Monday March 18 2013 Top 10 Risk Compliance News 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

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

Dear Member, Have you seen the average salary and the demand for Basel III skills in IT jobs?

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

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Source: IT Jobs Watch, that provides a unique perspective on today's information technology job market (no affiliation). Read more at Number 1 blow. Also, are you good in disaster management? According to Pentti Hakkarainen, Deputy Governor of the Bank of Finland, one aspect of disaster management is keeping particularly risky or vulnerable business in a separate legal unit thus making it easier to divest/withdraw without exposing the rest of the operations for contagion by cutting linkages rapidly. Read more at number 3 below. Welcome to the Top 10 list.

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Amazing: The average salary and the demand for Basel III skills in IT jobs advertised across the UK The table looks at the demand for Basel III skills in IT jobs advertised across the UK. Included is a guide to the average salaries offered in IT jobs that have cited Basel III over the 3 months to 6 March 2013 with a comparison to the same period in the previous 2 years.

Long-term interest rates Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve System, at the Annual Monetary/Macroeconomics Conference “The past and future of monetary policy”, sponsored by the Federal Reserve Bank of San Francisco, San Francisco, California

Re-evaluating the universal banking model: Can the Volcker, Vickers or Liikanen rules make banks safer? Remarks by Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, at the 4th Future of Banking Summit, organised by Economist Conferences, Paris

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Reflections on reputation and its consequences Speech by Ms Sarah Bloom Raskin, Member of the Board of Governors of the Federal Reserve System, at the 2013 Banking Outlook Conference, Federal Reserve Bank of Atlanta, Atlanta, Georgia

Opinion of the European Insurance and Occupational Pensions Authority on Supervisory Response to a

Prolonged Low Interest Rate Environment

Investigations by the Financial Supervisory Authority into issues connected with the banking collapse have now concluded Investigations by the Financial Supervisory Authority (FME) into the events preceding the banking collapse in the autumn of 2008, which began immediately following the failure of the three large commercial banks, have now concluded. FME investigated a total of 205 cases.

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A very interesting presentation

Icelands pre- and post-crisis experience

SECURITIES AND EXCHANGE COMMISSION

Notice of Filing of Proposed Rule Change to Require that Listed Companies Have an Internal Audit Function Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) and Rule 19b-4 thereunder, notice is hereby given that on February 20, 2013, The NASDAQ Stock Market LLC (“Nasdaq” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by the Exchange.

The European crisis and the development of the European Union Speech by Mr Lars Rohde, Governor of the National Bank of Denmark, at the European Affairs Committee’s consultation: “The European crisis and the development of the European Union”, former Upper Chamber of the Danish Parliament, Copenhagen

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Promoting an inclusive financial sector in Pakistan Speech by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the Closure Ceremony of Term Sarmaya Certificate (TFC) issued by Tameer Microfinance Bank, Karachi

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Amazing: The average salary and the demand for Basel III skills in IT jobs advertised across the UK The first table below looks at the demand for Basel III skills in IT jobs advertised across the UK. Included is a guide to the average salaries offered in IT jobs that have cited Basel III over the 3 months to 6 March 2013 with a comparison to the same period in the previous 2 years. The second table is for comparison and provides aggregates for all of the Quality Assurance & Compliance category.

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Source: IT Jobs Watch, that provides a unique perspective on today's information technology job market (no affiliation). To learn more: http://www.itjobswatch.co.uk/jobs/uk/basel%20iii.do

http://www.itjobswatch.co.uk/jobs/uk/basel%20iii.do

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Long-term interest rates Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve System, at the Annual Monetary/Macroeconomics Conference “The past and future of monetary policy”, sponsored by the Federal Reserve Bank of San Francisco, San Francisco, California

I will begin my remarks by posing a question: Why are long-term interest rates so low in the United States and in other major industrial countries? At first blush, the answer seems obvious: Central banks in those countries are pursuing accommodative monetary policies to boost growth and reduce slack in their economies. However, while central banks certainly play a key role in determining the behavior of long-term interest rates, theirs is only a proximate influence. A more complete explanation of the current low level of rates must take account of the broader economic environment in which central banks are currently operating and of the constraints that that environment places on their policy choices. Let me start with a brief overview of the recent history of long-term interest rates in some key economies. Chart 1 shows the 10-year government bond yields for five major industrial countries: Canada, Germany, Japan, the United Kingdom, and the United States. Note that the movements in these yields are quite correlated despite some differences in the economic circumstances and central bank mandates in those countries.

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Further, with the notable exception of Japan, the levels of the yields have been very similar – indeed, strikingly so, with long-term yields declining over time and currently close to 2 percent in each case. The similar behavior of these yields attests to the global nature of the economic and financial developments of recent years, as well as to the broad similarity in how the monetary policymakers in the advanced economies have responded to these developments. Of course, Japanese yields are clearly a case apart, as Japan has endured an extended period of deflation, while inflation in the other four countries has been positive and generally close to the stated objectives of the monetary authorities. But even Japanese yields have shown some tendency to fluctuate along with other benchmark yields, and they have also declined over the period shown. In my comments, I will delve more deeply into the reasons why these long-term interest rates have fallen so low.

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This examination may be useful both for understanding the current stance of policy and also for thinking about how rates may evolve. In short, we expect that as the economy recovers, long-term rates will rise over time to more normal levels. A return to more normal conditions in financial markets would, of course, be most welcome. Many commentators have noted, however, that both an extended period of low rates and the transition back toward normal levels may pose risks to financial stability. In the final portion of my remarks, I will discuss some aspects of how the Federal Reserve is approaching these risks.

Why are long-term interest rates so low? So, why are long-term interest rates currently so low? To help answer this question, it is useful to decompose longer-term yields into three components: 1. One reflecting expected inflation over the term of the security; 2. Another capturing the expected path of short-term real, or inflation-adjusted, interest rates; 3. And a residual component known as the term premium. Of course, none of these three components is observed directly, but there are standard ways of estimating them.

Chart 2 displays one version of this decomposition of the 10-year U.S.

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Treasury yield based on a term structure model developed by Federal Reserve staff. The broad features I will emphasize are similar to those found by other authors using a variety of methods. All three components of the 10-year yield have declined since 2007. The decomposition attributes much of the decline in the yield since 2010 to a sharp fall in the term premium, but the expected short-term real rate component also moved down significantly. Let’s consider each component more closely. The expected inflation component has drifted gradually downward for many years and has become quite stable. In large part, the downward trend and stabilization of expected inflation in the United States are products of the increasing credibility of the Federal Reserve’s commitment to price stability.

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In January 2012, the Federal Open Market Committee (FOMC) underscored this commitment by issuing a statement – since reaffirmed at its January 2013 meeting – on its longer-run goals and policy strategy, which included a longer-run inflation target of 2 percent. The anchoring of long-term inflation expectations near 2 percent has been a key factor influencing long-term interest rates over recent years. It almost certainly helped mitigate the strong disinflationary pressures immediately following the crisis. While I have not shown expected inflation for other advanced economies, the pictures would be very similar – again, except for Japan. With the expected inflation component of the 10-year rate near 2 percent and the rate itself a bit below 2 percent recently, it is clear that the combination of the other two components – the expected path of short-term real interest rates and the term premium – must make a small net negative contribution. The expected path of short-term real interest rates is, of course, influenced by monetary policy, both the current stance of policy and market participants’ expectations of how policy will evolve. The stance of monetary policy at any given time, in turn, is driven largely by the economic outlook, the risks surrounding that outlook, and at times other factors, such as whether the zero lower bound on nominal interest rates is binding. In the current environment, both policymakers and market participants widely agree that supporting the U.S. economic recovery while keeping inflation close to 2 percent will likely require real short term rates, currently negative, to remain low for some time. As shown in chart 2, the expected average of the short-term real rate over the next 10 years has gradually declined to near zero over the past few years, in part reflecting downward revisions in expectations about the

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pace of the ongoing recovery and, hence, a pushing out of expectations regarding how long nominal short-term rates will remain low. As the persistence of the effects of the crisis have become clearer, the Federal Reserve’s communications have reinforced the expectation that conditions are likely to warrant highly accommodative policy for some time: Most recently, the FOMC indicated that it expects to maintain an exceptionally low level of the federal funds rate at least as long as the unemployment rate is above 6.5 percent, projected inflation between one and two years ahead is no more than a half percentage point above the Committee’s 2 percent target, and long-term inflation expectations remain stable. In discussing the role of monetary policy in determining the expected future path of real short-term rates, I have cheated a little: What monetary policy actually controls is nominal short-term rates. However, because inflation adjusts slowly, control of nominal short-term rates usually translates into control of real short-term rates over the short and medium term. In the longer term, real interest rates are determined primarily by nonmonetary factors, such as the expected return to capital investments, which in turn is closely related to the underlying strength of the economy. The fact that market yields currently incorporate an expectation of very low short-term real interest rates over the next 10 years suggests that market participants anticipate persistently slow growth and, consequently, low real returns to investment. In other words, the low level of expected real short rates may reflect not only investor expectations for a slow cyclical recovery but also some downgrading of longer-term growth prospects.

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Chart 3, which displays yields on inflation-indexed, long-term government bonds for the same five countries represented in chart 1, shows that expected real yields over the longer term are low in other advanced industrial economies as well.

Note again the strong similarity in returns across these economies, suggesting once again the importance of common global factors. While indexed yields spiked up around the end of 2008, reflecting market stresses at the height of the crisis that undercut the demand for these bonds, these effects dissipated in 2009. Since that time, inflation-indexed yields have declined steadily and now stand below zero in each country. Apparently, low longer-term real rate expectations are playing an important role in accounting for low 10-year nominal rates in other industrial countries, as well as in the United States.

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The third and final component of the long-term interest rate is the term premium, defined as the residual component not captured by expected real short-term rates or expected inflation. As I noted, the largest portion of the downward move in long-term rates since 2010 appears to be due to a fall in the term premium, so it deserves some special discussion. In general, the term premium is the extra return investors expect to obtain from holding longterm bonds as opposed to holding and rolling over a sequence of short-term securities over the same period. In part, the term premium compensates bondholders for interest rate risk – the risk of capital gains and losses that interest rate changes imply for the value of longer term bonds. Two changes in the nature of this interest rate risk have probably contributed to a general downward movement of the term premium in recent years. First, the volatility of Treasury yields has declined, in part because short-term rates are pressed up against the zero lower bound and are expected to remain there for some time to come. Second, the correlation of bond prices and stock prices has become increasingly negative over time, implying that bonds have become more valuable as a hedge against risks from holding other assets. Beyond interest rate risk, a number of other factors also affect the term premium in practice. For example, during periods of financial turmoil, the prices of longer-term Treasury securities are often driven up by so-called safe-haven demands of investors who place special value on the safety and liquidity of Treasury securities. Indeed, even during more placid periods, global demands for safe assets increase the value of Treasury securities.

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Many foreign governments and central banks, particularly those with sustained current account surpluses, hold substantial international reserves in the form of Treasuries. Foreign holdings of U.S. Treasury securities currently amount to about $5-1/2 trillion, roughly half of the total amount of marketable Treasury debt outstanding. The global economic and financial stresses of recent years – triggered first by the financial crisis, and then by the problems in the euro area – appear to have significantly elevated the safe-haven demand for Treasury securities at times, pushing down Treasury yields and implying a lower, or even a negative, term premium. Federal Reserve actions have also affected term premiums in recent years, most prominently through a series of Large-Scale Asset Purchase (LSAP) programs. These programs consist of open market purchases of agency debt, agency mortgage-backed securities, and longer term Treasury securities. To the extent that Treasury securities and agency-guaranteed securities are not perfect substitutes for other assets, Federal Reserve purchases of these assets should lower their term premiums, putting downward pressure on longer-term interest rates and easing financial conditions more broadly. Although estimated effects vary, a growing body of research supports the view that LSAPs are effective at bringing down term premiums and thus reducing longer-term rates. Of course, the Federal Reserve has used this unconventional approach to lowering longer-term rates because, with short-term rates near zero, it can no longer use its conventional approach of cutting the target for the federal funds rate.

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Accordingly, this portion of the decline in the term premium might ultimately be attributed to the sluggish economic recovery, which prompted additional policy action from the Federal Reserve. Let’s recap. Long-term interest rates are the sum of expected inflation, expected real short term interest rates, and a term premium. Expected inflation has been low and stable, reflecting central bank mandates and credibility as well as considerable resource slack in the major industrial economies. Real interest rates are expected to remain low, reflecting the weakness of the recovery in advanced economies (and possibly some downgrading of longer-term growth prospects as well). This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks. Put another way, at the present time the major industrial economies apparently cannot sustain significantly higher real rates of return; in that respect, central banks – so long as they are meeting their price stability mandates – have little choice but to take actions that keep nominal long-term rates relatively low, as suggested by the similarity in the levels of the rates shown in chart 1. Finally, term premiums are low or negative, reflecting a host of factors, including central bank actions in support of economic recovery. Thus, while the current constellation of long-term rates across many advanced countries has few precedents, it is not puzzling: It follows naturally from the economic circumstances of these countries and the implications of these circumstances for the policies of their central banks.

