries, though, indicate a minimum retention period based on best practice and which can vary between 6 months and 2 years. Member States seem to comply as well with the application of the 50% minimum threshold for the instruments to be divided equally over the deferred and the non-deferred part, although some supervisors are of the opinion that rremuneration in shares is only likely to impact positively on behaviours if there is a requirement for the shares to be held for prolonged periods of time and that this is undermined by the requirement to pay 50% of the upfront portion in shares. Institutions signal the administrative burden in designing and implementing new CRD III compliant incentive plans. Another difficulty is adjusting the multi year framework to the tasks and responsibilities of the different Identified Staff; up to now, there is little differentiation among the different levels of personnel in the multi year elements that are applied to them.

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With a view to the length of the accrual period one year periods seem to be widespread. Nevertheless longer periods are also used, especially for higher management levels. For deferral, institutions stick to the legal minima, with little variation in the 40 to 60 % or the 3 to 5 years ranges. The percentage deferred is however in general slightly higher for executive members of the management body. In almost all countries, most of the Identified Staff receives 50% of variable remuneration paid in instruments. The deferral period is 3 years in the practice of almost all countries. The retention period most commonly chosen is between 6 months and 18 months. Occasionally, conceptually wrong deferral schemes are persistently presently by institutions. The following examples show a good and an inappropriate practice to consider a multi-year performance measurement:

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While the first example shows an approach that combines a longer accrual period with the other requirements of the CEBS Guidelines, especially with a view to the pay out requirements (deferral etc.), the approach in the second example does not.

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The approach in the second example considers the accrual period simultaneously as a deferral period. Beside the very clear textual distinction between these periods in CRD III and in the CEBS Guidelines, the approach unduly blends the ex ante and ex post perspectives of risk alignment. Finally the performance parameters can be changed annually during the accrual period. Thus the multi-year accrual period in fact has the character of a short term accrual period.

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NUMBER 4

Jumpstart Our Business Startups Act Frequently Asked Questions

Changes to the Requirements for Exchange Act Registration and Deregistration, April 11, 2012

The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012.

In these Frequently Asked Questions, the Division of Corporation Finance is providing guidance on the implementation and application of the JOBS Act, based on our current understanding of the JOBS Act and in light of our existing rules, regulations and procedures.

These FAQs are not rules, regulations or statements of the Commission.

Further, the Commission has neither approved nor disapproved these FAQs.

Title V and Title VI of the JOBS Act amend Section 12(g) and Section 15(d) of the Exchange Act as follows:

The holders of record threshold for triggering Section 12(g) registration for issuers (other than banks and bank holding companies) has been raised from 500 or more persons to either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors.

Banks and bank holding companies, as such term is defined in the Bank Holding Company Act of 1956, will have a Section 12(g) registration obligation as of any fiscal year-end after April 5, 2012 with respect to a class of equity security held of record by 2,000 or more persons.

Under Exchange Act Section 12(i), banks do not register their securities or file reports with the Commission. Accordingly, these FAQs relate only to bank holding companies.

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The holders of record threshold for Section 12(g) deregistration for banks and bank holding companies has been increased from 300 to 1,200 persons.

The holders of record threshold for the suspension of reporting under Section 15(d) for banks and bank holding companies has been increased from 300 to 1,200 persons.

In calculating the number of holders of record for purposes of determining whether Section 12(g) registration is required with respect to a class of equity security, issuers (including banks and bank holding companies) may exclude persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of Section 5 of the Securities Act.

(1) Question:

How do the amendments to Section 12(g)(1)(A) affect the obligations of issuers (other than bank holding companies) to register a class of equity security under Section 12(g) where such obligations were triggered as of a fiscal year-end before April 5, 2012?

Answer:

If an issuer that is not a bank holding company triggered a Section 12(g) registration obligation with respect to a class of equity security as of a fiscal year-end before April 5, 2012 but would not trigger such obligation under the amended holders of record threshold contained in the JOBS Act, and the issuer has not yet registered that class of equity security under Section 12(g), then the issuer is no longer subject to a Section 12(g) registration obligation with respect to that class.

Therefore, if the issuer has not filed an Exchange Act registration statement, it is no longer required to do so.

If the issuer has filed an Exchange Act registration statement and the registration statement is not yet effective, then the issuer may withdraw the registration statement.

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If the issuer has registered a class of equity security under Section 12(g), it would need to continue that registration unless it is eligible to deregister under Section 12(g) or current rules.

(2) Question:

How do the amendments to Section 12(g)(1)(B) affect the obligations of bank holding companies to register a class of equity security under Section 12(g) where such obligations were triggered as of a fiscal year-end on or before April 5, 2012?

Answer:

Under Section 12(g)(1)(B), a bank holding company will have a Section 12(g) registration obligation if, as of any fiscal year-end after April 5, 2012, it has total assets of more than $10 million and a class of equity security held of record by 2,000 or more persons.

We consider that the effect of this provision is to eliminate, for bank holding companies, any Section 12(g) registration obligation with respect to a class of equity security as of a fiscal year-end on or before April 5, 2012.

Therefore, if a bank holding company has filed an Exchange Act registration statement and the registration statement is not yet effective, then it may withdraw the registration statement.

If a bank holding company has registered a class of equity security under Section 12(g), it would need to continue that registration unless it is eligible to deregister under Section 12(g) or current rules.

(3) Question:

On or after April 5, 2012, how can a bank holding company terminate the registration of a class of equity security under Section 12(g)?

Answer:

If the class of equity security is held of record by less than 1,200 persons, the bank holding company may file a Form 15 to terminate the Section 12(g) registration of that class.

Form 15 has not yet been amended to reflect the change to Exchange Act Section 12(g)(4).

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Therefore, a bank holding company should include an explanatory note in its Form 15 indicating that it is relying on Exchange Act Section 12(g)(4) to terminate its duty to file reports with respect to that class of equity security.

Pursuant to Section 12(g)(4), the Section 12(g) registration will be terminated 90 days after the bank holding company files the Form 15.

Until that date of termination, the bank holding company is required to file all reports required by Exchange Act Sections 13(a), 14 and 16.

Alternatively, a bank holding company could rely on Exchange Act Rule 12g-4, which permits the immediate suspension of Section 13(a) reporting obligations upon filing a Form 15, if it meets the requirements of that rule.

Note that Rule 12g-4 has not yet been amended to incorporate the new 1,200 holder deregistration threshold.

(4) Question:

On or after April 5, 2012, how can a bank holding company suspend its reporting obligations under Section 15(d)?

Answer:

In general, the Section 15(d) reporting obligation is suspended if, and for so long as, the issuer has a class of security registered under Section 12.

When an issuer terminates Section 12 registration, it must address any Section 15(d) obligation that would apply once the Section 15(d) suspension is lifted.

For the current fiscal year, a bank holding company can suspend its obligation to file reports under Section 15(d) with respect to a class of security that was sold pursuant to a Securities Act registration statement and that was held of record by less than 1,200 persons as of the first day of the current fiscal year.

Such suspension would be deemed to have occurred as of the beginning of the fiscal year in accordance with Section 15(d) (as amended by the JOBS Act).

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If, during the current fiscal year, a bank holding company has a registration statement that becomes effective or is updated pursuant to Securities Act Section 10(a)(3), then it will have a Section 15(d) reporting obligation for the current fiscal year.

If a bank holding company with a class of security held of record by less than 1,200 persons as of the first day of the current fiscal year has a registration statement that is updated during the current fiscal year pursuant to Securities Act Section 10(a)(3), but under which no sales have been made during the current fiscal year, the bank holding company may be eligible to seek no-action relief to suspend its Section 15(d) reporting obligation. Such issuers should contact the Division’s Office of Chief Counsel for further information.

(5) Question:

Section 503 of the JOBS Act requires the Commission to revise the definition of “held of record” to exclude, from the Section 12(g)(1) holder of record calculation, persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of Section 5 of the Securities Act.

May an issuer (including a bank holding company) exclude such persons before the effective date of the revised definition?

If so, would an issuer also be able to exclude former employees?

Answer:

Yes.

As of April 5, 2012, an issuer (including a bank holding company) may exclude persons who received securities pursuant to an employee compensation plan in Securities Act-exempt transactions whether or not the person is a current employee of the issuer.

Although Section 503 of the JOBS Act directs the Commission to adopt “safe harbor provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in transactions that were exempt from the registration requirements of section 5 of the Securities Act of 1933,” the lack of a safe harbor does not affect the application of Exchange Act Section 12(g)(5).

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NUMBER 5

EBA, ESMA and EIOPA publish two reports on Money Laundering The Joint Committee of the three European Supervisory Authorities (EBA, ESMA and EIOPA) has published two reports on the implementation of the third Money Laundering Directive [2005/60/EC] (3MLD). The “Report on the legal, regulatory and supervisory implementation across EU Member States in relation to the Beneficial Owners Customer Due Diligence requirements” analyses EU Member States’ current legal, regulatory and supervisory implementation of the anti - money laundering/counter terrorist financing (AML/CTF) frameworks related to the application by different credit and financial institutions of Customer Due Diligence (CDD) measures on their customers’ beneficial owners. The report sought to identify differences in the implementation of the Directive and to determine whether such differences create a gap in the EU AML/CTF regime that could be exploited by criminals for money laundering and terrorist financing purposes. The “Report on the legal and regulatory provisions and supervisory expectations across EU Member States of Simplified Due Diligence

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requirements where the customers are credit and financial institutions” provides an overview of EU Member States’ legal and regulatory provisions and supervisory expectations in relation to the application of Simplified Due Diligence (SDD) requirements of the 3MLD. The report focuses exclusively on one particular situation of low risk where SDD is applicable, namely where the customer is a credit or financial institution situated in a EU/EEA state or in a country that imposes equivalent AML/CFT requirements. Both reports come to the conclusion that there are significant differences in the implementation across the EU Member States, and that some of these differences could create undesirable effects on the common European Anti Money Laundering Regime. The reports find that some of these differences are not due to the Directive’s minimum harmonisation approach, but instead appear to stem from different national interpretations of the Directive’s requirements. Both reports also call on the European Union to consider addressing these problems.