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How are long-term rates likely to evolve? So, how are long-term rates likely to evolve over coming years? It is worth pausing to note that, not that long ago, central bankers would have carefully avoided this topic. However, it is now a bedrock principle of central banking that transparency about the likely path of policy, in general, and interest rates, in particular, can increase the effectiveness of policy. In the present context, I would add that transparency may mitigate risks emanating from unexpected rate movements. Thus, let me turn to prospects for long-term rates, starting with the expected path of rates and then turning to deviations from the expected path that may arise. If, as the FOMC anticipates, the economic recovery continues at a moderate pace, with unemployment slowly declining and inflation expectations remaining near 2 percent, then long-term interest rates would be expected to rise gradually toward more normal levels over the next several years. This rise would occur as the market’s view of the expected date at which the Federal Reserve will begin the removal of policy accommodation draws nearer and then as accommodation is removed. Some normalization of the term premium might also contribute to a rise in long-term rates. To illustrate possible paths, Chart 4 displays four different forecasts of the evolution of the 10-year Treasury yield over coming years.

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The black line is the forecast reported in the December 2012 Blue Chip Financial Forecasts survey. The green line gives the Congressional Budget Office forecast published in February, and the blue line presents the median from the Survey of Professional Forecasters, as reported in the first quarter of this year. Finally, the purple line shows a forecast based on the term structure model used for the decomposition of the 10-year yield in chart 2. While these forecasts embody a wide range of underlying models and assumptions, the basic message is clear – long-term interest rates are expected to rise gradually over the next few years, rising (at least according to these forecasts) to around 3 percent at the end of 2014. The forecasts in chart 4 imply a total increase of between 200 and 300 basis points in long-term yields between now and 2017.

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Of course, the forecasts in chart 4 are just forecasts, and reality might well turn out to be different. Chart 5 provides three complementary approaches to summarizing the uncertainty surrounding forecasts of long-term rates.

The dark gray bars in the chart are based on the range of forecasts reported in the Blue Chip Financial Forecasts, the blue bars are based on the historical uncertainty regarding long-term interest rates as reflected in the Board staff’s FRB/US model of the U.S. economy, and the orange bars give a market-based measure of uncertainty derived from swaptions. These three different measures give a broadly similar picture about the upside and downside risks to the forecasts of long-term rates. Rates 100 basis points higher than the expected paths in chart 4 by 2014 are certainly plausible outcomes as judged by each of the three measures, and this uncertainty grows to as much as 175 basis points by 2017.

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Note, though, that while the risk of an unexpected rise in interest rates has drawn much attention, the level of long-term interest rates also could prove to be lower than forecast. Indeed, by the measures shown in chart 5, the upside and downside risks to the level of rates are roughly symmetric as of 2017. We also have some historical experience with increases in rates during tightening cycles to consider. For example, in 1994, 10-year Treasury yields rose about 220 basis points over the course of a year, reflecting an unexpected quickening in the pace of economic growth and signs of building inflation pressures. This increase in long-term rates appears to have reflected a mix of a pronounced rise in the expected path of the policy interest rate and some increase in the term premium. A rise of more than 200 basis points in a year is at the upper end of what is implied by the mean paths and uncertainty measures shown in charts 4 and 5, but these measures still admit a substantial probability of higher – and lower – paths. Overall, then, we anticipate that long-term rates will rise as the recovery progresses and expected short-term real rates and term premiums return to more normal levels. The precise timing and pace of the increase will depend importantly on how economic conditions develop, however, and is subject to considerable two-sided uncertainty.

Managing risks associated with the future course of long-term interest rates As I noted when I began my remarks, one reason to focus on the timing and pace of a possible increase in long-term rates is that these outcomes may have implications for financial stability.

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Commentators have raised two broad concerns surrounding the outlook for long-term rates. To oversimplify, the first risk is that rates will remain low, and the second is that they will not. In particular, in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe “reach for yield” either through excessive use of leverage or through other forms of risk-taking. My Board colleague Jeremy Stein recently discussed how this behavior may arise in some financial markets, including credit markets. Alternatively, we face a risk that longer-term rates will rise sharply at some point, imposing capital losses on holders of fixed-income instruments, including financial institutions. Of course, the two risks may very well be mutually reinforcing: Taking on duration risk is one way investors may reach for yield, and the losses resulting from a sharp rise in longer-term rates will be greater if investors have done so. One might argue that the right response to these risks is to tighten monetary policy, raising long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my discussion this evening has convinced you that, at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability. Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low.

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Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading – ironically enough – to an even longer period of low long-term rates. Only a strong economy can deliver persistently high real returns to savers and investors, and the economies of the major industrial countries are still in the recovery phase. So how can financial stability concerns – which the Federal Reserve takes very seriously – be addressed? Our strategy, undertaken in cooperation with other regulators and central banks, has a number of elements. First, we have greatly increased our macroprudential oversight, with a particular focus on potential systemic vulnerabilities, including buildups of leverage and unstable funding patterns as well as interest rate risk. Under the umbrella of our interdisciplinary Large Institutions Supervision Coordinating Committee, we pay special attention to developments at the largest, most complex financial firms, making use of information gathered in our supervision of the institutions and drawn from financial market indicators of their health and systemic vulnerability. We also monitor the shadow banking sector, especially its interaction with regulated institutions; in this work, we look for factors that may leave the system vulnerable to an adverse “fire sale” dynamic, in which declining asset values could force leveraged investors to sell assets, depressing prices further. We exchange information regularly with other regulatory agencies, both directly and under the auspices of the Financial Stability Oversight Council. Throughout the Federal Reserve System, work in these areas is conducted by experts in banking, financial markets, monetary policy, and other disciplines, and at the Federal Reserve Board we have established

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our Office for Financial Stability Policy and Research to help coordinate this work. Findings are presented regularly to the Board and to the FOMC for use in its monetary policy deliberations. Second, recognizing that our monitoring of the financial sector will always be imperfect, we are using regulatory and supervisory tools to help ensure that financial institutions are sufficiently resilient to weather losses and periods of market turmoil arising from any source. Indeed, reflecting expectations embodied in the new Basel III and Dodd-Frank standards, the largest and most complex financial firms have substantially increased both their capital and their liquidity in recent years. Our current round of stress testing of the largest bank holding companies, to be completed early this month, examines whether the largest banking firms have sufficient capital to come through a seriously adverse economic downturn and still have the capacity to perform their roles as providers of credit. In a related exercise, we are also asking banks to stress-test the adequacy of their capital in the face of a hypothetical sharp upward shift in the term structure of interest rates. Third, our approach to communicating and implementing monetary policy provides the Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp increases in interest rates. In 1994 – the period discussed earlier in which sharp increases in interest rates strained financial markets – the FOMC’s communication tools were very limited; indeed, it had just begun issuing public statements following policy moves. By contrast, in recent years, the Federal Reserve has provided a great deal of additional information about its expectations for the path of the economy and the stance of monetary policy.

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Most recently, as I mentioned, the FOMC announced unemployment and inflation thresholds characterizing conditions that will guide the timing of the first increase in the target for the federal funds rate. Further, the FOMC stated that a highly accommodative stance of monetary policy is likely to remain appropriate for a considerable time after our current asset purchase program ends. By providing greater clarity concerning the likely course of the federal funds rate, FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the Committee’s intentions would lead to unnecessary interest rate volatility. In addition, the Federal Reserve could, if necessary, use its balance sheet tools to mitigate the risk of a sharp rise in rates. For example, the Committee has indicated its intention to sell its agency securities gradually once conditions warrant. The Committee also noted, however, that the pace of sales could be adjusted up or down in response to material changes in either the economic outlook or financial conditions. In particular, adjustments to the pace or timing of asset sales could be used, under some circumstances, to dampen excessively sharp adjustments in longer-term interest rates.

Conclusion Let me finish with some thoughts on balancing the risks we face in the current challenging economic environment, at a time when our main policy tool, the federal funds rate, is near its effective lower bound. On the one hand, the Fed’s dual mandate has led us to provide strong support for the recovery, both to promote maximum employment and to keep inflation from falling below our price stability objective.

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One purpose of this support is to prompt a return to the productive risk-taking that is essential to robust growth and to getting the unemployed back to work. On the other hand, we must be mindful of the possibility that sustained periods of low interest rates and highly accommodative policy could lead to excessive risk-taking in some financial markets. The balance here is not an easy one to strike. While the recent crisis is vivid testament to the costs of ill-judged risk-taking, we must also be aware of constraints posed by the present state of the economy. In light of the moderate pace of the recovery and the continued high level of economic slack, dialing back accommodation with the goal of deterring excessive risk-taking in some areas poses its own risks to growth, price stability, and, ultimately, financial stability. Indeed, as I noted, a premature removal of accommodation could, by slowing the economy, perversely serve to extend the period of low long-term rates. For these reasons, we are responding to financial stability concerns with the multipronged approach I summarized a moment ago, which relies primarily on monitoring, supervision and regulation, and communication. We will, however, be evaluating these issues carefully and on an ongoing basis; we will be alert for any developments that pose risks to the achievement of the Federal Reserve’s mandated objectives of price stability and maximum employment; and we will, of course, remain prepared to use all of our tools as needed to address any such developments.

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Re-evaluating the universal banking model: Can the Volcker, Vickers or Liikanen rules make banks safer? Remarks by Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, at the 4th Future of Banking Summit, organised by Economist Conferences, Paris

Thoughts on the reasons why the universal bank model exists, i.e. why it is valuable “There are benefits from combining different business lines under one roof” There are a number of reasons why banks combine several business lines under one roof: – strive for optimal use of capital – diversification of risk as distribution of profits and losses of different business lines are less than fully correlated – synergies from combination of different expertises – servicing the multiple needs of clients, especially in the case of corporate clients (one-stop-shopping) There is now one way of structuring a universal bank. E.g. some universal banks have numerous business lines under one legal unit, whereas other universal banks operate as a holding group of separate companies. The business lines or legal units can be defined based on e.g. business areas or functions and/or geographical reach.

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The way banks aim to be structured is crystallised in the strategy, but e.g. M&A history and ability to achieve organic growth has had a great impact on how universal banks are structured today. “However, some banks already see the value of applying a universal bank model where various business activities are clearly structured and business lines are legally separated” Even without regulation requiring so, many banks already manage different business lines separately, which closely resembles a structure with different legal units. – Banks find management, risk management and HR/recruiting easier if the business is separated along logical units, i.e. functions/activities which fall naturally together. – From a risk management perspective, portfolios are already managed separately. – In some cases an important driver for legal separation of businesses is “Disaster management”, i.e. keeping particularly risky or vulnerable business in a separate legal unit thus making it easier to divest/withdraw without exposing the rest of the operations for contagion by cutting linkages rapidly. There are also benefits of being organised along separated business lines. – The pricing of internal funding of business units can be arranged at arm’s length with risk-adjusted transfer pricing. – Allocation of economic capital can be done by business line and even at the level of individual customers, which support decision making and carrying out the business in an optimal way. “Making the structure of universal banks clearer would simplify the governance of banks and improve risk management.”

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I have some insights from practice on what the consequences of legal separation of business lines could be. In my view legal separation would benefit in particular the governance and risk management of banks. – As the HLEG report states, I have also experienced that the cultures of traditional retail banking and investment banking/trading activities are very different and blended cultures can cause problems. – The nature of the business and the attitude towards risk-taking are different. In investment banking and trading activities profits are generated by actively seeking risk-taking opportunities by opening risky positions. Whether these risk exposures had good risk-adjusted return prospects, has often been of secondary importance. Models and warning signs flagged by risk management were often disregarded; high risks were taken even if the probability of success was low and the potential downside was significant. In traditional retail banking, profits are mainly earned from interest rate margin income from long term customer relationships in a more stable manner. Credit quality assessment and pricing policy lie at the core of the business. – Also the time horizon differs markedly. In the trading activity the results settled and assessed every single day. In retail banking profits are generated over several years time period. – The responsibility and independence of the management is enhanced if business lines are separated to legal entities.

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– Separation also facilitates management, risk management and HR/recruiting, as the objective and needs are clearer in a separately defined business unit. Aligning incentives to the strategy of the business line by means of targets included in remuneration schemes will also be easier. – If the operations to be separated are logical units then it is most probable that required reporting systems to support governance are already in place. Separation will also facilitate monitoring by external stakeholders thus improving market discipline, which can be seen as an extension to the internal corporate governance mechanisms. – Specifically, separation may improve transparency and reduce uncertainty about the quality of banks as an investment opportunity thus facilitating pricing of the separated parts. This, on the other hand, would improve the access to market funding among above average quality banks Moreover making the structure of universal banks clearer through separation of businesses also facilitates the task of supervisors and authorities responsible for resolution. – Separation will certainly facilitate the application of recovery and resolution measures hence reducing the likelihood of public bail-outs, which would in turn have dramatic implications for e.g. funding costs. Differences between the proposals of Independent Commission on Banking and High level Expert Group “The difference in the location of the ring-fence is important, ...”

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John Vickers has made very insightful comments on the compatibility of the proposal of his group, the Independent Commission of Banking with the proposal of the High-level Expert Group. I have a few comments on this theme: – ICB and HLEG proposals started from different directions; the approach taken by ICB started from the narrow banking philosophy, whereas HLEG focused on the most volatile parts of banking business. However, the groups ended up with qualitatively similar proposals. – As John Vickers has stated already, the main question as regards the position of the ring-fence is “Where should securities underwriting be; in the investment bank (such as in ICB) or in the deposit bank (as in HLEG)?” Another difference is that ICB’s proposal includes geographical restrictions as non-EEA customers cannot be served by the deposit bank. This highlights the focus on the viability of the UK banking sector in the ICB. – HLEG is based on the view that underwriting is closely connected with corporate banking and thus naturally belongs to the deposit bank. From the corporate client’s perspective, issuing a bond is an alternative way of financing to taking a bank loan. From the bank’s perspective, there are similar elements in both, because both involve a customer credit quality assessment, although in underwriting the bank’s own position taking is normally quite limited. – It is true that a promise of market making can be an important complement to a successful underwriting of a bond.

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However, separate entities within the bank group can well provide the underwriting and market making services without any additional cost to the customer. HLEG did emphasise the importance that authorities require additional separation if that is needed to make the recovery and resolution plans credible, a measure that would bring the HLEG separation proposal closer to the ICB ring-fencing proposal. The proposals are also somewhat different with respect to the height of the ring-fence. The ICB included restrictions on cross-ownership, for example. As suggested by the Parliamentary Commission of Banking, tasked with the pre-legislative review of the bill, the ring-fence will now be “electrified” by giving authorities reserve powers to require full separation. “... but the difference in capital requirements imposed on retail banking may have greater implications for banks.” However, in my view the fundamental difference between the two proposals is the difference in capital requirements. – ICB imposes an extra capital requirement on the ring-fenced retail bank (~deposit bank). – The HLEG was more concerned of strengthening the capitalisation of the trading entity and therefore suggested a review of capital requirements on trading book requirements. It also suggested a review on capital requirements on real estate related lending. HLEG did, however, not make any explicit requirement on imposing higher capital requirements.

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– I do recognise that the requirement to issue designated bail-in instruments can be interpreted as higher capital requirements. These would, however, apply across business lines not only to the deposit bank. Some banks might be able to implement separation without significant costs as many banks already have the needed governance system in place, whereas suggested changes to the funding structure (tougher capital requirements) could entail additional costs. I tend to agree with the critiques that it can be challenging for the ring-fenced banks to remain viable as the relatively narrowly defined operations might not be sufficient to generate the profits needed to build up the required level of capital. On the other hand, the HLEG proposal would not separate more activities than mandated, and this might be the voluntary outcome in some banks. It would also be very important to ensure that capital requirements are aligned globally to ensure the level playing field of banks. Now ICB proposal will set the UK banks and foreign subsidiaries in a disadvantaged position in comparison to foreign banks’ non-subsidiary operations in the UK and with non-UK banks which can provide UK customers with financing elsewhere. Finally, I would like to highlight the importance of sufficient loss absorption capacity across business areas. As highlighted in recent work by Anat Admati and Martin Hellwig, imposing higher capital requirements has a positive impact on bank incentives and behaviour. Among other things, well-capitalised banks maintain their lending also during downturns.

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Proprietary trading and market making – is the question whether they are separable or whether they should be separated? The first argument for the approach taken by HLEG is based on the desired scope of the safety net. – It is important to note that in the proposed separation, the question is not whether certain type of market making supports the real economy or not; as a starting point, all banking activities support the real economy. Instead, the question is whether there is a market failure of some degree in certain banking activities so that those activities need to be publicly supported by giving them access to insured deposits as a funding base. I.e., is it so that market making cannot be carried out in a profitable manner without cheap funding from deposit taking? If that is the case, then it means that market making is cross-subsidized. – To draw on a recent comment by Darrell Duffie “the more limited the types of risks that are legally permitted by those within the safety net, the less opportunity for moral hazard” I would like to highlight the importance of ensuring that as small a fraction of banking activity as possible, preferably only the activities essential to the functioning of the society, i.e. the deposit taking, payment system, and perhaps lending to households and SMEs, ought to benefit from a government safety net. – When deciding what activities are allowed to be funded with insured deposits, there may of course be a question of level playing field between different jurisdictions. But that should be addressed via sufficient harmonisation of the structural measures taken, not by being too lax about extending the use of deposits. – In short, there appears to be no clear case that market making, excluding few exceptions, ought to benefit from explicit or implicit government guarantees.

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So, market making should not have access to insured deposits. The second argument underlying the HLEG proposal relates to whether it is possible to make the distinction between proprietary trading and market making. – From a regulatory and supervisory perspective it is very challenging to draw a clear line between proprietary trading and market making. E.g. in the US the implementation of the Volcker rule has been delayed as a result and when implemented the supervisors will have to rely on tedious transaction-by-transaction supervision. – In its pure form, market making is not about taking open positions and the price spreads given re very narrow. Only when things do not go as planned inventory is building up and this is when we get closer to the territory of proprietary trading. – At the level of the trading floor, it is relatively easy to distinguish the proprietary trading and market making. – However, things can also be hidden if so desired, hence making the supervision potentially very difficult.

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Reflections on reputation and its consequences Speech by Ms Sarah Bloom Raskin, Member of the Board of Governors of the Federal Reserve System, at the 2013 Banking Outlook Conference, Federal Reserve Bank of Atlanta, Atlanta, Georgia Good afternoon. I want to thank the Federal Reserve Bank of Atlanta for inviting me to join you for today’s 2013 banking outlook discussion. There are a number of interesting and very relevant topics on your agenda, most of which are rightly focused on the financial and regulatory environment. I would like to share some thoughts this afternoon on a broader topic, however, that may be due for a refreshed look: the relevance of a bank’s reputation. Let’s start in an elementary way in constructing a concept of reputation: We know that reputation is not entirely a moral trait. We understand that there is a distinction between character and reputation. When we say that someone shows good character, we are usually referring to something at the core of their being or personality. On the other hand, when we refer to a person’s reputation, we recognize that reputation is our perception of the person, that it is externally derived and not necessarily intrinsic to that individual. In other words, we understand that a person may not have complete control over the perception that has been created. Reputation, through no fault of one’s own, can be tarnished.

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In the same way, one’s reputation can be golden, even though nothing was done to earn it. But like the notion of character, reputation can be earned and it can be a type of stored value for when challenges to one’s own reputation come later. Now let’s bring this distinction into the context of banks: Many bankers have a sterling character, and they operate financial institutions with sterling reputations that reflect that basic character. At the same time, there are bankers who, regardless of their personal character, manage financial institutions with reputations that have been tarnished. Their banks’ reputations could have been tarnished by almost anything, but likely most tarnish is attributable to the subprime mortgage meltdown and the ensuing financial crisis that cost the economy trillions of dollars; left millions of Americans bankrupted, jobless, nderemployed, or homeless; triggered massive litigation; and shook the confidence of our nation to the core. Many of the darkest manifestations of the financial crisis have finally begun to diminish: the boarded-up homes with overgrown lawns, the half-built skyscrapers, the “We Buy Houses Cheap” signs planted at exit ramps, the eviction notices nailed to front doors. But even as the economy comes back to life, our memory of these events is still sharp and the reputational damage suffered by U.S. financial institutions during the crisis endures. To be blunt, a lot of people have negative feelings about banks, which they distrust and blame for the huge infusions of taxpayer money into the financial system that were deemed necessary during the crisis. These reputational consequences – whether justified or not – are to be expected.

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Sociologists and economists have long remarked upon the central role that social trust plays in healthy markets. Market transactions depend on a whole series of assumptions that people must be able to rely on, including the soundness of money, the enforceability of contracts, the good will of their partners, the integrity of the legal system, and the common meanings of language. Social trust is the glue that holds markets and societies together. In the context of banking, social trust and reputation are related concepts. Banks themselves – in crisis or not – are particularly vulnerable to reputational consequences because of their public role. The principal social value of financial institutions is their ability to facilitate the efficient deployment of funds held by investors (and entities that pool these funds) to productive uses. This value is maximized when the cost to the entity putting capital to work is close to the price demanded by the entity that seeks a return on its investment. In traditional banking, this means that financial intermediation occurs most effectively when the interest rate charged for use of funds in lending is close to the interest rate paid for deposits. As the difference between the two grows (which would be attributable to amounts extracted by intermediaries as compensation for essential intermediation), the costs of borrowing for the purposes of creating productive projects become higher than they should be, with arguably negative reputational consequences. Given these particular reputational dimensions associated with financial institutions, might financial regulators have an interest in considering reputational harms analytically?

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Could there be benefits to understanding the ways that an individual financial institution’s reputation – or that of the financial industry as a whole – might have particular effects on, for example, safety and soundness, financial inclusion, or financial innovation? In my remarks today, I want to consider various aspects of how reputational harm manifests itself in banks and begin a dialogue with you about how we might refresh our thinking about this category of risk. I will start with a description of some factors that can affect a bank’s reputation, especially in the wake of the financial crisis. Next, I will talk about ways in which reputation matters, including how supervisors can use their unique ability to see inside the institutions that they examine to uncover some early indicators of reputational problems. I will then turn to other reasons why policymakers may want to think about reputation. One reason involves possible consequences regarding financial inclusion; that is, a customer’s ability to have a relationship with his or her bank that puts them in the position to save, access credit in a sustainable way, and understand the nature of the financial transactions in which they participate. Reputation also may help or hinder a bank’s ability to innovate, so I will introduce this topic next. Finally, I want to frame a discussion around the recent cybersecurity threats that banks are facing and place them in the context of reputational risk so that they too can be discussed constructively. Of course, I preface these remarks with the admonition that these views are my own and may not be representative of those of the Federal Reserve Board.

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The financial crisis and the reputation of financial institutions It has been more than five years since this country began experiencing a financial crisis that reverberated well beyond Wall Street. This crisis was unique, and many of its marks on individuals and communities remain. It was a crisis in which significant numbers of both subprime and prime mortgage defaults quickly spread across whole cities and regions until the impact was felt throughout the country. The devastation was magnified by waves of foreclosures, significant drops in house values, job losses, and, ultimately, significant reductions in household wealth, which have been responsible, in part, for the slow recovery we confront today. The causes of the crisis and the subsequent devastation are myriad, but to large swaths of the American public who have experienced the devastation, the causes rest squarely on the shoulders of financial institutions, especially the largest institutions. Further, many Americans direct their anger at not only banks, but policymakers as well. Because the economy pulled back from the brink of depression only through a massive and unprecedented infusion of public dollars, American taxpayers feel that they were forced into a position of accepting that the government had to put a lot on the line to save the financial system from ruin. And many of those taxpayers are still unhappy about such a massive government intervention that seemed to aid banks that were not held to account, while distressed households were left to pay the price. Unfortunately, in the public’s view, little has happened to restore their trust and confidence in financial institutions.

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Since the crisis, the public’s views of banks have been informed – for better or worse – by their experiences and those of their families and neighbors, who may have lost their homes, their jobs, or their household wealth. Many attempted unsuccessfully to modify their underwater mortgages, even when they were current on their payments. Against this backdrop, the public’s lack of trust and confidence has been magnified by, among other things, the Occupy Wall Street movement, payday loans, overdraft fees, raterigging settlements in London Interbank Offered Rate (LIBOR) cases, executive compensation and bonuses that seem to bear no relationship to performance or risk, failures in the foreclosure process, and a drumbeat of civil litigation. In the Internet age, the impact of consumer distrust is amplified: anyone can easily, cheaply, and anonymously create, organize, and participate in a protest. Participants do not have to gather physically to make their action felt. A recent survey found that • 60 percent of American adults use social media, such as Facebook or Twitter, and • 66 percent of those social media users (39 percent of all American adults) have used social media to engage on civic and political issues, including by encouraging other people to take action on a political or social issue. Take, for example, the impact of the consumer backlash that erupted in late 2011 when one of the nation’s largest banks attempted to charge a $5 monthly fee for its debit card. A California woman, frustrated with the bank’s decision to impose the fee, created a Facebook event, dubbed “Bank Transfer Day,” and invited her friends to join her in transferring their money from large banks to credit unions on that day.