The Joint Committee The Joint Committee is a forum for cooperation that was established on 1st January 2011, with the goal of strengthening cooperation between the European Banking Authority (EBA), European Securities and Markets Authority (ESMA) and European Insurance and Occupational Pensions Authority (EIOPA), collectively known as the three European Supervisory Authorities (ESAs). Through the Joint Committee, the three ESAs cooperate regularly and closely and ensure consistency in their practices. In particular, the Joint Committee works in the areas of supervision of financial conglomerates, accounting and auditing, microprudential

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analyses of crosssectoral developments, risks and vulnerabilities for financial stability, retail investment products and measures combating money laundering. In addition to being a forum for cooperation, the Joint Committee also plays an important role in the exchange of information with the European Systemic Risk Board (ESRB) and in developing the relationship between the ESRB and the ESAs.

Interesting Abbreviations AML – Anti Money Laundering AMLTF – Anti-Money Laundering Task Force of the EBA, ESMA and EIOPA AML Committee – The Joint Committee of the European Supervisory Authorities’ Sub Committee on Anti Money Laundering CDD - Customer Due Diligence CPMLTF – EU Committee on the Prevention of Money Laundering and Terrorist Financing CTF – Counter Terrorist Financing EBA - European Banking Authority EC – European Commission EEA - European Economic Area EIOPA - European Insurance and Occupational Pensions Authority EDD – Enhanced Due Diligence ESMA - European Securities and Markets Authority EU – European Union

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FATF – Financial Action Task Force ID - Identity ML – Money Laundering MS – Member State of the European Union SDD - Simplified Due Diligence TF – Terrorist Financing UBO – Ultimate Beneficial Owner WG – Working Group 3rd MLD - Third Money Laundering Directive (2005/60/EC)

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NUMBER 6

BIS - Peer review of supervisory authorities' implementation of stress testing principles -April 2012 Stress testing is an important tool used by banks to identify the potential for unexpected adverse outcomes across a range of risks and scenarios. In 2009, the Committee reviewed the performance of stress testing practices during the financial crisis and published recommendations for banks and supervisors entitled Principles for sound stress testing practices and supervision. As part of its mandate to assess the implementation of standards across countries and to foster the promotion of good supervisory practice, the Committee's Standards Implementation Group (SIG) conducted a peer review during 2011 of supervisory authorities' implementation of the principles. The review found that stress testing has become a key component of the supervisory assessment process as well as a tool for contingency planning and communication. Countries are, however, at varying stages of maturity in the implementation of the principles; as a result, more work remains to be done to fully implement the principles in many countries. Overall, the review found the 2009 stress testing principles to be generally

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effective. The Committee, however, will continue to monitor implementation of the principles and determine whether, in the future, additional guidance might be necessary.

Peer review of supervisory authorities’ implementation of stress testing principles, April 2012 Executive summary This report summarises the Basel Committee’s peer review on how supervisory authorities have implemented the Committee’s 2009 Principles for sound stress testing practices and supervision.

The global financial crisis and the 2009 stress testing principles

Stress testing is an important tool for banks to identify unexpected adverse outcomes across a range of risks. It plays a particularly important role in:

- providing forward-looking assessments of risk;

- overcoming limitations of models and historical data;

- supporting internal and external communication;

- feeding into capital and liquidity planning procedures;

- informing the setting of banks’ risk tolerance; and

- facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

In 2009, the Committee reviewed the performance of stress testing practices during the crisis and found weaknesses in various areas.

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Based on the findings, and as part of its efforts to incorporate lessons from the crisis in supervisory practices, the Committee published recommendations for banks and supervisors entitled Principles for sound stress testing practices and supervision.

The guidance sets out a comprehensive set of principles for the sound governance, design and implementation of stress testing programmes at banks.

The principles also established high-level expectations for the role and responsibilities of supervisors in evaluating stress testing practices.

Scope of the review

As part of its mandate to assess the implementation of standards across countries, during 2011 the Committee's Standards Implementation Group undertook a peer review of supervisory authorities’ implementation of the principles.

The review was conducted via an off-site survey of supervisory authorities. All Committee member countries and one non-member country participated in the review. The review focused primarily on progress in supervisory processes used to implement the principles. It was not designed to provide a detailed country-by-country assessment or to assess the adequacy of banks' stress testing programmes. Increasingly, supervisory stress tests are being used to set minimum capital requirements, determine explicit capital buffers or to limit capital distributions by banks. This recent development was not extensively considered in the principles and as a result was not a key focus of the review.

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Key findings

Progress overview

In the period since the principles were issued, stress testing has become a key component of the supervisory assessment process as well as a tool for contingency planning and communication.

Many of the countries participating in this peer review have been working to implement and refine stress testing frameworks and methodologies at the same time as their economies and banking systems have been affected by a high degree of global economic and financial uncertainty.

Although many supervisory authorities and banks had operational stress testing frameworks in place, existing guidance and rules had to be revised and new expectations put in place to broaden and deepen stress testing capabilities at both banks and supervisory authorities.

The review found that countries are at varying stages of maturity in their implementation of the principles.

Nearly half of the countries were considered to be at an early stage.

These countries showed some progress toward implementing the principles, but they may not have issued or finalised prudential requirements on enterprise-wide stress testing since the principles were published.

They generally had not conducted regular on-site or off-site reviews other than in the context of risk-specific modelling requirements such as for market risk, and had conducted industry-wide stress tests infrequently, or only as part of International Monetary Fund Financial Sector Assessment Program (FSAP) reviews.

In contrast, a few countries were considered to be advanced.

For these countries, the survey responses provided evidence of a rigorous regular review process that included a combination of on-site and off-site assessments, some review and feedback on detailed stress testing models

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used by banks, evidence of follow-up actions and a well-embedded supervisory stress testing programme that was not limited to externally imposed scenarios.

The remainder of countries were found to fall between the above two groups.

These countries have issued some formal requirements or guidance consistent with the principles, are generally performing regular supervisory stress tests on large banks in their jurisdictions and are reviewing stress testing in the context of annual internal capital adequacy assessment process (ICAAP) reviews and specific risk reviews.

These countries have more to do in deepening their stress testing programmes, including issuing updated requirements and conducting more detailed on-site and off-site reviews of banks' stress testing capabilities.

Remaining challenges and examples of good practices

The most common overall supervisory approach was to conduct some review of banks' stress testing as part of regular ICAAP assessments and in the context of specific risks where ongoing supervisory review of exposure modelling is now routine, notably market and liquidity risks. Conducting more detailed, comprehensive reviews of banks' enterprise-wide stress testing governance and modelling as envisioned in the principles requires expert skills and resourcing at both banks and supervisors, and as a result has not yet become standard practice in many countries. A significant development in the last several years has been the increased use of supervisory stress tests.

A majority of countries now regularly conduct mandated stress tests with prescribed scenarios across the large banks in their jurisdictions, although for some countries, this is limited to the FSAP stress tests.

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A number of countries noted the resource-intensive nature of industry-wide stress tests.

In particular, the more advanced countries note that resourcing at both supervisory authorities and banks to support stress testing is challenging, with a trend towards establishing specially staffed units or internal task forces for stress testing.

Many, however, found that these exercises have been helpful in terms of enhancing the visibility of stress testing and providing a structured basis for dialogue with banks on their capabilities.

It was noted that industry dialogue around mandated stress tests had led to improvements in bank capabilities.

The following types of practices are also associated with relatively more advanced countries:

- plans for, or completed horizontal or thematic reviews of, stress testing either at an enterprise-wide level or for specific portfolios;

- engagement with boards of directors on stress testing scenarios and governance;

- review of detailed evidence of how banks are using stress test

outcomes in their decision-making and risk-appetite setting;

- well-articulated plans for improving their stress testing supervision programmes;

- involvement of both generalist and specialist supervision staff; and

- publication of the results and provision of consistent feedback to

banks.

While not a primary focus of the peer review, many countries provided views on areas for improvement in stress testing practices at banks.

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These responses focused fairly consistently on areas such as governance and the use of stress testing in bank decision-making, data and information technology infrastructure, severity of scenarios and firm-wide modelling challenges.

The review found the principles to be generally effective. The Committee, however, will continue to monitor implementation of the principles and determine whether, in the future, additional guidance might be necessary.

Introduction Stress testing is an important tool for banks to identify unexpected adverse outcomes across a range of risks.

The financial crisis highlighted significant weaknesses in banks' stress testing programmes that contributed to failures to identify the nature and magnitude of key risks.

As a result, the Committee engaged with the industry in examining stress testing practices and, in May 2009, the Committee published recommendations for banks and supervisors entitled Principles for sound stress testing practices and supervision.

The guidance set out a comprehensive set of principles for the sound governance, design and implementation of stress testing programmes at banks.

The principles established expectations for the role and responsibilities of supervisors in evaluating stress testing practices. Overall, the guidance includes fifteen principles for banks and six principles for supervisors.

As part of its mandate to assess the implementation of its standards across countries, the Committee's Standards Implementation Group undertook a peer review of supervisory authorities’ implementation of the principles.