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In the five weeks leading up to Bank Transfer Day, this Facebook event received extensive press coverage and resulted in billions of dollars in deposits reportedly shifting out of large banks. The bank targeted by the Facebook protest ultimately reversed itself and declined to assess the monthly fee.

How reputational risk may be relevant Financial institutions of all sizes have shared in the fall-out – fairly or unfairly – from a general decline in their industry’s reputation among the public. Moreover, the steady stream of litigation against financial institutions since the crisis has further harmed the reputations of specific firms among their customers. Consider that in today’s financial institution sector, a substantial portion of a bank’s enterprise value comes from intangible assets such as brand recognition and customer loyalty that may not appear on the balance sheet but are nevertheless critical to the bank’s success. Also consider that at the end of 2012, deposits at commercial banks reached a record $10 trillion. At the same time, the share of each deposit dollar that banks lent out hit a post-financial crisis low in the third quarter, which means that banks’ net interest margins have fallen sharply. Across the industry, loan-to-deposit ratios are going down. In 2007, banks’ aggregate loan-to-deposit ratio was 91 percent. This ratio currently stands at 70 percent. In such a context, achieving higher earnings is a challenge.

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If bank profitability is going to improve in a context of low interest rates and higher compliance costs, lending income may remain low. Profits will need to come from elsewhere. One source of profits would be products that are not interest-rate dependent, but fee-dependent. In other words, compressed net interest margins mean that many banks may look to new fee-generating products and trading activity to enhance profits. The pressure to generate enhanced profits through high fees is palpable, and banks may choose to move aggressively down these paths. But when a bank already suffers from a poor reputation – either deservedly or as a knock-on effect of broader discontent with the financial industry – it likely will face difficulties in introducing new fee-generating products or activities without inviting further criticism and damage to its reputation. So an evaluation of the effects of the new product or activity on the bank’s reputation prior to launch is arguably necessary.

Reputational risk and supervision The effects of the financial crisis, combined with the power of the Internet to broadly and quickly publicize information – whether factually accurate or not – should alert banks to how they are managing their reputations. And supervisors have a duty to see that all risks are fully understood, even those risks that, like reputational risk, are unquantifiable or have not fully emerged. I believe this is an area where supervision can add value.

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To the extent possible, supervision can unveil hidden loss exposures that may be building up through the accumulation of reputational risk elements. If we were better able to identify and monitor such free-floating risk, and in so doing, to push bank boards of directors and senior management to pay more attention to reputational risk, we could help reduce the underpricing of these risks. Many have argued, and I think it’s a compelling argument, that ineffective supervision and enforcement of existing laws and regulations contributed to the financial crisis. By tolerating reduced transparency of risk in balance sheets and in complex institutional portfolios, as well as arbitrage around capital requirements and other prudential measures, supervision may have encouraged the underpricing of risk. And the sudden correction of this underpricing of risk, in turn, accelerated the crisis. The crisis punished investors who accepted more risk than they thought they had taken on, it punished consumers who overleveraged themselves, it punished Americans who lost their jobs and homes, and it contributed to the decline of once-vibrant neighborhoods and towns. To mitigate the chances of such a crisis occurring again, supervisors need to redouble their efforts toward promoting greater transparency of risks and early confrontation of potential loss exposures. We should view these efforts as a set of responsibilities for both banks and regulators that are aligned to assure the public and markets that risks can be fully understood and accurately estimated and priced. In some ways, this perspective is not new territory for bank regulators.

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The Federal Reserve, for example, issued supervisory guidance in 1995 that identified the six primary risks that remain the focus of its supervisory program, and reputational risk is among them. Having said that, it is still a risk that both banks and supervisors should learn how to identify ex ante rather than ex post. So, while reputational risk is not a new concept by any means, it is an area that is ripe for additional work. For example, the enterprise risk management framework of the Committee of Sponsoring Organizations of the Treadway Commission – the so-called “COSO standard” – does not address reputational risk. Likewise, the Basel capital frameworks exclude reputational risks from regulatory capital requirements. Accordingly, the current approach to managing reputational risk is largely reactive rather than proactive. Banks and examiners tend to focus their energies on handling the threats to their reputations that have already surfaced. This is not risk management; it is crisis management – a reactive approach aimed at limiting the damage. Instead, we should think about a supervisory approach that incentivizes bank managers to sufficiently contemplate, quantify if necessary, and control the factors that affect the level of such risks before they fully emerge in an unmitigated form. The way that the Federal Reserve supervises banking organizations may help identify risks sooner. For all banking organizations, the supervisory program here does not simply rely on an annual onsite examination.

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The Federal Reserve supplements its regular examination activities with a program of continuous monitoring between examinations. One of the key objectives of this program is to identify emerging risks and communicate with other regulators and the banks an updated risk assessment and supervisory strategy based on these risks. When we contemplate a supervisory approach that illuminates reputational risk, we might be able to more fully uncover the interconnection of risks that certain activities could impose on investors, creditors, counterparties, and taxpayers. In this approach, we would first and foremost need to encourage banks to assess the potential riskiness of particular operations, investments, products, and decisions to their reputations and, ultimately, to their enterprise value. As supervisors, one objective as we work with financial institutions to extract such information would be to try to develop ways of measuring the value of the risks that banks shift onto the financial safety net.

Reputation and financial inclusion There is also a relationship between reputation and financial inclusion, by which I mean the extent to which consumers can participate in a financial marketplace that consists of competitive providers of credit, savings vehicles, and sources of enabling financial information. As policymakers, we must address the perceived trustworthiness of those financial institutions that interact with the public and move the millions of Americans lingering in the margins of the financial marketplace into relationships that provide them with sustainable access to banking and credit, an understanding of how mortgages and credit work, and an understanding of how to create savings. Data from the Federal Reserve’s Survey of Consumer Finances and the Federal Deposit Insurance Corporation’s survey of the unbanked and underbanked show that the percentage of families earning $15,000 per

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year or less who reported that they have no bank account has been increasing steadily for the past five years, resulting in more than 28 percent of these families being unbanked as of 2011. Families slightly further up the income distribution scale, earning between $15,000 and $30,000 per year, are also financially marginalized: 12 percent reported being unbanked and almost 26 percent reported being underbanked in 2011. There are several potential reasons for these impediments to inclusion. When we examine barriers that individual consumers face in becoming financially included, we uncover trustworthiness and reputation. A Federal Reserve analysis of the most recent Survey of Consumer Finances suggests that the primary reason individuals do not have a transaction account is a simple dislike of dealing with financial institutions. If that dislike emanates from the reputation of the particular bank, or the reputation of the banking industry as a whole, policymakers and financial institutions will not be able to enhance financial inclusion without addressing the reputational context.

Reputation and innovation I’d like to imagine how the public’s sense of well-being might be enhanced by their interactions with financial institutions. If we paid attention to the experiences of consumers as they interact with various segments of the financial marketplace, what could we learn? If we see rigidities or imperfections in that interactive experience, what innovation might we imagine that would not only reduce reputational risk but create something new and potentially advantageous? Technological innovation was the subject of a recent award ceremony in San Francisco.

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The winners were companies with names like SoundCloud, GitHub, MakerBot, Techmeme, and Snapchat, all of which presumably do amazing things, although I don’t understand exactly what. But, evidently, the real buzz at the ceremony was over something much more mundane that I for one have no problem understanding. That buzz was around a pedestrian item – a new and improved coffee cup lid. This lid, called FoamAroma, reportedly provides exactly the right set of openings to maximize aroma and recyclability, while minimizing the effects of coffee spurting out too fast. The point here is that the innovator noticed something simple that others had not: many coffee shop employees don’t drink their coffee from cups with plastic lids like their customers do, so there was a market need that had not been recognized and then addressed. Here I am not just talking about the mixed miracle of mobile banking and mobile payments or being able to take a picture of a check with a smart phone and it appearing in my checking account. That’s a topic that is amazing in its own right and worthy of a separate speech. I am talking about encouraging banks to pay attention to the banking experiences of their customers and finding process improvements or service elements that may lead to something seemingly mundane but valuable nonetheless. Some innovators see reputation itself as not just something to be managed, but as a product in and of itself. With buyers and sellers repeatedly and constantly interacting on the Internet, there are “reputation trails” that are being created that, when compiled, give an alternative set of markers about how trustworthy a particular buyer or seller may be.

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These reputation trails – gathered when you evaluate a product you’ve bought online or when you deliver the product that you’ve promised – create a picture of trust that some have argued has value that can be shaped.

Reputational risks and cybersecurity Perhaps reputation will one day transform commerce. But in the meantime, I would like to mention one set of reputational issues that the banking industry is confronting as we speak. As is the case for reputation trails, it too involves the Internet, but this use of the Internet is not being done in the spirit of cooperation and enhancement of public trust. This set of reputational issues comes in response to the recent substantial increase in cyberattacks, all of which have the potential to undermine the fundamental trust that the public puts into financial institutions. Cyberattacks on banks are occurring with increasing frequency, and concerted cooperative work between government and financial institutions is underway. Customers are increasingly being affected by the cybersecurity threats that banks face. Recently, distributed denial-of-service attacks have caused temporary disruptions of some web services. In September, the websites of several large banks were rendered inaccessible for several hours from attacks now attributed to possible foreign state-sponsored hackers. One of the greatest threats facing not just banks but many businesses and government agencies is hacking – and the possible theft of proprietary data and personal information about customers.

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This cybersecurity threat is increasing at a time when more and more bank customers depend on electronic and mobile banking. Workers are using their own laptops and smart phones or working remotely from home computers, and this increases the entry points to the systems that need to be protected. In addition, customers and vendors are linking their systems, enhancing efficiency, but also creating more opportunities for potential intrusions. But even beyond the potential theft of data and disruption of service, cyberattacks can represent significant reputational risk because they have the potential to create dissatisfaction among many customers or, even more chilling, total loss of consumer confidence. Cooperative work between government and industry is underway. Through the Department of the Treasury, many of the affected institutions have requested and received technical assistance from the Department of Homeland Security, which has been helpful in mitigating the attacks. Some institutions are researching new technologies for defense against cyberattacks through their Internet service providers or security vendors, and others are reviewing their incident response processes to better manage recovery time and communications among information technology, employees, vendors, media, and customers. The Financial and Banking Information Infrastructure Committee, the Financial Services Information Sharing and Analysis Center, and the Financial Services Sector Coordinating Council are serving as the forum through which the financial services sector shares important information and develops critical infrastructure protection policies. Through their coordination, affected institutions and law enforcement agencies can share threat information and mitigation techniques.

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In addition, a recent Executive Order issued by the President represents a continued commitment to enhancing the security and resiliency of the nation’s critical infrastructure to meet future threats.

Conclusion In closing, these have been some of my reflections on reputation as it applies to the business of banks. The concept of trust is relevant to how bankers engage in a business that is of benefit to the public and provides meaningful innovation to the core function of financial intermediation, as well as to how we as supervisors can engage in a process of observation that is forward-looking and of benefit to both the public and the institutions that we regulate.

Thank you for your attention today. I look forward to taking your questions.

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Opinion of the European Insurance and Occupational Pensions Authority on Supervisory Response to a Prolonged Low Interest Rate Environment Introduction and Legal Basis 1. This Opinion is issued under the provisions of Article 29(1) (a) of Regulation (EU) No1094/2010 of the European Parliament and of the Council of 24 November 2010 (hereafter the ‘Regulation’). As established in this Article, EIOPA shall play an active role in building a common Union supervisory culture and consistent supervisory practices, as well as in ensuring uniform procedures and consistent approaches throughout the Union. 2. This Opinion is being issued in fulfilment of EIOPAs responsibilities to facilitate and coordinate supervisory actions under Article 18(1) and Article 31(e) of the ‘Regulation’. 3. The information gathering requirements in the Opinion are included under the provisions of Article 35 of the ‘Regulation’. 4. This Opinion is addressed to the national competent authorities represented in EIOPA’s Board of Supervisors. 5. The Opinion includes an appendix setting out key tasks for EIOPA and National Supervisory Authorities.

Context 6. The Japanese experience in the 1990s and early 2000s demonstrates both the plausibility of a prolonged period of low interest rates, as well as the impact of such a scenario.

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Many Japanese life insurers had built up substantial books of guaranteed business from the 1980s and were vulnerable to a prolonged period of low interest rates. The result was that between 1997 and 2001, seven Japanese firms failed and legislation was passed to allow insurers to alter guaranteed rates on policies where they face a high probability of bankruptcy. 7. EIOPA has been highlighting for some time the potential solvency risks arising from a prolonged period of low interest rates. In 2011 EIOPA carried out a stress test including a “low yield scenario” to assess the effects on the EU insurance sector of a prolonged period of low interest rates/yields. Two scenarios involving different profiles for yields were tested. The exercise concluded that “5% to 10% of the included companies would face severe problems, in the sense that their MCR ratio would fall below 100%. In addition, an increased number of companies would observe that their capital position would deteriorate with MCR rates only slightly above the 100% mark, whereby they could become vulnerable to other potential external shocks.” It is also highlighted in the recently published EIOPA Risk Dashboard as a significant risk identified by national supervisory authorities. 8. The EIOPA Financial Stability Report for the second half of 2012 highlights the complex and uncertain financial and economic situation facing European insurers. EIOPA has focused to date on insurers but the low interest rate environment is also having an impact on occupational pension funds. EIOPA plans to explore this more fully during the course of 2013.

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9. On one hand, weak economic conditions across the European economy imply that monetary conditions in the EU are likely to remain adaptable to the prevailing economic environment. This is reflected in the official interest rates in Europe that remain at low levels and on a downward trend. On the other hand, European government bond yields continue to be divergent with some countries experiencing negative real yields at some maturities due to a flight to quality, while others are experiencing highly positive real yields across most maturities reflecting creditworthiness concerns and other uncertainties. 10. Long term interest rates are of critical importance to life insurers, since these institutions typically have long-run obligations to policyholders that become more expensive in today’s terms when market rates are low. Consequently, the financial position of these firms typically deteriorates under such conditions, in particular where the duration of liabilities exceeds that of assets. This problem is even more pronounced where guaranteed rates of return have been offered to policyholders. 11. A prolonged period of low interest rates may also have an adverse impact on non-life insurers pursuing a business model where investment returns are used to compensate for weak underwriting results. In some cases, buoyant investment returns have facilitated intense price competition for market share with some firms operating with technical underwriting losses. If underlying insurance business is being supported by investment returns this business model will be challenged by a prolonged low yield environment if no management action is taken to change the business model.

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12. Non-life insurers may also be affected in a situation where low yields do not provide sufficient returns to counteract the effects of inflation on longer tailed business. This is a more difficult situation, since it requires inflation hedging over a long maturity. 13. The precise timing of when the effects of a prolonged low interest rate environment would manifest themselves on insurers’ balance sheets depends on the accounting methodology in use, as well as the business lines being written. 14. If market value is in use, the impact is very rapid since any decline in benchmark interest rates is reflected in the discount rate applied to liabilities. This effect being amplified where the duration of liabilities is greater than that of assets. The outcome is that available assets to cover solvency are eroded. A relatively small number of EU jurisdictions utilise market value in insurance at present and they have already felt the impact of low interest rates. 15. If historic cost accounting is used then the impact on an insurer’s balance sheet appears more slowly since it emerges through lower profits or losses that are ultimately taken to the balance sheet. The fact that the effects of low interest rates are slow to emerge in balance sheet terms does not mean the problem is not there and there is a real risk that firms could build up hidden problems. This argues for the examination of a wider set of metrics when assessing the performance and condition of firms exposed to this risk.

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Examination of market value and historic cost accounting balance sheets can provide useful comparative information, while analysis of firms’ cashflows provides an insight into emerging imbalances. 16. In life insurance, guaranteed business is the most exposed to a prolonged period of low interest rates since there may be a “yield spread compression”. In this case, as assets are (re)invested the achievable spread between returns on assets and guaranteed rates shrinks. This reinvestment risk is the primary means by which the impact of low interest rates affects the financial position of firms in a historic cost accounting environment. 17. In terms of official solvency requirements, Solvency I is mainly based on historic cost accounting and is not a risk based framework. As a result, the potential solvency impact under Solvency I is limited and may take some time to emerge in terms of solvency cover. Nevertheless, some national supervisory authorities rate a prolonged low interest rate environment as an important risk for the insurance sector. 18. The implementation of Solvency II would see a move to market value and a risk based solvency requirement that would explicitly calculate the interest rate risk capital charge and would discount insurance liabilities using risk free rates as a basis. In this context, it is important that insurers do not store up risks that may crystalize suddenly with the implementation of Solvency II. Any delay in the full implementation of Solvency II should be used as a window for national supervisory authorities and insurers to deal with the issue.

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19. The impact of the current period of low interest rates has been felt in several European jurisdictions, where the national supervisory authorities have already taken a range of different measures to deal with the issue. 20. Internal research by EIOPA has highlighted the challenges faced by national supervisory authorities and individual insurers in responding to the risks posed by low interest rates. In terms of guaranteed business, there are no immediate options available in relation to existing business which must be addressed through more medium term measures, such as increased reserving. New business, on the other hand presents more options in terms of changes in product design to “de-risk” them or changes in the mix of business. Firms have already started to respond by utilising these options.

Taking the above into consideration, EIOPA recommends the following supervisory responses: Scoping the Challenges 21. National competent authorities, if they have not already done so, should actively assess for the insurance industry in their jurisdiction the potential scope and scale of the risks arising from low interest rates. National competent authorities should then report to EIOPA their findings regarding potential scope and scale of risks. 22. EIOPA would coordinate a further exercise to assess the conditions that would be required for significant adverse solvency and/or systemic stability problems to arise, as well as to estimate when such problems would arise.

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23. National competent authorities should intensify the monitoring and supervision of insurance undertakings identified as having greater exposure to the risks posed by a low interest rate environment. This should follow a clear escalation of supervisory activity dependent on the situation of the individual firm being considered.

Promoting Private Sector Solutions 24. Unsustainable business models in particular should face challenge from supervisors at an early stage and it is expected that insurance undertakings should be encouraged to resolve their own problems. Even in those countries where the capital impact of low interest rates has already been recognized through market-consistent accounting, a threat to business models still exists. Persistent low interest rates may damage the underlying value proposition of insurers, resulting in a downward pressure on sales and consequently pressures on expense ratios. Additionally low interest rates may encourage other business model changes such as alterations in asset allocations in a “search for yield”, which may create new risks on the asset side of the balance sheet. 25. National competent authorities should actively engage with insurance undertakings in exploring private sector measures to address the risks raised by a prolonged period of low interest rates. They should take into consideration the maintenance of the stability of firms and policyholder interests in this engagement. In particular, they should consider the balance of risk exposure between insurance undertaking and policyholders. This effort should cover both “in-force” business (policies already written) and new business.

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26. National supervisory authorities should explore with insurance undertakings measures to improve undertakings’ own financial resilience. This is especially important in relation to “in-force” business, where measures such as increased reserving are likely to be the only options. In terms of new business, if product redesign is not being considered, then national supervisory authorities should explore what measures firms would take to ensure their financial resilience. 27. National supervisory authorities should explore with insurance undertakings the other measures that could be taken regarding new contracts. Such measures might include adaptation product designs in such a way as to address the risks arising from low interest rates. The latter could include a de-risking of products or measures to increase their flexibility.

Supervisory Action 28. If national competent authorities have taken or are considering taking measures that would be applied to all firms in their jurisdiction facing these risks, EIOPA recommends that such measures should incorporate, as appropriate, conditionality and exit features if needed. It is expected that conditionality would set out clear criteria for availing of the measures being offered. Equally, there should be clear exit criteria for the cessation of such market wide measures, if feasible. 29. If national competent authorities are considering taking market-wide measures then they should notify EIOPA and its Members of this intention.

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This will allow better coordination of measures across jurisdictions in terms of timing and broad design. Discussion of proposed measures with EIOPA Member authorities that have already taken such action would also help to improve policy design. 30. EIOPA would engage in a follow-up exercise with Members in 2014 to explore what actions have been taken in light of this Opinion. A formal report would be prepared for consideration at the EIOPA Board of Supervisors. This opinion and its Appendix (Summary of recommended Key Tasks and Deliverables) will be published on EIOPA’s website. Done at Frankfurt am Main, 28 February 2013 [signed] Gabriel Bernardino Chairperson For the Board of Supervisors

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Appendix – Summary of recommended Key Tasks and Deliverables National Supervisory Authorities (NSAs) 1. NSAs to carry out a coordinated exercise to quantify the scale and scope of the risks arising from a prolonged low interest rate environment (coordination by EIOPA – see below point 2). 2. To intensify the monitoring and supervision of insurers identified as facing greater exposure to the risks posed by a prolonged low interest rate environment. 3. To engage with insurers to explore private sector measures to address the impact of low interest rates that balance both financial stability and policyholder interests. This would include exploration of actions that firms could take to improve their financial resilience. In particular, NSAs would actively challenge business models that are identified as being unsustainable and to encourage insurers to take appropriate actions. 4. To explore measures to “de-risk” new business and also measures related to “in-force” business to improve financial resilience. 5. To report progress in these areas to EIOPA, preferably, on a half yearly basis and to participate in an EIOPA coordinated stocktake in 2014. 6. Where NSAs are planning to, or are about to, take supervisory action, to notify EIOPA and its Members. EIOPA 1. To develop with NSAs an agreed framework for the quantitative assessment of the scope and scale of the risks posed by a prolonged low interest rate environment.

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2. To coordinate the exercise described above under point 1 and collate results for reflection back to NSAs. 3. To develop a reporting template for NSAs to report on a –preferably– half yearly basis progress in supervisory interaction with firms on this subject. EIOPA will work with NSAs to agree details of the information to be reported, so that this can be effectively collated, analysed, and reflected back to NSAs. 4. To undertake a stocktaking exercise in 2014 to assess progress in dealing with the impact of a prolonged period of low interest rates.

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Investigations by the Financial Supervisory Authority into issues connected with the banking collapse have now concluded Investigations by the Financial Supervisory Authority (FME) into the events preceding the banking collapse in the autumn of 2008, which began immediately following the failure of the three large commercial banks, have now concluded. FME investigated a total of 205 cases. Complaints concerning 66 of these cases have been lodged with the economic crime division of the National Commissioner of Police or the Office of the Special Prosecutor (OSP). Furthermore, 37 cases of alleged violations of the General Penal Code have been referred to the Office of the Special Prosecutor, making a total of 103 cases referred for further action.

Individual cases may result in complaints concerning a number of different statutory provisions of the Act on Securities Transactions and Act on Financial Undertakings.

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Furthermore, many complaints have included alleged breach of fiduciary duty. The number of alleged offences is thus higher than the number of cases which have been referred onwards or complaints lodged. Investigations have revealed alleged violations in numerous categories of economic crime. The most prominent, however, are market abuse, violations of rules on large exposures, insider trading and breach of fiduciary duty. The most extensive cases involve alleged market abuse and breach of fiduciary duty. FME wishes to point out, however, that violations concerning large exposures can also be very extensive, involve significantly large amounts and thereby contribute to undermining the financial stability of the banking system. The figure below shows examples of the types of offences, but is not an exhaustive summary.

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Immediately following the collapse, investigations began by FME with the assistance of external experts. When it became clear that the extent of the investigations would be very considerable, FME requested additional budget allocations to ensure it would be possible to handle this large and important project professionally and with sufficient force. In recent years as many as 15 experts have been working concurrently on investigations within FME with qualifications in business administration, law, engineering and economics. The investigation was split between two teams, showing special regard for employees' eligibility. At least one investigator and one attorney worked on each investigation. The investigating teams placed strong emphasis on working professionally and with integrity. They aimed at gathering sufficient data to shed as clear a light as possible on the series of events being investigated and based their decision concerning the outcome of the case on the relevant data. Substantial expertise and experience in investigating economic crime has been accumulated by FME in the past few years, making the Authority well prepared to deal with demanding tasks in this area in the future. Furthermore, comments and suggestions received by FME from external parties, including regulated entities, institutions, undertakings and individuals, have increased in number.

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A very interesting presentation

Icelands pre- and post-crisis experience

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SECURITIES AND EXCHANGE COMMISSION Notice of Filing of Proposed Rule Change to Require that Listed Companies Have an Internal Audit Function Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) and Rule 19b-4 thereunder, notice is hereby given that on February 20, 2013, The NASDAQ Stock Market LLC (“Nasdaq” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by the Exchange. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change The Exchange proposes to require that listed companies establish and maintain an internal audit function. The text of the proposed rule change is below. Proposed new language is in italics.

Internal Audit Function Each Company must establish and maintain an internal audit function to provide management and the audit committee with ongoing assessments of the Company’s risk management processes and system of internal control. The Company may choose to outsource this function to a third party service provider other than its independent auditor.