The objectives of this review were to:

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- assess the extent to which the principles have been implemented in a rigorous and consistent manner across the Committee's member authorities;

- identify and provide feedback on factors that are most critical to the effective implementation of the principles; and

- assess the effectiveness of the principles themselves.

An important element of the review was the context in which the principles are being implemented.

Many of the countries participating in this peer review have been working to implement and refine stress testing frameworks and methodologies at the same time their economies and banking systems have been affected by a high degree of global economic and financial uncertainty.

Although many supervisory authorities and banks had operational stress testing frameworks in place, existing guidance and rules had to be revised and new expectations put in place to broaden and deepen stress testing capabilities at both banks and supervisors.

This is being done in a stressed environment and is also being conducted at a time when stress testing infrastructure, including the ability to collect appropriate data, develop models and aggregate results, is evolving.

As a result, the current environment has provided a useful early test of how countries are putting the principles into practice.

More broadly, it was evident that countries are implementing stress testing regimes and activities in different ways that may reflect their individual situations and not all will follow the same progression or path in implementing the principles.

The review was intended to deliver feedback on good supervisory practice to help supervisors implement standards more effectively.

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Indeed, several countries have reported significant progress subsequent to the completion of the peer review survey, particularly with regard to supervisory stress testing practices.

Methodology

The peer review was conducted through a questionnaire which was distributed to Committee member countries in September 2011. Analysis of the responses was conducted by a working group of representatives of supervisory authorities with expertise in stress testing. The questionnaire focused primarily on the implementation activities of supervisors and consisted of both factual multiple choice questions and free-form responses. The review team used the information provided by each country and, where relevant, source documents demonstrating its implementation of the principles, to assess and compare the progress made across countries.

Given the off-site and high-level nature of the review, it was not intended to produce a definitive assessment of individual countries' implementation of the principles, but, rather, to allow an overall view of progress across countries.

A detailed report was provided to the Standards Implementation Group and to the Committee.

The review focused primarily on the implementation of principles 16-21 for supervisors, as it was not within the scope of the peer review to assess compliance by banks with principles 1-15 on stress testing practices.

However, countries were invited to provide their views on the ease and effectiveness of implementation for each of the principles for banks in their jurisdiction.

In their responses, supervisory authorities were asked to focus on supervision of the largest banks in their jurisdiction, although some also

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addressed their supervisory expectations for stress testing at smaller banks.

Assessment of principles for supervisors

Overall maturity of implementation

For purposes of assessing and comparing implementation of the principles, participating countries were stratified as being in an early, intermediate or advanced state of implementation.

These assessments were based on indicators of maturity developed for this purpose by the review team, as well as the quality and thoroughness of the questionnaire responses.

Countries in the early category (nearly half of respondents) showed some progress towards implementing the principles; however, they may not have issued or finalised prudential requirements on enterprise-wide stress testing since the principles were published.

These countries generally had not conducted regular on-site or off-site reviews other than in the context of risk-specific modelling requirements such as for market risk, and have conducted industry-wide stress tests infrequently, or only as part of FSAP reviews.

In contrast, a few countries were classified as advanced. For these countries, the review team saw evidence of a rigorous regular review process that included a combination of:

- on-site and off-site assessments;

- some review and feedback on detailed stress testing models used by banks;

- evidence of follow-up actions; and

- a well-embedded supervisory stress testing programme that was not

limited to FSAP or regionally-imposed scenarios.

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The remainder of countries (approximately half of respondents) fell into the intermediate category.

These countries have issued some formal requirements or guidance consistent with the principles, were generally performing regular supervisory stress tests on their large banks and were reviewing stress testing in the context of annual ICAAP reviews and specific risk reviews.

These countries have more to do in deepening their programmes, including issuing updated requirements and conducting more detailed on-site and off-site reviews of banks' stress testing capabilities.

Notably, several countries have reported significant progress subsequent to the completion of the peer review survey, particularly with regard to supervisory stress testing practices and also in some cases issuance of stress testing requirements or guidance.

Specific areas of supervisory activity in relation to the principles are discussed in more detail below.

Prudential framework

The review found that all countries have in place prudential requirements relating to stress testing.

In many cases these requirements were implemented as a component of Basel II, namely the ICAAP requirements, or otherwise pre-date the principles.

In addition, a large majority of the respondents stated that they had issued specific rules or guidance implementing the principles.

However, approximately one-third of respondents has not issued any rules or guidance on stress testing post-2009, and thus would not be considered to have implemented the principles explicitly.

These countries rely on other rules relating to stress testing, particularly under the Basel II credit or market risk requirements.

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In terms of future plans, a number of countries across different levels of maturity are in the process of, or are planning to strengthen or finalise guidance or regulations.

In some cases, key elements of the principles have been incorporated into the Pillar 2 requirements and in other cases as (non-mandatory) guidance for banks.

Some countries issued informal guidance based generally on the principles or on other regional guidelines.

A number of countries are still in the early phases of issuing prudential expectations for enterprise-wide stress testing.

At least a few countries have not yet issued requirements relating to Basel II ICAAPs, which was the most common means of implementing the principles.

Other countries have already updated their rules and adapted the principles or other guidelines for their own circumstances.

These would be considered to have a more mature supervision framework for stress testing.

A few other countries have issued their own good practice guidelines which incorporate the principles as well as key findings from supervisory activities and industry dialogue.

Roughly three-quarters of respondents reported that there have not been any impediments to implementing the principles.

However, resourcing and other supervisory priorities were noted as a constraint by a number of other countries.

A number of countries asserted that because their banks or banking systems are not complex, some of the aspects of the principles are not relevant (eg structured products and highly leveraged counterparties).

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Further, banks in some jurisdictions generally do not have the infrastructure and skills to be able to comply with sophisticated stress testing requirements.

Supervisory review

Principle 16 recommends that supervisors should make regular and comprehensive assessments of banks' stress testing programmes.

The review found that supervisory authorities use a combination of on-site and off-site reviews to assess banks’ stress testing practices.

Most countries indicated that they have conducted some form of on-site review of stress testing at banks.

For specific risk areas (primarily market, liquidity and to some extent credit risk), there are well established supervisory review programmes.

Almost three-quarters of countries indicated that they perform extensive regular review of firm-wide stress testing practices.

The most common approach for assessing firm-wide stress testing is through annual ICAAP reviews, which generally cover capital planning as well as other matters.

Given the scope of ICAAP reviews, it may be difficult to assess all of the principles during a routine ICAAP review.

Indeed, a few countries indicated that they conduct horizontal or thematic reviews specifically on firm-wide stress testing including the principles, which is considered a more advanced practice.

The frequency of on-site reviews of firm-wide stress testing varied across countries.

About one-third of countries conducted less-than-annual reviews (every 2-4 years) while roughly half of responding countries reported that they conduct annual or more frequent on-site reviews of stress testing.

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Some supervisors have conducted a one-time review of the principles through self-assessments, questionnaires, or benchmarking studies across a range of banks.

In terms of the scope of supervisory review, supervisory activities regularly covered stress testing for firm-wide risks, general credit risks, retail mortgages and corporate credit risks, market risk, banking book interest rate risk and liquidity risk.

Authorities reported that areas such as operational risk, overseas operations, as well as specific portfolios such as commercial property and sovereign risks, receive less coverage.

Supervisory authorities in most countries reported conducting annual or more frequent review of board and senior management reporting of stress test results.

Use of stress testing in loan loss provisioning was reviewed regularly by about half of the countries.

The role of stress testing to help set risk appetite and identify risk concentrations were areas that were less commonly reviewed; this is an area where supervisory and bank practice is at a very early stage.

Review of contingency plans for operational risk is the surveyed area least likely to have been assessed by supervisors in the context of stress testing.

Some countries noted different requirements or expectations of stress testing across banks, mainly depending on the banks’ systemic importance (including size, complexity and relevance to economy) and risk profile.

Most emphasised that supervisors have proportionately different expectations when conducting stress testing reviews of smaller banks. Several countries (particularly those at the more advanced stages of implementation of the principles) indicated that they are planning to increase the expectations of smaller institutions with respect to stress testing going forward.

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Supervisory action

Principle 17 indicates that supervisors should take action on deficiencies in banks' stress testing programmes.

The review found that the two most common areas for supervisory follow-up were improving governance processes for stress testing and use of additional (in particular, more severe) scenarios.

Many countries either regularly or occasionally imposed requirements to improve data or model validation processes.

The least common supervisory follow-up action indicated in the responses was to require the bank to review or change limits or exposures (less than half of the countries reported taking this action regularly).

Principle 19 encourages supervisors to consider the results of stress tests in assessing capital adequacy and in setting prudential buffers for capital and liquidity.

A large majority of countries indicated that they sometimes or regularly impose capital or liquidity requirements as a result of stress testing deficiencies.

In particular, use of stress scenarios for setting liquidity requirements appears to be fairly well established, particularly as countries work toward implementing the Basel III liquidity framework, which is based on stressed cash flows.

Nearly all of the countries indicated regular review of liquidity stress testing.

Use of stress tests for setting minimum capital requirements, determining explicit capital buffers or for limiting capital distributions by banks is a more recent development that was not extensively considered in the principles and as a result was not a key focus of the review.

A small number of countries indicated that stress testing has become a key tool for setting or assessing capital requirements.

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Some countries have issued new requirements in the past year or so specifically related to the use of stress tests in assessing capital adequacy.

While use of stress tests to set formal minimum capital requirements is not common, use of standard supervisory stress scenarios as a benchmarking tool is increasingly prevalent.