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The audit committee must meet periodically with the internal auditors (or other personnel responsible for this function) and assist the Board in its oversight of the performance of this function. The audit committee should also discuss with the outside auditor the responsibilities, budget and staffing of the internal audit function. A Company listed on Nasdaq on or before June 30, 2013, must establish an internal audit function by no later than December 31, 2013. A Company listed after June 30, 2013, must establish an internal audit function prior to listing. II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, the Exchange included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. The Exchange has prepared summaries, set forth in Sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose Nasdaq proposes to adopt a new rule to require all listed companies to establish and maintain an internal audit function. The purpose of the rule is to ensure that listed companies have a mechanism in place to regularly review and assess their system of internal control and, thereby, to identify any weaknesses and develop appropriate remedial measures.

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The rule is also intended to make sure that the listed company’s management and audit committee are provided with ongoing information about risk management processes and the system of internal control. Nasdaq also believes that the rule will assist listed companies’ efforts to comply with their obligations under federal securities law, including but not limited to Rules 13a-15 and 15d-15 under the Act, which require most companies to maintain and to evaluate, with the participation of their principal executive and principal financial officers, or persons performing similar functions, the effectiveness of the internal control over financial reporting. To preserve flexibility, listed companies may choose to outsource this function to a third party service provider other than their independent auditor. However, in all instances, the audit committee has sole responsibility to oversee the internal audit function and cannot allocate or delegate this responsibility to another board committee. Finally, while Nasdaq believes that, consistent with best practices, many listed companies have already established and implemented an internal audit function, to allow sufficient time for companies that have not yet done so, each company listed on Nasdaq on or before June 30, 2013, will be required to establish an internal audit function by no later than December 31, 2013. Companies listed after June 30, 2013, will be required to establish an internal audit function prior to listing. 2. Statutory Basis Nasdaq believes that the proposed rule change is consistent with the provisions of Section 6 of the Act, in general and with Section 6(b)(5) of the Act, in particular in that it is designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in

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regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest. The proposed rule change will require listed companies to establish and maintain an internal audit function. It is intended to ensure that listed companies have a mechanism in place to regularly review and assess their system of internal control and, thereby, to identify any weaknesses and develop appropriate remedial measures. It is also intended to make sure that management and the audit committee are provided with ongoing information about the company’s risk management processes and system of internal control. As such, it is designed to protect investors and the public interest. B. Self-Regulatory Organization’s Statement on Burden on Competition Nasdaq does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act, as amended. In this regard, Nasdaq notes that the competition among exchanges for listings is robust and vigorous, and the proposed rule change is not intended, nor is it expected, to reduce or diminish such competition. C. Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received from Members, Participants, or Others Written comments were neither solicited nor received. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

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Within 45 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the Exchange consents, the Commission shall: (a) by order approve or disapprove such proposed rule change, or (b) institute proceedings to determine whether the proposed rule change should be disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act.

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The European crisis and the development of the European Union Speech by Mr Lars Rohde, Governor of the National Bank of Denmark, at the European Affairs Committee’s consultation: “The European crisis and the development of the European Union”, former Upper Chamber of the Danish Parliament, Copenhagen Thank you for inviting me to speak here today. The EU member states have been severely affected by the financial crisis and then the sovereign debt crisis. The recession is now in its fifth year. Many measures have been taken to contain the crisis, and more are in the pipeline. Being a small, open economy, Denmark is highly vulnerable to developments in the EU. We participate in many community efforts, but not in the monetary union. We have opted out, but at the same time the krone is tied closely to the euro. The purpose of keeping the krone stable against the euro is to avoid exchange-rate uncertainty – which is very important to an economy such as the Danish one, with exports accounting for almost half of the gross

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domestic product. At the same time, inflation and inflation expectations are anchored to an area pursuing stability-oriented economic policies with low and stable inflation. The fixed exchange-rate policy means that fiscal policy is the instrument at our disposal to stabilise the economy. This arrangement has served us well for 30 years. Denmark’s economic policy enjoys considerable credibility – also in the financial markets. This is why we have for some time been – and indeed, we are still – seen as a safe haven for international investors. This has resulted in historically low interest rates. Despite the most recent increase, Danmarks Nationalbank’s deposit rate is still negative. The low level of interest rates has mitigated the real economic consequences of the financial crisis. But at some point interest rates will normalise. The stability of the anchor currency – i.e. of the euro area – is important to the Danish economy. The political system in a non-euro area EU member state such as Denmark must perform a balancing act – how far should we go in terms of participation? This question was topical in relation to the issue of closer fiscal cooperation, as it is in the current process towards a banking union.

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In the early 1990s, the European foreign-exchange market came under strong speculative pressure and one currency after the other came under attack. The crisis culminated in 1993 with speculation against the Exchange-Rate Mechanism, ERM, existing at the time. Some 20 years down the line, the financial crisis and sovereign debt crisis in certain European countries have once again put the European economic cooperation under pressure. The most recent crisis has differed from the situation in the early 1990s when each EU member state had its own currency. If national currencies had not been replaced by the euro in 1999, we could very well have seen an extensive currency crisis on top of the financial crisis and the sovereign debt crisis. For the euro area, the euro has prevented this. The Danish krone, on the other hand, was hit by short-term currency unrest in the autumn of 2008, as were other small currencies. Subsequently, the sovereign debt crisis has, from time to time, led to pressure on the krone, but this has been upward pressure due to large capital inflows. A fixed-exchange-rate system is not in itself an effective bulwark against irresponsible policies. The euro area sovereign debt crisis could very well have taken a far more dramatic path, leading to disorderly sovereign defaults, without the variety of pan-European initiatives to solve the sovereign debt crisis that were the result of the economic-political cooperation between the euro area member states.

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The introduction of the euro back at the turn of the millennium caused interest rates to drop markedly in many euro area member states, and yield spreads within the euro area were all but eliminated. But the interest-rate gains were not used for consolidation. Instead, they boosted domestic demand. As a result, competitiveness was eroded, and these member states saw increasing current-account imbalances. At the same time, housing bubbles emerged in several member states, and this later caused distress for the banks that had helped to fund property projects at inflated prices. The euro area systems for monitoring and addressing government deficits and other macroeconomic imbalances proved to be completely inadequate. This was one of the reasons why the imbalances were allowed to develop – and to become much more serious than they had been ahead of the crisis in the early 1990s. Furthermore, risk premiums on the government bonds of these member states were unsustainably low for a long period after the introduction of the euro. Hence market pressures for political action were correspondingly low. This changed abruptly when the financial crisis and sovereign debt crisis set in. Since many countries had failed to take advantage of the favourable economic climate in the early years of this century to consolidate public finances, their position was weak when the crisis struck.

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Still, most countries eased fiscal policy in 2009 as part of concerted European efforts to offset the negative impact of the crisis on growth and employment. This caused further deterioration of public finances, and for several euro area member states it led to an outright sovereign debt crisis. One reason was that the banks’ non- performing loans eventually became a problem for the public sector, thereby weighing down on government finances. In many countries, fiscal expansion during the boom immediately before the crisis has now made way for extensive consolidation. In other words, fiscal policy has amplified cyclical fluctuations instead of dampening them. Therefore, the lesson to us all – from the ERM crisis in the early 1990s and recent years’ financial crisis and sovereign debt crisis – is that it is important to address macroeconomic imbalances in time to prevent systemic risk. The financial crisis and the sovereign debt crisis revealed a clear need to strengthen political cooperation between euro area member states. The most recent crisis has exposed at least two fundamental weaknesses in the EU’s economic cooperation. Firstly, the pressure for budgetary discipline was not strong enough. Secondly, the one-sided focus on fiscal policy was too narrow. A comprehensive view of the member states’ economic situation is required. It is also evident that price stability alone is not sufficient to ensure financial stability.

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In recent years, the EU member states have adopted a series of new rules aimed at addressing these weaknesses, including the Fiscal Compact, which tightens the requirements for fiscal discipline. In addition, the EU member states have adopted rules for surveillance of macroeconomic imbalances, under which the European Commission is to monitor whether a member state is building up excessive imbalances. There is now more focus on systemic risk, and a European Systemic Risk Board, ESRB, has been set up. In Denmark, we have introduced the Systemic Risk Council, whose members were appointed last Thursday. Although Denmark has, in many ways, navigated the financial crisis better than many other countries, we have generally had to learn the same economic policy lessons as others. In Denmark, too, fiscal policy in the pre-crisis years reinforced the boom rather than dampening it. Among other things, this led to higher wage inflation and weaker competitiveness. As a result of the procyclical fiscal policy, the downturn was more severe than it would otherwise have been. But the underlying fiscal policy was sounder than in the member states now experiencing problems. This is true both in terms of cyclical stabilisation and long-term fiscal sustainability, although we lost focus in the pre-crisis years. The conclusion to be drawn from developments in the 2000s, not only in Denmark but throughout the EU, is that if fiscal policy is procyclical in a boom, it will have to be procyclical also in the subsequent downturn. Obviously, this is not expedient.

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Denmark has chosen to adopt the Fiscal Compact as a framework for future fiscal policy. This has been reflected in a Budget Act with a more stringent sanctions regime vis-à-vis local and regional government – the levels at which it has, historically, been most difficult to observe budgets and agreements. Major steps have already been taken to strengthen economic cooperation in the EU with stronger budgetary discipline and increased macroeconomic surveillance, but all the same it is essential that there is still political will to ensure that the policies pursued have a strong medium-term orientation while also dampening, not amplifying cyclical fluctuations. It is important to observe the spirit as well as the letter of the common rules. This also applies in the event of a future banking union. *** The financial crisis was succeeded by a sovereign debt crisis in the EU. This has revealed close negative interaction between the economy and bank finances in a number of member states. To prevent the credit lending from collapsing, governments have had to use public funds to support the banking sector. At the same time, the sovereign debt crisis has made these governments more dependent on the banks, which buy up a large share of the domestic government bonds. Fiscal developments have raised concerns about these member states’ ability to continue to support the banking sector. This has had a negative impact on the banks’ access to funding and reinforced the tendency for banks to reduce their lending.

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Since lower lending volumes may further curb economic activity, the economic challenges become even greater. In the short term, the banking union represents an attempt to break the negative interaction between governments and banks. The vision behind the banking union is to prevent crises like the one seen in recent years and to mitigate the impact if a crisis should, nevertheless, arise. The aim is to shield developments in the financial sector from developments in public finances in individual member states – and vice versa – and increase financial stability. In the longer term, a banking union is to help support financial integration in the EU, and hence the single financial market. Vulnerable euro area member states are facing major challenges in relation to both public finances and the financial sector. A banking union does not necessarily address these challenges. The reforms required in these member states will undoubtedly be costly and have real economic implications. It is imperative to find a solution to existing challenges in vulnerable states and banks so as to bring them back on the right track without undue delay. Danmarks Nationalbank supports the overall vision for a banking union. A banking union makes good sense in an integrated financial market, where financial institutions are free to operate across national borders. The single market for financial services has contributed to strengthening competition and the supply of credit, to the benefit of both the Danish financial sector and its customers.

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Integration within the European financial sector increased until 2007, but has since the onset of the financial crisis been decreasing. Like the other EU member states, Denmark has an interest in a well-functioning single financial market. I see merit in the current discussions on the establishment of a banking union as a mechanism for supporting financial integration in the EU. Developing the individual elements of a banking union will be a huge task. If the vision is to be realised, the banking union must comprise at least three elements: (1) a single supervisory mechanism, (2) a single resolution mechanism for failing banks, and (3) a single deposit guarantee scheme. Initially, focus has been on establishing a single supervisory mechanism under the auspices of the European Central Bank in order to solve some of the problems currently faced by some European banks. The single supervisory mechanism is primarily aimed at euro area banks, but non-euro area member states may opt in. The framework conditions will differ, depending on whether the member state in question has adopted the euro. At present it looks as if non- euro area member states will be able to participate in the single supervisory mechanism on an equal footing with euro area member states. This is positive.