Other countries took the view that stress test results are just one factor in assessing how much capital is needed to offset the risk of unexpected losses.

In a number of countries, and even those with fairly advanced stress testing supervision programmes, stress testing was seen as one of several tools in assessing capital adequacy and there was a reluctance to place primary reliance on stress test scenario outcomes.

This may reflect the evolving nature of supervisory and bank practices.

Supervisory resourcing

As stress testing is a fairly new and specialised area of supervision, the review found that resourcing and capabilities for stress testing supervision were key challenges for many supervisory authorities.

Only a few countries have established units specifically dedicated to stress testing.

Most countries are primarily relying on separate teams of staff to conduct supervisory stress tests and, in many cases, also to review stress testing practices at banks.

These teams also perform other tasks in addition to reviewing or conducting stress testing.

Typically, a set of specially trained supervisors is responsible for coordinating with banks with respect to the collection of data for stress testing and reviewing and consolidating the stress test information.

Often an inter-departmental team is used to conduct the stress tests.

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In general, it was noted that staff with a variety of different backgrounds can be useful in stress testing, including macro-surveillance economists, risk specialists and modelling experts, as well as generalist supervisors who are most familiar with individual institutions or accounting experts.

Similarly, most countries utilise both risk specialists and generalist supervisors in reviewing stress testing practices at banks.

In most countries, generalist supervisors are involved in the review of stress testing practices; however, they are not generally involved in conducting supervisory stress tests.

At the same time, some countries noted that where stress testing is allocated to a separate unit, it can be more difficult to ensure that stress testing is embedded within routine supervision and that stress test outcomes are understood and used by the generalist supervisors.

This was seen as an evolving challenge.

The more advanced countries, in particular, noted a general lack of specialised stress testing resources.

Indeed, some countries found that prioritisation of supervisory work is a major issue as key individuals involved often have other responsibilities.

Most countries indicated they had established some form of training programme on stress testing for supervisors.

In many cases, the training was of a quite general nature and in some cases limited to presentation of the results of supervisory stress tests or high-level discussion in the context of introductory training on Pillar 2 approaches.

A few countries provide quite advanced training programmes, including case studies, and some offer training to other countries' supervisors or to banks in their jurisdiction.

Not surprisingly, several countries noted that stress testing training is an area of focus in their future plans.

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Supervisory stress testing

Principle 20 recommends that supervisors should consider implementing stress test exercises based on common scenarios.

It is clear that there has been a significant increase in the use of supervisory stress tests in recent years.

In fact, all countries indicated that they conduct some form of supervisory stress test.

As a result, progress in this area can be considered more advanced generally than some other aspects of the principles.

Portfolio-level stress tests were reported by more than half of the countries.

In recent years, this has included specific stress tests on, for example, housing loan portfolios, consumer debt, sovereign risks and liquidity risk.

Some countries indicated that they conduct very frequent sensitivity testing for specific risks, for example, applying market risk and liquidity shocks on a regular basis.

In terms of firm-wide stress tests based on a common scenario, there was a range of experience.

A few countries have performed FSAP stress tests only.

While these stress tests provide an important basis and experience for designing supervisory stress tests, in many cases they tended to be led by the FSAP mission team and the national central bank, and did not have a supervisory focus.

About one-third of countries were not running stress tests on a firm-wide basis.

In a couple of countries, firm-wide stress tests were conducted by the (non-supervisory) central bank, although with some involvement by the supervisory authority.

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Many countries conduct both bank-run and supervisor-run stress tests.

This can involve the supervisory authority running the same scenario using supervisory or public data in order to benchmark banks' results from the bank-run stress test. Some countries run both regional and country-specific stress tests.

Directing banks to run a stress test using a common scenario is considered to be a more advanced practice for supervisors, as it requires more detailed understanding of bank modelling capabilities and an ability to assess the results.

About half of the countries have conducted bank-run, firm-wide stress tests (outside of the FSAP process), of which about half conduct these on an annual basis.

Supervisory assessment and challenge

The overall assessment and challenge of the reasonableness of banks' stress test scenarios and outputs is a difficult area for supervision.

In many countries, the models, assumptions and approaches used are evolving, and banks are at varying degrees of sophistication.

At a general level, the review found a range of supervisory methods for challenging the scope and results of banks’ stress tests and scenarios.

The most widely used method was to compare outputs with historical experience, such as a past severe recession.

However, in countries with little history of financial crisis, this approach may be more difficult.

A number of countries conducted their own parallel stress tests on bank financial data to benchmark results produced by banks or placed high reliance on reasonableness checks based on supervisors’ understanding of portfolios.

Peer comparisons were very useful in countries where banks subject to stress testing are comparable in size and scope.

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Some countries facilitate this by requiring banks to report the results of their stress tests in a standardised manner.

A number of countries also place moderate to high reliance on banks' own internal model validation reporting.

Independent review by external auditors or consultants can be one element of the assessment and challenge process for some countries.

But more than half of countries indicated they do not rely at all on independent review of stress testing results as part of their supervision activities.

Another supervisory trend is that supervisory authorities are more actively reviewing scenarios chosen by the banks in their internal stress testing and, for example, the banks’ ICAAPs.

Monitoring or keeping a systematic inventory of scenarios used by banks is a more advanced practice as it allows better benchmarking of peer banks’ internal view of stressed conditions and possible vulnerabilities.

Several countries maintain a database of scenarios used by their banks, and others have plans to do this.

Over half of the countries periodically review the scenarios used by banks in their internal stress testing.

A few countries in the earlier stages of maturity were not regularly reviewing scenarios used by banks.

Supervisory authorities in several countries indicated that they have performed reverse stress tests, that is, stress tests designed to be sufficiently severe that they challenge the viability of the bank.

However, reverse stress testing has not become a common supervisory practice.

In fact, the supervisory stress tests appear to be the vehicle for assessing the impact of more severe scenarios.

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In terms of the choice of scenario for supervisory stress tests, the most common approach was to look to a previous severe recession or input from the central bank.

Also very common was to target the scenario to known vulnerabilities. About half of the countries have used externally prescribed scenarios (for example, from a regional authority or FSAP process).

Dialogue with public and private sectors

Stress testing is increasingly part of the public debate on the strength and transparency of supervision.

Supervisory authorities have regular discussions with banking industry risk officers or hold occasional seminars, workshops or roundtables with banks to exchange experiences on stress testing methodologies and use of results.

In some cases, this has resulted in publication of local industry guidance based on the Committee's principles.

Some supervisors also have a formal process for coordinating with other official organisations within their country.

In some cases, a formal committee of regulators and other authorities (including the central bank) discusses systemic vulnerabilities and provides input into stress testing programmes and the scenarios to be tested.

A number of other supervisors coordinate with their central bank in conducting a quantitative macroeconomic stress test, including consideration of potential systemic issues that may be caused by banks’ management reactions to a common stress scenario.

Regional-level coordinating bodies have also become increasingly important.

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Effective supervisory approaches

The review highlighted a number of different supervisory approaches that appear to have been more effective and are reflective of more advanced progress.

One of the most effective tools in advancing stress testing practices has been the significantly heightened focus on industry-wide supervisory stress tests.

Many countries found that this process has helped focus on common expectations, provide a structured approach for dialogue on better stress testing practices, and identify gaps in banks' stress testing infrastructure.

By challenging the loss results reported by banks on the prescribed scenarios, supervisors have motivated banks to justify their results and hence improve their internal assessment of key risk areas.

In contrast, there was some evidence that countries that have only conducted supervisory stress tests or supervisory review of stress testing practices without leveraging these two aspects together have not made as much progress in implementing the principles.

In addition, countries that address bank stress testing practices through the ICAAP review process have generally found this to be an effective mechanism, although periodic horizontal or thematic reviews that allow detailed comparison of practices across banks is a more advanced approach that is in use or under consideration in some countries.

A formal self-assessment process conducted in some countries helped banks identify where their practices are consistent with the principles and where gaps exist in stress testing programmes.

Open dialogue with banks was also seen as a key element of an effective supervisory programme.

Annual meetings with banks can include discussions of risk developments and best practices in stress testing that effectively create incentives for banks to strengthen their own practices.

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Another approach highlighted by some countries was to engage in dialogue on scenario selection, dynamics of models, reporting templates and data capabilities, and overall robustness of the stress test at the highest level of bank management.

Several countries have issued publications describing observed good practices arising from benchmarking or initial implementation reviews of the principles.

This type of guidance allows banks to benchmark themselves against their local peers.

Banks, and to some extent regulators, are increasingly using stress testing as a means of communicating their risk profiles to the market.

However, disclosure requirements and practices vary considerably by country.

Many countries now publish aggregate summaries of stress tests results in their regular financial stability reports, and in some cases outcomes for individual banks.

Some banks now routinely provide stress test results as part of their financial results.

Future plans

Most supervisory authorities described future enhancements to their stress testing supervision programmes.

Those countries in the early phases of maturity are planning to issue, finalise or update rules on stress testing and to commence review and assessment of stress testing practices.

Some are also conducting supervisory stress tests for the first time.

Those supervisory authorities in intermediate to advanced stages of maturity plan to focus on deepening their current on-site and off-site review programmes, with the aim of better assessing how stress test outcomes are used in bank decision-making and risk appetite setting.

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Stress testing results are expected to have a greater impact on contingency planning including recovery and resolution.

Additional supervisory work is planned for identifying and assessing how banks are integrating stress tests results in the development of risk appetite and overall risk management.

Some supervisors will also use horizontal reviews across multiple banks to assess these areas as well as to benchmark banks’ internal stress test scenarios and assumptions.