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The set-up with a single supervisory mechanism can enhance the credibility of financial supervision in the EU, especially in the euro area, and will contribute to financial stability, which will also be an advantage for the Danish economy – whether or not we decide to join. The Commission is expected to table proposals for the remaining elements of the banking union later this year. The content is as yet unknown, and it is difficult to predict the final set-up. The distribution of costs is a politically sensitive issue, not least in terms of whether legacy assets are to be included in the equation. The establishment of a strong single deposit guarantee scheme, and not least a credible single resolution mechanism with bail-in for failing banks, is essential if the EU is to succeed in containing the negative contagion from banks to governments in a future banking union. In Denmark we already have a credible resolution mechanism, and we have retained our AAA rating throughout the crisis. Both have served us well. All the same, it cannot be ruled out that Denmark’s independent resolution approach has increased the banks’ funding costs in the short term, so it is important to establish a single European framework for resolution of banks. The Danish banking sector is characterised by substantial cross-border activities among the largest banks. The consolidated assets of Danish banks amount to almost four times Denmark’s GDP. In addition, the ratio of the largest Danish bank's consolidated assets to GDP is among the highest in the EU. Due to the size of the banking sector and the high degree of concentration, a single European insurance scheme, as provided for by a

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banking union, will, other things being equal, be attractive from a Danish point of view. After all, insurance schemes work best when many equal policyholders share the burden. *** Overall, I believe that it would be an advantage for Denmark to participate in the banking union once the remaining two legs – the deposit guarantee scheme and the resolution mechanism – are in place. Therefore it is important to remain firmly seated at the negotiation table and contribute to ensuring a robust and effective set-up which Denmark may join if we choose to do so. If a credible framework is established for a banking union, and tax payers will not have to foot the bill when banks fail in the future, this will have a stabilising effect, not only within the euro area but also in other member states. As I see it, that is in itself a strong argument in favour of Danish participation in a banking union. Thank you for your attention.

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Promoting an inclusive financial sector in Pakistan Speech by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the Closure Ceremony of Term Sarmaya Certificate (TFC) issued by Tameer Microfinance Bank, Karachi Mr. Nadeem Hussain, President/CEO of Tameer Microfinance Bank Ladies and Gentlemen Good afternoon! It is a pleasure for me to witness the successful closure of the first ever Term Finance Certificate (TFC) issued by any microfinance bank in Pakistan. This is indeed a significant achievement for the microfinance industry and capital markets that has been made possible by collaborative efforts of the diverse stakeholders involved in such a complex transaction. As someone once said: “Coming together is a beginning, staying together is progress, and working together is success.” Therefore, I would like to congratulate Tameer Microfinance Bank, Standard Chartered Bank, IGI Investment Bank, JCR VIS, Karachi Stock Exchange, SECP, and my colleagues at SBP, for collaborating together to make this TFC issuance a success under the SBP’s Microfinance Credit Guarantee Facility. I sincerely hope that this first issuance of TFC by Tameer Bank would open up new funding avenues for microfinance providers and would give further impetus to our efforts in promoting an inclusive financial sector in the country, thereby enhancing the financial sector’s stability and viability in the long-run.

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The importance of financial services in the development of any economy cannot be overemphasized. There is no denial of the fact that access to finance has positive impact on economic growth as it promotes entrepreneurship, generates employment, fosters innovation, reduces poverty levels and enhances social equality. The financial sector in Pakistan remains restricted in its outreach both in terms of its depth and breadth. According to the Access to Finance Study of 2008, hardly 12% of the population has access to formal banking services and another 32% is informally served whereas 56% of the adult population is totally excluded. Similarly in Pakistan, the estimated size of the microfinance market is in the range of 25–30 million clients which indicates that the current level of microfinance access at 2.4 million clients is only 10% of the potential market. Financial Inclusion has progressively assumed greater priority in SBP’s financial sector development strategy. SBP is pursuing a multi-pronged approach to tackle the challenge of high financial exclusion in our country. In particular, SBP is aiming to develop an efficient and sustainable market-based financial structure meeting the financial needs of the marginalized population including women and young people. Let me be clear that the estimated microfinance market of 25–30 million clients may not necessarily just need credit services. It is of utmost importance that the industry should aim to provide holistic and appropriate financial services, including deposit, credit, insurance and remittance services. SBP is well aware of the fact that the industry is beset with a number of

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challenges in the way of achieving this high objective. SBP is actively engaged with all stakeholders to address the sector specific challenges in a sustainable manner. One of the fundamental challenges faced by microfinance providers is how to match the massive scarcity of funding to scale up microcredit services to the majority of the microfinance market. SBP had launched the Microfinance Credit Guarantee Facility (MCGF) to achieve this very objective through a sustainable market based mechanism. Prior to the MCGF launch in Dec 2008 and apart from one-off funding deals between the few MF providers and Commercial Banks, the commercial funding market was non-existent for microfinance providers. Therefore, the microfinance industry was severely handicapped and highly donor dependent for its funding needs. The MCGF was initially started with the help of the UK Department of International Development (DFID) grant amount of GBP 10 million which has been recently increased to GBP 15 million. The MCGF is a credit enhancement facility to attract long term commercial funding for microfinance providers. The objective of the facility is to incentivize commercial banks through a risk sharing mechanism to provide wholesale funds to microfinance banks and institutions for on-lending to the poor and marginalized groups. Recently, the scope of the facility has been enhanced to allow microfinance providers to mobilize non-bank financing from capital markets, further diversifying sources of financing for micro borrowers.

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It is heartening to see that a number of microfinance providers, including Tameer microfinance bank, while benefitting from the MCGF, has helped the facility to attain this objective. Let me briefly share with you that the facility has been instrumental in relaxing funding constraints of the microfinance sector in Pakistan: • So far, 25 guarantees have been issued under MCGF, mobilizing over Rs. 7 billion for 5 leading MF providers, enabling microcredit access to around 350,000 new micro borrowers. • The facility, due to its risk sharing structure has achieved a leverage of 3 times, mobilizing an additional Rs. 5 billion from private capital markets, establishing that microfinance may not be that risky as a business proposition, and • Most of all, the facility has engaged 16 commercial banks and recently retail investors in funding the microfinance providers. In doing so, the facility has accomplished the following key long-term development objectives: First, the Guarantee has helped build links between micro borrowers and Banks/DFIs. The familiarization of the Banks/DFIs with the client will eventually lead to mainstreaming and graduation of the micro borrower; Second, the facility has introduced microfinance business to Banks/DFIs as Banks have to evaluate the microfinance providers which must have helped them develop their own sense of the risks involved in microfinance. As a result, banks are now more willing to invest in micro banking; and Finally, and more importantly, the facility has helped microfinance providers to offer small ticket sizes for retail investors.

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This has offered small retail investors an alternate channel for investing their savings and earning relatively higher returns, encouraging the concept of micro-savings. I would like to conclude by saying that the MCGF has attained most of its developmental objectives. Moreover, I firmly believe that this TFC issuance will go a long way in diversifying funding for the microfinance sector. I strongly encourage all the financial market players to develop a long term vision for making the financial sector in Pakistan more inclusive. Thank you!

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Brief strategy for the revitalization of the Pakistani economy Speech by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the Pakistan Navy War College, Lahore Respected guests, esteemed servicemen, and students at this fine establishment, Assalamo-Alaikum! I’m glad that you could join us today and thank you for inviting me to introduce you, very briefly, to a strategy for the revitalization of the Pakistani economy. Our roles at the State Bank, and your roles in the armed forces, are not very different from each other. We are both tasked with guarding national interests and we both seek to actively mitigate threats – both from within our boundaries, and from the outside world. Today, I hope to be able to share with you, how we, at the central bank, guard and guide this economy towards a path of sustainable growth and stable prices. But before I go down that path, I would like to put some things in perspective here. For instance, I’d like to point out that we are not in the middle of an economic meltdown. In fact, we are not even close to being in an economic meltdown. That is why the topic of this lecture “A strategy to improve economic meltdown” may just have been a tad misleading. So yes, we certainly face challenges, but I assure you that they can hardly be categorized as a meltdown.

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Since we’re on the subject of economic catastrophes, I think it would be enlightening if we talk about a few countries that have seen their economies collapse in the past few years. Let’s start with Greece. Their latest unemployment rate is roughly 27 percent. That means that more than one in four people remain jobless. Let me reemphasize that: one out of every four individuals does not have a job! Can such a high unemployment rate be socially acceptable or sustainable? Of course not. That’s why the country was beset with riots, massive protests, political bickering and a very uncertain and bleak outlook. Youth unemployment in Greece is more than 50 percent. That means that more than half of the youth – the most productive part of any labor force – remains jobless. Can you imagine how demoralizing that is for new entrants into the workforce? If you throw this into the mix, you will have some very strong incentives for social unrest, with sharp rises in crime, hooliganism, and general despondency. It’s no surprise then that the suicide rate in the country has doubled in the past five years. 2013 will mark the sixth year of the Greek Depression.

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For six consecutive years, the economy has shrunk. The light at the end of the tunnel is a very, very long way off for Greece. That – ladies and gentlemen – is an economic meltdown. In fact, southern Europe has been teetering on the edge of an economic disaster for a while now. Their governments borrowed incredible sums of money when times were good in the first few years of the 21st century, and are now struggling to repay their debts. In some instances, their debts reached 200 percent of their GDP – twice the size of their entire economy’s output. It was fiscal irresponsibility at its worst. Pakistan’s national debt is 60 percent of its GDP – and that is an uncomfortable level for us. 200 percent, on the other hand, is a completely different ballgame. Now they have to balance their books once more and live within their means. And they’re discovering just how painful the process of deleveraging, or paying off their debts, can be. Their economies are facing serious difficulties, unemployment is very high, and the prospect of default looms large. Since their economies are so interconnected with the rest of Europe and indeed, with the rest of the world, they are threatening to plunge the entire world into a recession if their economic conditions deteriorate further.

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And if that happens, ladies and gentlemen, I will be inclined to believe that we are living in the middle of a global economic meltdown. At this point, let me walk you through a meltdown that happened quite recently in the largest economy in the world: the financial meltdown of 2008–2009 in the US. It started off with irresponsible lending by the banks, which was backed implicitly by the government, to individuals who wanted to buy property – and not just one. Investment banks then bought these loans from the banks that had originated them, and proceeded to create complex financial products anchored to these loans, which were then peddled to other investors. Some of those investors were pension funds, and state governments – funds that basically came from hardworking families’ taxes and savings. Such funds are only allowed to invest in riskless assets, ones which are considered as safe as possible. But most investors did not truly understand the nature of these products, and instead turned to rating agencies for assurance. Rating agencies, such as S&P and Moody’s, evaluate financial assets and rate them in terms of their riskiness. For reasons that should not be mentioned, these agencies decided that the toxic assets were of the highest quality, and least riskiness – equal to sovereign debt. All this while, the regulators had, more or less, gone to sleep. Eventually, they woke up to a very rude shock. Since the financial system was so interconnected, one ripple is all it needed to create a tidal wave in such an unstable scenario.

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Banks’ irresponsible lending meant that eventually, individuals defaulted on their mortgages. Once this cycle of defaults started, it spilled over from mortgage companies to investment banks. Of the five large investment banks in the US, one defaulted, two got sold, and two others had to be rescued by the government. The fear and panic that gripped the financial markets meant that banks were reluctant to lend to each other – markets froze completely. The regulators had to no choice but to step in, but a lot of the damage had already been done. The economy went into recession, and the next four years brought a flickering flame of economic growth – vulnerable to the next gust of wind that threatens to blow it out altogether. [Governor’s comments on the future of the US and the Euro, and their efforts to rekindle their economies after the financial meltdown…] Let me get back now to the Pakistani economy. The word that’s been used to describe our economy quite a few times has been “resilient”. I think it’s worth talking about how that word describes this economy. In 65 years, Pakistan has never gone through an episode of hyperinflation; Pakistan has never defaulted on its international and domestic debts; in fact, our economy has grown consistently, but not spectacularly, over the past six decades. Not many countries in the developing world can claim to have achieved all of that.

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This has been despite periods of international alienation and sanctions, three expensive wars, two hostile fronts, regular political upheaval, social unrest, sharp increases in the price of oil, and much, much more. However, it would be dishonest to say that the economy’s resilience is completely by design. Yes, regulation and strict oversight has had a part to play in it. And I’d like to briefly touch upon that here. The State Bank has always ensured that the financial system of the country remains safe and stable. We may not have always gotten things completely correct, but we have made sure that banks remain healthy and depositors’ money remains safe. We have managed to do this despite privatizing the banking system almost entirely. This means that capital is now allocated more efficiently, and private sector businesses can borrow freely for their requirements. I must add though that we are a little disappointed with the current risk aversion of the banks. The reforms process was initiated in the early 90s and focused on more private sector participation as financial intermediaries; developing a more robust regulatory framework; restructuring banks; and developing non-bank financial institutions (also known has NBFIs), as well as equity and bond markets, as alternatives to the banking system for both savers and borrowers. The financial sector was essentially given a completely new look during the course of that decade.