Greater focus on the use of stress test outputs in assessing capital adequacy and liquidity was evident in a few countries, with some also planning more explicit consideration of stress test outcomes in setting capital buffers.

Principles for Banks

As the peer review focused on supervisory implementation, an assessment of stress testing practices at banks was not within the scope of this review.

Nevertheless, many countries provided high-level comments on progress of banks in their jurisdictions that were reasonably consistent and may be of broader interest.

In particular, all countries reported significant improvements in stress testing capabilities at banks since publication of the principles.

Authorities noted an overall improvement in the rigor and quality of stress testing and the quality of information presented in ICAAPs.

Risk-specific stress testing, particularly regarding market and liquidity risk, was found to be reasonably well developed.

More recently, banks have focused increasingly on centralised, firm-wide stress testing that encompasses a broader range of risks, but many countries note this area is still evolving.

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Banks have strengthened their resourcing, with some banks now having set up dedicated stress testing units.

Banks are using a broader range of scenarios, including those that are more severe and complex.

However, as noted below, many countries indicated that banks’ scenarios continue to be less severe than supervisors might find appropriate.

Banks generally are establishing stronger governance frameworks with clear lines of responsibility for stress testing, and some banks are giving more importance to stress test results in their decision making.

Some countries have seen an improvement in data systems and ability to adapt to new vulnerabilities and specific scenarios.

The level of documentation has also improved.

Countries' responses to the review survey highlighted the following common areas of future improvement in bank stress testing practices.

Integrating results into decision-making.

A number of countries pointed to challenges banks have in incorporating stress test results into business and strategic decisions.

Stress testing tools are still immature and some countries felt that in many cases the banks take a compliance-oriented approach in order to meet regulatory requirements.

Governance

There is a sense that banks need to have a better understanding of stress testing limitations, assumptions, and uncertainties by users of stress test results, including senior management and the board of directors.

Severity of scenarios

A number of countries saw a need for firms to deepen the severity of scenarios.

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Supervisors in these countries remain concerned that banks' internal stress test scenarios do not plausibly reflect potential severe scenarios and outcomes.

Data and IT infrastructure.

A number of countries noted that data and IT systems remain a key impediment to implementing effective stress testing programmes. Accumulation of sufficient data for modelling purposes is a challenge for banks in some countries and aggregating information across the bank remains an issue. Generally, some manual intervention is needed to support the banks’ current IT and data infrastructure to run regular stress tests.

Modelling issues

Translating and calibrating scenarios into stress outcomes continues to be an area where banks' capabilities are challenged. Multiple risk class impacts generally have not been modelled in a sophisticated manner, although some banks attempt to take into account correlations between risks. Incorporating feedback effects and system-wide interactions remains very difficult. Another technical area cited is the identification and aggregation of correlated risks and integration between credit, market and liquidity risks.

Conclusions

The current environment has provided a sound test of how countries are putting into practice the Committee's 2009 principles for stress testing supervision.

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There is clearly room for further progress among the supervisory community in the supervision of stress testing. Many countries in the early to intermediate stages of implementation are working to finalise their prudential requirements for stress testing and implement regular review programmes that cover enterprise-wide stress testing governance, capabilities and models. Even those countries considered to be in the advanced phase of implementation of the principles felt that there are many remaining challenges with respect to their own stress testing programmes. Authorities are continuing with their efforts to embed the use of stress testing within their supervisory programmes. In many cases, this requires additional resources and training for both generalist and specialist supervision staff. Stress testing infrastructure, including the ability to collect appropriate data, develop models and aggregate results, continues to evolve. Explicit consideration of stress test outcomes in assessing liquidity and market risk capital requirements is well established in supervisory frameworks. Stress testing has traditionally not featured as prominently in assessment of overall bank capital adequacy but practices are evolving in this area. The peer review has highlighted that there are different supervisory approaches and it is difficult to state which is most effective. A combination of supervisory stress tests together with involvement of generalist and specialist supervision staff in reviews of banks’ stress testing practices at an enterprise-wide level often characterises the more well developed supervisory programmes.

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More advanced countries are encouraging development of more rigorous practices at banks by conducting horizontal and thematic reviews, publishing the results and providing feedback to banks. Finally, while the review found the principles themselves to be generally effective in setting high-level expectations, the Committee will continue to monitor implementation of the principles and determine whether, in the future, additional guidance might be necessary.

1 Stress testing should form an integral part of the overall governance and risk management culture of the bank. Stress testing should be actionable, with the results from stress testing analyses impacting business decisions of the board and senior management. Board and senior management involvement in the stress testing programme is essential for its effective operation

2 A bank should operate a stress testing programme that promotes risk identification and control; provides a complementary risk perspective to other risk management tools; improves capital and liquidity management; and enhances internal and external communication.

3 Stress testing programmes should take into account of views from across the organisation and should cover a range of perspectives and techniques.

4 A bank should have written policies and procedures governing the stress testing programme. The operation of the programme should be appropriately documented.

5 A bank should have a suitably robust infrastructure in place, which is sufficiently flexible to accommodate different and possibly challenging stress tests at an appropriate level of granularity.

6 A bank should regularly maintain and update its stress testing framework. The effectiveness of the stress testing programme, as well as the robustness of major individual components, should be

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assessed regularly and independently.

7 Stress tests should cover a range of risks and business areas, including at the firm-wide level. A bank should be able to integrate effectively, in a meaningful fashion, across the range of its stress testing activities to deliver a complete picture of firm-wide risk.

8 Stress testing programmes should cover a range of scenarios, including forward-looking scenarios, and aim to take into account system-wide interactions and feedback effects.

9 Stress tests should feature a range of severities, including events capable of generating the most damage whether through size of loss or through loss of reputation. A stress testing programme should also determine what scenarios could challenge the viability of the bank (reverse stress tests) and thereby uncover hidden risks and interactions among risks.

10 As part of an overall stress testing programme, a bank should aim to take account of simultaneous pressures in funding and asset markets, and the impact of a reduction in market liquidity on exposure valuation.

11 The effectiveness of risk mitigation techniques should be systematically challenged.

12 The stress testing programme should explicitly cover complex and bespoke products such as securitised exposures. Stress tests for securitised assets should consider the underlying assets, their exposure to systematic market factors, relevant contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the subordination level in the issue structure.

13 The stress testing programme should cover pipeline and warehousing risks. A bank should include such exposures in its stress tests regardless of their probability of being securitised.

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14 A bank should enhance its stress testing methodologies to capture the effect of reputational risk. The bank should integrate risks arising from off-balance sheet vehicles and other related entities in its stress testing programme.

15 A bank should enhance its stress testing approaches for highly leveraged counterparties in considering its vulnerability to specific asset categories or market movements and in assessing potential wrong-way risk related to risk mitigation techniques.

16 Supervisors should make regular and comprehensive assessments of a bank's stress testing programme.

17 Supervisors should require management to take corrective action if material deficiencies in the stress testing programme are identified or if the results of stress tests are not adequately taken into consideration in the decision-making process.

18 Supervisors should assess and if necessary challenge the scope and severity of firm-wide scenarios. Supervisors may ask banks to perform sensitivity analysis with respect to specific portfolios or parameters, use specific scenarios or to evaluate scenarios under which their viability is threatened (reverse stress testing scenarios).

19 Under Pillar 2 (supervisory review process) of the Basel II framework, supervisors should examine a bank's stress testing results as part of a supervisory review of both the bank's internal capital assessment and its liquidity risk management. In particular, supervisors should consider the results of forward-looking stress testing for assessing the adequacy of capital and liquidity.

20 Supervisors should consider implementing stress test exercises based on common scenarios.

21 Supervisors should engage in a constructive dialogue with other public

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authorities and the industry to identify systemic vulnerabilities. Supervisors should also ensure that they have the capacity and skills to assess a bank's stress testing programme.

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NUMBER 7

Progress of the HKMA's investigations in Lehman-Brothers-related cases

The Hong Kong Monetary Authority (HKMA) announced (Thursday) that investigation of over 99% of a total of 21,851 Lehman-Brothers-related complaint cases received has been completed. These include: - 15,769 cases which have been resolved by a settlement agreement

reached under section 201 of the Securities and Futures Ordinance; - 3,370 cases which have been resolved through the enhanced

complaint handling procedures required by the settlement agreement; - 2,467 cases which were closed because insufficient prima facie

evidence of misconduct was found after assessment or no sufficient grounds and evidence were found after investigation;

- 25 cases (including minibond cases) which are under disciplinary

consideration after detailed investigation by the HKMA, of which proposed disciplinary notices are being prepared; and

- 168 cases in respect of which investigation work has been completed

and are going through the decision process to decide whether there are sufficient grounds for disciplinary actions or whether the cases should be closed because of insufficient evidence or lack of disciplinary grounds.

Investigation work is underway for the remaining 50 cases.

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Notes: These are cases where eligible customers accepted the settlement offers made by the distributing banks in respect of Lehman Brothers-related investment products in accordance with the agreements reached under section 201 of the Securities and Futures Ordinance. The HKMA has informed the distributing banks that, since these agreements contain detailed arrangements for settlement of claims and the implementation of robust systems for selling unlisted structured investment products and dealing with related customer complaints in future, it is not the intention of the HKMA to take any enforcement action in relation to the Lehman Brothers-related cases that involve eligible customers who accept the settlement offers made by the distributing banks pursuant to these agreements.

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NUMBER 8

DARPA SEEKS ROBOT ENTHUSIASTS (AND YOU) TO FACE OFF FOR $2M PRIZE! Hardware, software, modeling and gaming developers sought to link with emergency response and science communities to design robots capable of supervised autonomous response to simulated disaster As iconic symbols of the future, robots rank high with flying cars and starships, but basic robots are already in use in emergency response, industry, defense, healthcare and education. DARPA plans to offer a $2 million prize to whomever can help push the state-of-the-art in robotics beyond today’s capabilities in support of the DoD’s disaster recovery mission. DARPA’s Robotics Challenge will launch in October 2012. Teams are sought to compete in challenges involving staged disaster-response scenarios in which robots will have to successfully navigate a series of physical tasks corresponding to anticipated,

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real-world disaster-response requirements. Robots played a supporting role in mitigating fallout from the Fukushima nuclear plant disaster in Japan, and are used by U.S. military forces as assistants for servicemembers in diffusing improvised explosive devices. True innovation in robotics technology could result in much more effective robots that could better intervene in high-risk situations and thus save human lives and help contain the impact of natural and man-made disasters. The DARPA Robotics Challenge consists of both robotics hardware and software development tasks. It is DARPA’s position that achieving true innovation in robotics, and thus success in this challenge, will require contributions from communities beyond traditional robotics developers. The challenge is structured to increase the diversity of innovative solutions by encouraging participation from around the world including universities, small, medium and large businesses and even individuals and groups with ideas on how to advance the field of robotics. “The work of the global robotics community brought us to this point—robots do save lives, do increase efficiencies and do lead us to consider new capabilities,” said Gill Pratt, DARPA program manager. “What we need to do now is move beyond the state of the art. This challenge is going to test supervised autonomy in perception and decision-making, mounted and dismounted mobility, dexterity, strength and endurance in an environment designed for human use but degraded due to a disaster. Adaptability is also essential because we don’t know where the next disaster will strike. The key to successfully completing this challenge requires adaptable robots with the ability to use available human tools, from hand tools to

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vehicles. “Robots undoubtedly capture the imagination, but that alone does not justify an investment in robotics,” said DARPA Acting Director, Kaigham J. Gabriel. “For robots to be useful to DoD they need to offer gains in either physical protection or productivity. The most successful and useful robots would do both via natural interaction with humans in shared environments.” The DARPA Robotics Challenge supports the National Robotics Initiative launched by President Barack Obama in June 2011. To answer questions regarding the Robotics Challenge and provide an opportunity for interested parties to connect, DARPA will hold a virtual Proposers’ Day workshop on April 16, 2012. This online workshop will introduce interested communities to the effort, explain the mechanics of this DARPA challenge, and encourage collaborative arrangements among potential performers from a wide range of backgrounds. The meeting is in support of the DARPA Robotics Challenge Broad Agency Announcement.

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NUMBER 9 SEC Announces Members of New Investor Advisory Committee

Washington, D.C., April 9, 2012 –The Securities and Exchange Commission today announced the formation of a new Investor Advisory Committee required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The 21-member committee replaces the advisory committee that was disbanded after the Dodd-Frank Act became law.

Section 911 of the Dodd-Frank Act established the new committee to advise the Commission on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace.

The Dodd-Frank Act authorizes the committee to submit findings and recommendations for review and consideration by the Commission.

Members of the newly formed committee were nominated by all five sitting Commissioners and represent a wide variety of interests, including senior citizens and other individual investors, mutual funds, pension funds, and state securities regulators.

"The SEC’s new Investor Advisory Committee is made up of individuals with a broad range of backgrounds and experiences," said SEC Chairman Mary Schapiro.

"I look forward to their insight and recommendations as to how we can further the SEC’s critical investor protection mission."

The members of the new Investor Advisory Committee are:

Darcy Bradbury, Managing Director and Director of External Affairs, D.E. Shaw & Co., L.P.

J. Robert Brown, Jr., Law Professor, University of Denver

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Joseph Dear, Chief Investment Officer, California Public Employees’ Retirement System

Eugene Duffy, Partner and Principal, Paradigm Asset Management Co. LLC

Roger Ganser, Chairman of the Board of Directors of BetterInvesting

James Glassman, Executive Director, George W. Bush Institute

Craig Goettsch, Director of Investor Education and Consumer Outreach, Iowa Insurance Division

Joseph Grundfest, William A. Franke Professor of Law and Business, Stanford Law School

Mellody Hobson, President and Director of Ariel Investments, LLC

Stephen Holmes, General Partner and Chief Operating Officer, InterWest Partners

Adam Kanzer, Managing Director and General Counsel of Domini Social Investments and Chief Legal Officer of the Domini Funds

Roy Katzovicz, Partner, Investment Team Member and Chief Legal Officer, Pershing Square Capital Management, L.P.

Barbara Roper, Director of Investor Protection, Consumer Federation of America

Kurt Schacht, Managing Director, CFA Institute

Alan Schnitzer, Vice Chairman and Chief Legal Officer, The Travelers Companies, Inc.

Jean Setzfand, Director of Financial Security for the AARP

Anne Sheehan, Director of Corporate Governance, California State Teachers’ Retirement System

Damon Silvers, Associate General Counsel for the AFL-CIO

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Mark Tresnowski, Managing Director and General Counsel, Madison Dearborn Partners, LLC

Steven Wallman, Founder and Chief Executive Officer, Foliofn, Inc.

Ann Yerger, Executive Director, Council of Institutional Investors

The Investor Advisory Committee will begin its work in the near future.

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NUMBER 10

EIOPA - Report on Good Practices for Disclosure and Selling of Variable Annuities

1. This Report summarises the findings of an Expert Group, set up in May 2011 under the auspices of EIOPA’s Committee on Consumer Protection and Financial Innovation (CCPFI) with the aim of establishing good disclosure and selling practices for variable annuities (VA).

2. It seeks to inform the debate on variable annuities from a consumer protection perspective with the aim of promoting common supervisory approaches and practices.

However, it does not set forth any guidelines or recommendations.

3. The Expert Group has been able to draw on the conclusions of a previous Task Force, established by EIOPA’s predecessor, the Committee of Insurance and Occupational Pensions Supervisors (CEIOPS), which had assessed variable annuities from a prudential perspective.

In addition the Expert Group has been assisted in its work by the analysis on market structure and basic product features, undertaken by EIOPA’s Financial Stability Committee.

The outcome of this analysis has been published in EIOPA’s Financial Stability Report for Spring 20112.

The Expert Group also benefitted from comments received during public consultation and from a Feedback Statement by EIOPA’s Insurance and Reinsurance Stakeholder Group (IRSG).

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4. In response to the losses suffered by some large insurance groups on their VA books during the recent financial crises, product characteristics have changed significantly to allow for better risk management.

As a consequence of an increased focus on risk management, insurance undertakings have had to reflect the associated costs in the charging structure for variable annuity products, thus reducing the potential benefits to customers compared to pre-crises product offerings.

5. The Expert Group referenced the cross-border business model often encountered in relation to the writing and sale of variable annuities.

Many large insurance groups have set up specialised subsidiaries dedicated to this business (“VA product companies”), which underwrite variable annuities in several Member States through freedom of establishment or freedom of services.

The Group also considered the objectives of consumers who invest in these policies. Consumers may purchase them as a means of saving for their retirement or for investment purposes more generally as an alternative to traditional life insurance or other savings products.

Both the business model and the objectives pursued by customers have a bearing on what constitutes good disclosure and selling practices.

6. Good disclosure practices attempt to ensure that customers can make their choices on an informed basis.

Customers need to be informed how the product works under different market conditions, what they are charged and which options they can exercise during the life of the contract.

In addition they need to be provided with some general information on the product provider, the law governing the contract and details on the relevant supervisory authorities to take account of the common cross-border business model referred to above.

The use of “frequently asked questions” is considered to be a transparent way of communicating the relevant information.

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7. Good selling practices for variable annuities have to ensure that the demands and needs of a customer are taken into account.

Because of their inherent complexity, variable annuities should always be sold on an advised basis via a salesperson, which may be an insurance intermediary or an agent or employee of the insurance undertaking.

To avoid the risk of misselling a number of areas, in particular, should be addressed by the salesperson.

The Expert Group has suggested an indicative list of questions that could be used in this context.

8. Finally, chapter 4.2. examines good practices by the product provider where it does not control the sales process.

Insurance undertakings should still ensure that sales are adequate by, inter alia, carrying out a due diligence on the intermediary firms as well as reviewing the clients they have taken on to ensure that they are as expected regardless of who controls the sales process.

9. The main findings of the Report are that good practices

• in relation to disclosures

o should provide general information on the insurance undertaking and the legal and supervisory regime it operates under to take account of the cross-border nature of this business

o should also include product specific information to address product complexity

• in relation to selling practices

o should ensure that variable annuities are always sold on an advised basis, even when they are sold directly by the company

o should focus on the customer’s objectives to determine his demands and needs.

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2. BACKGROUND TO THE REPORT 2.1.MANDATE AND SCOPE OF WORK

Mandate

10. This Report examines, specifically in relation to variable annuities, good practices on product disclosure and selling arrangements.

These issues had not been covered by the mandate of the previous CEIOPS Task Force that focused only on prudential matters.

11. Following the adoption of the recommendations put forward by the previous Task Force, the Board of Supervisors therefore requested the Committee on Consumer Protection and Financial Innovation (CCPFI) to look into these consumer-related issues.

To this end, the CCPFI set up a subgroup (Expert Group) to assist it in its work. This exercise was informed by the potential of some variable annuities products to achieve outcomes that are not easy for the consumer to understand.

12. The Report benefitted from the comments received during public consultation and from the Feedback Statement prepared by EIOPA’s Insurance and Reinsurance Stakeholder Group (IRSG).