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The purpose of all these changes was to enhance competition and efficiency in the financial sector. That would mean that capital gets allocated into productive investment, which can drive future growth. Simultaneously, as banks became more efficient, savers could receive a better return on their deposits and borrowers could finance themselves at lower rates. The robustness of our financial system, is a direct consequence of the reforms process and the State Bank’s constant vigilance. There’s a lot that can be improved in our financial system – for instance, I would love to see the development of efficient debt markets, even better regulatory and reporting practices, and the broadening of the financial sector’s scope to include largely unbanked, such as agriculture, small and medium enterprises, and housing. Despite this wish-list, the fact remains that our financial system is, by design, secure and does not pose any threat to the economy as a whole. Now let’s turn to the features of this economy that have, helped the country become and remain resilient in the face of adversity. I believe that our social system in Pakistan influences why the economy remains resilient. Our family structure is a huge blessing in economic terms. Children take care of their parents, and that spares the state from the responsibility of taking care of the elderly and sick. Governments in developed economies are currently struggling to meet their social commitments, with healthcare costs surging for an aging population. Our social fabric also ensures that informal employment is always

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readily available in some shape or the other – relatives and family friends usually help out in providing the unemployed with some form of work, and the immediate family supports unemployed individuals financially. That spares the state from paying out unemployment benefits to such individuals. I believe that the nature of our society and the close relationships of a family-oriented society, is one of the primary reasons for Pakistan’s relatively low rate of unemployment and overall resilience to adverse conditions. I would like to clarify here that this resilience has come with a cost: the size of the informal sector. The size of Pakistan’s undocumented economy is, by some estimates, as large as the formal economy. The informal economy does not file taxes and, while it does absorb a significant chunk of the labor force, it also evades corporate and labor laws. Therefore, although close informal relationships do make the economy more resilient, they do so at a cost to the overall economy, by eroding the ambit of the regulators. Ideally, we, at the State Bank, would like to see a smaller informal economy, while society retains the structure that has made it so resilient. The second factor that has unintentionally helped the country’s resilience is the limited interconnectedness between the Pakistani and the global financial and economic system. Although the absence of such integration is by no means desirable, it has happened due to non-economic factors, and has insulated our domestic economy.

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It’s also the reason that our financial system and financial markets remain relatively sheltered from global events. Let me re-emphasize here, that greater integration with global markets is something that we should aspire towards. But that does not mean we should not have proper controls and mechanisms in place to safeguard our own interests. For instance, greater integration with financial markets will mean that capital will flow more quickly through our borders. It’s definitely something that will boost the national economy, but, as most East Asian countries learned in the 90s, it can be a double-edged sword. Therefore, having some capital controls in place, which reduce the volatility of capital flows, is a necessary regulation in this day and age. Personally, I believe the role of effective regulation only increases as the economy becomes more integrated and more market-oriented. Markets in themselves have no moral character. Inherently, they are neither good, nor evil. But they remain very powerful tools that distribute goods and services across the economy. Regulation is necessary because it gives markets a direction, and can govern them with a set of values, which markets do not possess innately. Less, but more effective regulation is the need of the hour for our own economy too. It’s an essential part of what is needed today to get the economy on a track for steady and sustainable growth.

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The government’s footprint in some sectors of the economy is very large, and quite negligible in other sectors. Such divergence is unhealthy. For instance, the government has a very large presence in our agriculture and energy markets. Those sectors are, in some ways, over-regulated. Too much regulation and red tape can breed incentives for the abuse of power, mismanagement and corruption. It also acts as a disincentive for the private sector. And we must remember here that it is always the private sector that functions as the engine of the economy. However, effective regulation is sorely lacking in other sectors. The tax machinery can be tightened considerably. One of the country’s most challenging problems today is the size of the fiscal deficit – and a large part of the solution lies in increasing our tax base by enacting regulation that encourages tax compliance, and punishes tax evasion. The link between better tax collection and faster economic growth deserves to be flushed out here. Better tax collection means that the government has to depend less on foreign support for its budgetary needs, and can decrease its fiscal deficit. More importantly, the government will not have to borrow as much from the domestic banking system to finance itself. Less borrowing from commercial banks will encourage market rates to fall and banks will lend more to the private sector.

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As investment picks up, the growth potential of the economy increases. Similarly, the government will need to borrow less money from the central bank as well. Borrowing from the central bank is popularly known as printing money. This is inflationary, and I don’t think I need to introduce you to the problems associated with high levels of inflation. If government borrowing from the central bank falls, inflation will follow suit. Therefore, better tax collection is a necessary condition for faster economic growth. And for that we need to have more effective tax regulation. Another problem that we desperately need to fix is our energy problem. It’s something that has been affecting every citizen of the state, and I don’t think that I need to highlight the scope of the problem here. Similarly, I think the effect on the economy of an energy shortage should be fairly straightforward: energy is one of the key inputs in any value-added production process. Less energy availability will translate into lower output. The solutions to the energy problem will take time – unfortunately, there is no magic pill here. We will need to invest in infrastructure for hydro-electricity, natural gas transportation and transmission, and more efficient power plants. Moreover, we will need to move to greater private sector participation in the energy sector.

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That means there will, once again, be a need for less, but more effective regulation – one that safeguards the rights of both producers and consumers, while ensuring adequate incentives for the exploitation of our natural resources The most important incentive here will be prices. Unfortunately, a large part of our energy problems today can be traced to a mispricing of fuels. Under-pricing any commodity will always lead to a shortage – that’s one of the fundamental axioms of economics. Letting the market decide the price is one way of ensuring that future shortages are averted. But remember that markets do not have morals – and that’s why we will need regulation to make sure that those markets serve and protect the interests of all stakeholders. At this point, I would also like to touch very briefly upon the State Bank’s efforts to accelerate economic growth. As you may know, any central bank’s primary policy tool is the discount rate – the basic interest rate which acts as an anchor for all other rates in the economy. Unlike most central banks, and similar to the US Federal Reserve, the State Bank has a dual mandate: it must tackle the issue of maintaining price stability, i.e. inflation, while also keeping an eye on economic growth. The preamble to the SBP Act of 1956 defines that the institution has “to regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources”.

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So at the State Bank, we need to pay close attention to both monetary stability and fuller utilization of the country’s resources. That is a tough balance to strike in the best of times. The Bank’s policy is to use any room available to cut interest rates in order to promote economic growth. After being in double digits almost consistently for two years, inflation has come down substantially in the past few months to single digit, because of this, the Bank decided to reduce its interest rate into single-digits. The benchmark rate now stands at 9.5 percent. We also expect that average inflation for the year will remain in the 8.50–9.50 percent range. Interest rates are reviewed, and may be revised, every two months, which allows our policy responses to be nimble and respond quickly to any changes in the economic environment. The Bank also ensures that the money market is never short of funds, which means that monetary policy signals are transmitted efficiently. Our primary constraints to faster growth, however, remain the large size of the fiscal deficit and the energy shortfall. As with most economic problems, there is no immediate solution. Both problems require systemic changes that will take time to achieve, through the implementation of effective regulation and a move towards greater private sector participation. Meanwhile, rest assured that while our current economic situation is less than optimal, it is also very far from what may be described as an economic calamity.

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In fact, over the years, this economy has shown an inherent resilience, and I’ve shared my thoughts about why I think our economy has the ability to navigate through choppy waters. Nevertheless, this economy remains quite far below its potential – however, the solutions to our problems regarding faster growth are an open secret. It’s only a question of implementing them. I’d like to end my talk here on that relatively optimistic note. Unlike the problems of the US and the Euro, our problems have very attainable solutions. Those economies are still trying to work out what would work best for them. We already know what we need to do. It’s only a matter of execution now. I’m excited by the economic potential that this country holds, and I encourage you all to become a part of the country’s future, by becoming a part of the solution. Thank you!

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Developing non-bank financial models while addressing the risks of shadow banking Address by Mr Yaseen Anwar, Governor of the State Bank of Pakistan, at the SECP (Securities and Exchange Commission of Pakistan) Conference on “Non-bank financial institutions”, Karachi Mr. Muhammad Ali, Chairman, SECP, Distinguished Speakers, Ladies and Gentlemen – Good Afternoon! I would like to thank the SECP for inviting me to join you and address this very timely conference on Non-Bank Financial Institutions (NBFIs). I congratulate the organizers for holding this pertinent event which has gained special prominence in the aftermath of the global financial crisis. I sincerely hope that today’s session will give further impetus to our efforts in promoting NBFIs as an alternative source of funding for businesses and also as a separate class of assets for investors in the country, adding to the financial sector’s diversity, stability and viability in the long-run. Globally, NBFIs have gained a prominent position and role in the financial sector and economy. However, the role of this sector has recently been scrutinized for its contribution to financial sector fragility during the recent global financial crises. Therefore, at the November 2010 G20 Seoul Summit, while reviewing the new capital standards for banks (Basel III), the G20 Leaders identified some remaining issues of financial sector regulation that warranted attention. They highlighted “strengthening regulation and supervision of shadow banking” as one of these issues and requested the Financial Stability Board (FSB), in collaboration with other international standard setting

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bodies, develop recommendations to strengthen the oversight and regulation of the “shadow banking system”. The “shadow banking system” is defined as “the system of credit intermediation that involves entities and activities outside the regular banking system” in other words intermediation through non-banks. The term started to be used widely at the onset of the recent financial crisis. The emergence of the term reflected recognition of the increased importance of entities and activities structured outside the regular banking system that perform bank-like functions. The financial sector in Pakistan comprises of Commercial Banks, Development Finance Institutions (DFIs), Microfinance Banks (MFBs), Non-banking Finance Companies (NBFCs) (leasing companies, Investment Banks, Discount Houses, Housing Finance Companies, Venture Capital Companies, Mutual Funds), Modarabas, Stock Exchange and Insurance Companies. Under the prevailing legislative structure the supervisory responsibilities in case of Banks, Development Finance Institutions (DFIs), and Microfinance Banks (MFBs) falls within legal ambit of State Bank of Pakistan while the rest of the financial institutions are monitored by other authorities such as Securities and Exchange Commission and Controller of Insurance. In Pakistan, while the overall assets of the financial sector have increased from Rs. 5.202 trillion in 2005 to Rs. 11.107 trillion in 2011, the share of the financial sector in terms of GDP is very low at 57.4 percent. In 2011, Banks held 74 percent of the financial assets while the share of NBFIs was only 4.7 percent of the total financial sector assets which was around 7.6 percent in 2005. The low financial sector to GDP ratio and NBFIs declining share in financial sector assets clearly underscores the need for financial sector

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development and diversification of financial sector assets to attract investors with different return expectations and risk appetite and channelize financial resources for the economic development of the country. Therefore, today’s conference is very important and we should use this opportunity to understand the key bottlenecks in the way of financial sector development and also come up with concrete measures to address these shortcomings in a sustainable manner. Alan Greenspan identified the role of NBFIs in strengthening an economy, as they provide “multiple alternatives to transform an economy’s savings into capital investment [which] act as backup facilities should the primary form of intermediation fail”. On the other hand, the NBFIs offer an alternative to typical commercial banking saving-investment products. However, in Pakistan, NBFIs other than Investment banks and leasing companies which offer saving and investment products on a relatively small spectrum need to develop appropriate and affordable products to increase its market share. The key negative outcome of this is that there remains limited access to funding resources and relatively higher risk avenues to earn spreads. Here I would like to briefly touch on the major constraints that the NBFI sector in Pakistan is beset with: First, although there has been an increasing effort by NBFIs to broaden the range of their business activities and product base, thereby diversifying their revenue streams, the sector is yet to make a breakthrough in this regard. Second, the sector is fragmented and each NBFI is trying to create its niche market in pursuit of establishing a sustainable revenue stream.

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In this regard, most companies are concentrating on financial advisory and other fee-based income segments. Unfortunately, the sector is yet to capitalize on the huge opportunities offered by previously relatively untapped areas like SMEs, Consumer, and Agriculture segments to enhance avenues for fund deployment. Third, the sector needs to develop and diversify sources of funding for sustainable growth. This would require a shift from the traditional sources such as commercial banks credit lines etc for on lending to clients. The NBFIs need to develop capital market instruments to pool funds from a diverse set of investors to ensure certainty to the source and cost of funding. Fourth, we need to strengthen the oversight and regulation of NBFIs to reduce the risks emanating from “shadow banking”. As observed by FSB, the objective of this exercise should be to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that do not pose such risks. The measures articulated today adhere those very regulatory issues going forward. In conclusion, I would like to say that the financial system in Pakistan is yet to grow to its full potential and play a more meaningful role in the economic development of the country. Therefore, we definitely need to add to its diversification and depth. NBFIs can play a meaningful role in this pursuit. In light of the global financial crises, we are better informed about the various risks that the NBFIs/Shadow Banking carries with it.

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As regulators we need to remain vigilant to ensure that those risks are mitigated without inhibiting sustainable non-banking financing models. Thank you.

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Monday March 18 2013 Top 10 Risk Compliance News Events

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