Scope

13. Concerning product disclosures, the objective is to identify good practices regarding the product-specific information aimed at providing a proper understanding of the risks assumed by the policyholder in a variable annuity contract.

These disclosure requirements apply in addition to the information that needs to be provided on the life insurance undertaking and on the commitments the undertaking assumes vis-à-vis the policyholders.

14. In this context, particular attention should be paid to the multi-layered charging structure often encountered in variable annuities.

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15. Concerning selling practices, the aim is to look at good practices regarding advice given to customers, which should be based on their demands and needs.

Where the sales process takes place through insurance intermediaries as defined in the IMD, it has also been assessed how insurance undertakings should ensure that sales are appropriate.

16. This Report has been prepared in response to EIOPA’s monitoring role in relation to new financial activities.

Variable annuities fall within the broader category of insurance contracts with an investment element.

Bearing in mind that at a European level there are several legislative initiatives under way, which may have an impact on the sales of variable annuities, namely on product disclosure and on selling practices (such as the upcoming legislative proposal on Packaged Retail Investment Products –PRIPS- and the revision of the Insurance Mediation Directive -IMD), the purpose of the Report is limited to analysing good practices, to promote common supervisory approaches and practices, and to inform the debate on this topic.

However, its aim is not to pre-empt the above mentioned legislative proposals nor does it set forth any guidelines or recommendations.

17. The Report has a clear product-specific focus in line with its mandate, which has driven the range of topics that have been analysed by the Expert Group.

The scope of previous work by EIOPA’s predecessor CEIOPS in the form of technical advice to the European Commission on PRIPS and on IMD had been determined by the respective call for advice and, in relation to selling practices, covered a number of areas (such as transparency of remuneration, conflicts of interests and inducements), which are not dealt with in this Report.

These aspects are broader in nature and should be developed further as the wider legal framework evolves.

18. In identifying good practices, the Expert Group has taken existing EU legislation for the insurance sector as a starting point.

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In the future, legal concepts originally developed for other financial sectors (such as the KIID for pre-contractual disclosures or MiFID for rules on sales) may be increasingly relevant as a benchmark for the insurance sector.

As these issues are equally of a wider nature, the Expert Group did not want to anticipate any developments in this respect.

19. The focus of this Report is on good practices at the point of sale. Given the long term nature of many VA contracts with options that can be exercised over the lifetime of the policy, the CCPFI noted the importance for policyholders to receive timely and clear information on the performance of their account value, so that they can exercise their options on an informed basis.

2.2. BASIC PRODUCT FEATURES

20. Variable annuities (VAs) are unit-linked life insurance contracts with investment guarantees provided by the insurance undertaking which, in exchange for single or regular premiums, allow the policyholder to benefit from the upside of the unit, but be partially or totally protected when the unit loses value.

21. A common business model pursued by many larger insurance groups consists of setting up specific subsidiaries dedicated to variable annuities business, which underwrite in several Member States, through freedom of establishment or freedom of services.

22. In the US (where variable annuities have been sold in a significant way since the 1990s) as well as in some other markets such as Japan these products are very popular.

In Europe, VAs have become increasingly widespread too, as the possibility to gain from the exposure to specific underlying assets and being protected against a depreciation of these assets at the same time makes them quite appealing.

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23. Recently, in some countries new variants of unit-linked policies have emerged that equally aim to provide some downside protection, but which do not include a guarantee by the insurance company.

24. As per the previous paper, these types of contracts fall outside the scope of this report.

25. In their basic form, the guarantees embedded in variable annuities cover the amount of premiums paid, but quite often they entail additional features, for instance, that the premiums paid yield at least at a pre-defined interest rate (roll-up).

Alternatively, the guarantee may be reset to the highest account value throughout the insurance period, evaluated in accordance to a set of pre-defined time frames (ratchet).

26. Policyholders’ entitlements are determined on the basis of the guaranteed minimum benefits, if the underlying funds depreciate in value (or gain less than warranted by the roll-up rate).

In all other instances, their claims are determined by the performance of the underlying funds.

27. Regarding the size and the characteristics of the VA market EIOPA has published the key findings of a survey concentrating on larger insurance groups in its First Half Year Financial Stability Report 2011.

From a consumer perspective it is important to look at the type of minimum benefit being offered.

28. There are several kinds of guarantees or minimum benefits that can be embedded into a VA contract. Examples of common offerings include:

• GMDB (guaranteed minimum death benefit): Minimum benefit in case of death;

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• GMAB (guaranteed minimum accumulation benefit): Minimum guaranteed capital after a predefined period;

• GMIB (guaranteed minimum income benefit): Minimum guaranteed lifetime or term annuity starting at a predefined age on a defined benefit base;

• GMWB (guaranteed minimum withdrawal benefits): deferred or immediate, temporary or lifelong income stream.

29. The Financial Stability Report indicates that most contracts (72.2 % of gross written premiums) include a minimum death benefit. Regarding minimum living benefits, GMAB seems the most frequent feature, followed by GMWB and GMIB.

Most policies are single premium contracts.

30. There are two major markets for these products.

Some variable annuity contracts are intended for specific purposes (such as for private retirement savings) and seek to attract specific customer groups (such as affluent individuals approaching retirement age), often when the products are offered in tax preferred wrappers.

In relation to these products, the “insurance element” (i.e. the guaranteed minimum living benefits) typically plays a prominent role in their marketing.

31. Other offerings are less focused in terms of the target clients and their goals.

They look to attract a broad range of customers by promoting variable annuities as an investment opportunity with limited downside risk.

For these offerings, more emphasis is generally placed on the “investment element” (i.e. the underlying funds).

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2.3. CURRENT TRENDS IN PRODUCT DEVELOPMENT

32. Current trends in product development can be traced back, to a large extent, to the lessons learned during the recent financial crises, which resulted in severe losses for some important insurance groups.

To mitigate the effects of losses, these groups had, for example, to inject significant levels of capital into VA subsidiaries, halt product offerings and/or withdraw from certain markets.

The complexity of the products offered, market volatility, inadequate hedging and poor product design were some of the main reasons why these losses occurred.

33. One of the key features of many variable annuity products is the long-term nature of the guarantee in the form of living benefits.

In addition, policyholders are usually given a number of choices and options – for instance in relation to fund selection - which they can exercise at inception or during the life of the contract.

These two factors combined tend to make variable annuities offerings particularly complex from a risk management perspective.

In particular, the implementation of a robust hedging programme, designed to ensure that the movements in the liabilities are offset by the movement in the financial derivative instruments used for hedging, presents a huge challenge for VA product companies.

The losses experienced in the course of the financial crises have evidenced that the risks associated with these products are difficult to understand and to risk manage.

34. VA product companies have put in place various initiatives with the aim to reduce the risk embedded in VA contracts. These trends in product development include, among others, the use of volatility limits

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and the reduction of fund options (for example, through only allocating investments to index based funds).

This Report has as its sole objective to evaluate the impact of such initiatives on consumers, but does not assess their effectiveness from a risk management perspective.

35. It should be noted, however, that the cost of hedging and related risk-mitigation must be fully reflected in the charging structure for these products, thus reducing the potential benefits to consumers compared to pre-crises offerings.

It is, therefore, important that the product information provided is sufficiently clear to enable consumers to fully understand the VA contract they have been presented with.

3. DISCLOSURES

3.1. GENERAL AND PRODUCT SPECIFIC DISCLOSURES

36. The purpose of this section is to outline a possible approach to good disclosure practices for variable annuities.

Under current EU law, insurance companies are obliged to provide a certain set of pre-contractual information on the life insurance policies they offer, but the format, in which it is presented, is up to their discretion.

To convey the essential product characteristics in a short document insurers often use a key features document, which is prescribed by national law in some jurisdictions.

37. The key features document and any promotional material that may be used for pre-contractual information must be consistent with the general terms and conditions applicable to a variable annuities offering.

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It is therefore seen as good practice for the promotional material to refer, where appropriate, to the relevant sections of the general terms and conditions.

In doing so, the insurance companies can ensure consistency between their disclosure documents and the actual provisions in the contract, but it also allows customers to see how the pre-contractual information they receive is reflected in the general terms and conditions.

38. It is essential for the product provider to explain a number of areas of relevance to a customer in terms that are easily understandable, clear, fair and not misleading.

In relation to variable annuities some of the features, which need to be conveyed, are very product specific such as those that result from the interplay of minimum benefits and the performance of the underlying funds.

Others concern general information on the product provider, the law governing the product offering and the supervisory regime. Their relevance is due to the cross-border business model generally found with variable annuities.

39. EIOPA recognises that consumers in different European countries may have different preferences for the types of product disclosures received.

One way of addressing consumer information needs is through the use of frequently-asked-questions (FAQs).

The questions below, which could be presented to the potential customer both in the promotional material and in the pre-contractual information documents, are aimed at ensuring that any reader will have a good understanding of the product, the charges, terms in relation to redemption/maturity and any specific risks that they should be aware of.

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These have therefore been grouped under 5 headings, although these are by no means exhaustive.

Notwithstanding the questions below, insurance companies must follow all legal and regulatory requirements they are subject to.

Finally, the questions as laid out below are indicative only, and companies may be flexible in their presentation of these to prospective customers, for example using scenarios, tables, graphics and “frequently asked questions” to ensure that the information is portrayed in a consumer-friendly manner.

3.1.1. THE PRODUCT

• What is the product and how does it work? (This should describe the main features of the product and the type of guarantee(s) offered. It should clearly state at what point any monies are payable and how much these will be.)

• What choice does the policy holder have in where premium(s) are invested and what are those choices? (This should describe the underlying funds in which monies may be invested and the ability of the investor to choose)

• What are the main features of these funds in terms of investment objective and risk profile? (This should describe the investment objective of the underlying funds in a clear manner with an indication of risk which should follow the same approach as that used for UCITS)

• How does the guarantee work? (This should describe how the investment works, how the guarantee works and the interaction between the two)

• Is the insurance undertaking entitled to unilaterally modify the degree of the guarantee? If so, is the minimum degree of the guarantee determined?

• Do the guarantee benefits rise or fall under any circumstances? (If the product is subject to mechanisms such as roll-up or ratchet, this should clearly describe how these mechanisms work)

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• Are there any circumstances where the guarantee will not be applicable? (This should clearly state any circumstances where the guarantee will cease to exist or clearly state that the guarantee will apply in all eventualities)

• If the underlying funds lose money, what will be impact on the policy? (This should describe, perhaps by way of a simple table or graph, what happens to the payout to the policy holder in certain situations)

• May the policy-holder change the funds in which money is invested? (This will describe the process whereby a policy-holder may or may not have discretion on allocation, and if there is discretion, how often and to what extent that can be exercised)

• Will changing allocation cost the policy holder anything?

3.1.2. CHARGES

• What charges are applicable to the policy and how much are they in percentage terms?

• How much of the initial premium(s) is/are used to pay the various charges payable under the policy?

• What charges are payable on a regular basis and what is the impact of these? (This will describe the effect the regular charges have on the return on the policy)

• If the policy-holder redeems early, will there be a cost associated with that? Or how long does the policy-holder have to stay in the policy to avoid any such surrender cost?

• In case the charges can be modified unilaterally, is the maximum amount of those charges determined?

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3.1.3. SURRENDERS/REDEMPTIONS/MATURITY

• When does the policy mature?

• What does the policy-holder receive on maturity?

• Can the policy be surrendered earlier than maturity?

• What happens if surrendered early and is there a cost associated?

• Does the guarantee lapse if surrendered earlier than maturity?

• Are there any bonus payments payable?

• Can the benefits of the policy be transferred to someone else?

• If so, how will this affect the policy?

3.1.4. RISKS

• Is there any risk that the insurance company will not be able to pay the benefits?

• How exposed is the policy-holder to the riskiness in the underlying funds?

• Are there any circumstances where the policy-holder may not obtain the guarantee?

• Is the policy-holder exposed to the risk that the funds will perform badly?

• How does the policy-holder know that the premiums are being invested as requested?

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3.1.5. COMPLAINTS/LEGAL/TAX/REGULATION

• Which company does the policy-holder have a contract with?

• What is the name and address of the regulatory body of the insurance company that the policy-holder has a contract with?

• Which regulatory body does the policy-holder contact in the event of a complaint? Does he have access to an Alternative Dispute Resolution (ADR) system?

• Is that company a member of an Insurance Guarantee Scheme? In what country?

• What are the legal consequences for the policy-holder in the event that the insurance company becomes insolvent or winds up?

• In the event of a legal dispute between the policy-holder and the insurance company, under which jurisdiction will the legal proceedings happen (i.e. the governing law of the contract)?

• Are there any tax or legal issues that the policy-holder should be aware of?

3.2. ILLUSTRATIONS

40. The use of illustrations is governed by EU legislation in a number of aspects.

For the insurance sector Directive 2009/138/EC (“Solvency II”), in particular, sets forth certain requirements on insurance undertakings, when they provide figures relating to potential payments above and beyond the contractually agreed payments.

These also apply in relation to variable annuity contracts, as the guaranteed benefits constitute minimum promises, which may

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be increased in the event that the underlying funds appreciate in value.

The following examples illustrate, specifically for variable annuities, good practice in implementing these legal requirements.

41.Illustrations should be used to give customers an understanding of what payouts they may receive and what it might cost them in a given set of circumstances.

It is usually sensible to show this on a number of different bases derived from the specific details of the case.

Other illustrations on top of these could be provided but these should not assume investment growth above the top rate of the core illustration.

42. By contrast, the systematic use of favourable scenarios (when all scenarios presented lead to a positive outcome) would be misleading.

Unfavourable scenarios should always also be presented and illustrated; otherwise the customer could wrongly assume that his contract has no downside.

The scenarios should also make clear the maximum risk assumed by the customer.

43. In addition given that many of the charges applied to these products are based on the underlying investment it is also good practice to show the effect of these charges on the growth of the fund.

This can be done as an effective reduction on the yield of the investment or as an effect of charges calculation (based on a standard investment growth rate or indeed no growth).

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44. Furthermore it is also reasonable to use case studies to show what might happen in certain circumstances but these should not be misleading, should show the negative cases as well as the positive ones and should not take away from the standard illustrations above.

45. All of the above should be caveated with the fact that these are just illustrations and should not be seen to give any promise that this will be what the customer will actually get.

4. SELLING PRACTICES

4.1. DEMANDS AND NEEDS OF THE CUSTOMER

46. This section identifies good selling practices for variable annuities irrespective of the distribution channel via which they are sold (direct sales or through intermediaries).

For the insurance sector, current EU legislation only covers sales by insurance intermediaries, defined as any person who, for remuneration, takes up or pursues insurance mediation.

Insurance intermediaries shall specify prior to the conclusion of any specific contract, in particular on the basis of information provided by the customer, the demands and needs of that customer as well as the underlying reasons for any advice given to the customer on a given insurance product.

47. In view of the complexity of many VA offerings, their long-term nature and the importance these products frequently have in the context of private wealth management, it is good practice to apply these principles to the distribution of variable annuities generally as, irrespective of the distribution channel, the demands and needs of a customer should always determine the type of contract that is being offered.

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The sales process should be conducted by suitably qualified salespersons.

48. The objective pursued by a customer, based on the material facts that he has disclosed, should be a key consideration in assessing his demands and needs.

Determining whether a certain product offering is suitable will namely depend on whether it is used for private retirement savings or as investment opportunity more generally.

49. The Expert Group identified a number of areas where there is a potential risk of mis-selling (advice based on personal circumstances, use of clear projections, use of clear language).

The questions below are intended to prevent such risk from materialising.

It should be noted that this list is indicative.

4.1.1. PERSONAL CIRCUMSTANCES

• Does the sales person ask for customer’s age, financial situation, personal demand, knowledge of financial markets and the time horizon for his investment (short, medium or long-term) etc.?

• Based on this demand does the sales person outline alternative products (direct investments, unit-linked contracts etc.) to VA products? Which features should the customer focus on when comparing VA to other products?

• Is the VA product tailored to the customer’s demand (private pension plan, investment)?

• Are there any personal circumstances under which the sales person should not advise VA?

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4.1.2. USE OF CLEAR PRODUCT DESCRIPTIONS INCL. ILLUSTRATIONS

The sales person should inform the customer in a clear and comprehensive way about the relevant aspects of the VA product to ensure the customer understands correctly the product he wants to buy.

• Have potential risks of the VA product been explained in detail?

• Has the fund performance been illustrated by adequate and plausible scenarios? (An adequate depiction includes positive scenarios as well as negative developments. It should also include a worst case scenario.)

• What are the benefits of the contract in case of surrender and death and have these been clearly illustrated?

• Does the insurance undertaking prepare information sheets for the sales person/intermediary that they should use when informing the customer?

• Does the insurance undertaking monitor the intermediary?

• Does the customer have to confirm in writing that he understood the information received?

4.1.3. USE OF CLEAR LANGUAGE

The sales person should be able to illustrate all relevant aspects of the VA product without using too many technical terms to avoid any confusion.

If technical terms are used, for instance in written product information (e.g. volatility), the intermediary should be able to explain them in a clear manner.

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The customer should be able to take purchase decisions and to exercise his options during the contract period on an informed basis.

• Does the sales person use terms which are understandable also for non experts?

• Is the sales person trained to explain the complex basis of the VA products?

• Does the sales person explain the written product information to the customer?

4.1.4. UNDERSTANDING POTENTIAL FUTURE OUTCOMES

The performance of funds underlying VA contracts depends on different economic variables and conditions.

Despite a variety of illustrations the customer may not be able to assess, which scenario is more realistic, if he is unaware of these variables and how they may affect the performance of fund investments underlying his policy and ultimately his account value.

Customers should be made aware that the performance of their account value depends on how these economic variables and conditions change over time in a way, which is comprehensible to them. Only then can they decide which illustration they consider more realistic.

• Does the sales person explain how external factors e.g. on capital markets can affect the fund development?

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• In order to explain how external factors can affect the fund development, does the sales person refer to fund developments of the past?

Does he explain that past performance is not necessarily an indication of future performance?

• How does the sales person measure that the customer has understood the information received?

The mechanics how a VA-product generates profits or losses may be very complex.

Even if the customer can assess which scenario is more realistic, he does not know whether he has losses or profits in such a scenario.

• Does the sales person explain the basic features and underlyings of the VA-product in question?

• Depending on the type of the VA-product, does the sales person show the difference between a classical unit-linked product and a VA-product (Type of guarantee, contractual claims in case of a positive or negative fund development, structure of charges)?

• Does the sales person explain what kind of different options the customer can exercise during the duration of the contract and how this can affect the fund development?

• Does the sales person explain in which cases the customer gets only the guaranteed benefits at the end of the contract duration (e.g. adverse fund development) or to what extent he benefits from a positive fund performance?

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Monday April 16 2012 - Top 10 risk and compliance management related news stories and world events

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Transcript of Monday April 16 2012 - Top 10 risk and compliance management related news stories and world events