Risk Compliance News September 2012

_____________________________________________________________ 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

Dear Member, Modelling risks … … this is really one of the most interesting topics

Agathe Côté: Modelling risks to the financial system

Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 21 August 2012. * * *

Introduction It has become a summer tradition for the Bank of Canada to address the Canadian Association for Business Economics. This year it is my pleasure and I thank you for the kind invitation. An audience of colleagues and fellow economists offers me an opportunity to delve into a complex subject, and one that is particularly timely: financial system risk.

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We continue to see today the enormous costs to the global economy of the financial crisis that started five years ago. Of the many lessons we have learned from the crisis, a key one is this: we need to pay more attention to the stability of the financial system as a whole. This means understanding better how risks get transmitted across financial institutions and markets, and understanding better the feedback loop between the financial system and the real economy. From a policy perspective, this means taking a system-wide approach to financial regulation and supervision. Major reforms of the global financial system now under way address this need. System-wide risk has been a focus of attention at the Bank of Canada, and at other central banks, for some time. Ten years ago, the Bank issued the first edition of its semi-annual Financial System Review in which it identifies key sources of risks to the Canadian financial system and highlights the policies needed to address them. A year later, in 2003, we organized our annual conference on the theme of financial stability. In the wake of the global financial crisis, the Bank has intensified its research efforts in this area. In particular, a priority is to improve the theoretical and empirical models we use to analyze elements of the financial system that can lead to the emergence of risks and vulnerabilities.



With more finely tuned quantitative models and tools, the Bank will be better able to identify risks on a timely basis so that the private sector and policy-makers can take corrective action to support financial stability. Let me acknowledge upfront that this task is complex. While macroeconomic models have long been used to guide monetary policy decisions by central banks, models of financial stability and systemic risk are much less advanced. In my remarks today, I want to talk about the progress that we have made at the Bank in modelling risks to the financial system. I will start by briefly describing the notion of systemic risk and various approaches used to identify and measure it. I will then discuss two state-of-the-art quantitative models that we have developed to improve our assessment of risks to the Canadian financial system.

The multiple dimensions of systemic risk Systemic, or system-wide, risk goes beyond individual institutions and markets. It is the risk that the financial system as a whole becomes impaired and that the provision of key financial services breaks down, with potentially serious consequences for the real economy. Systemic risk manifests itself in different ways. There is a time dimension, which refers to the accumulation of imbalances over time, and a cross-sectional dimension, which refers to how risk is distributed throughout the financial system at a given point in time.



Procyclicality is the key issue in the time dimension. It reflects the tendency to take on excessive risk during economic upswings – too much punch from the punchbowl, if you will – and to become overly risk averse during the downturns. Procyclicality makes the financial system and the economy more vulnerable to shocks, and increases the likelihood of financial distress. Risk concentrations and interconnections are the key issues in the cross-sectional dimension. Financial institutions can have similar exposures to shocks or be linked through balance sheets. As a result, losses in one institution can lead to fears of contagion that amplify the adverse effects of the initial shock. For instance, uncertainty about the viability of counterparties can lead to hoarding of liquidity, which may seem like an appropriate action for the individual institution but can have disastrous consequences for the financial system as a whole. System-wide surveillance requires that we regularly assess the importance of various types of systemic risk. How we judge a particular risk will be based on the probability that it will lead to financial system distress, and on the extent of its impact should that distress materialize.

Early-warning indicators A fundamental challenge is to detect the risks arising from both global and domestic sources in an environment with a vast number of potential indicators.



Therefore, one direction of research at the Bank has been to isolate the key signals from this broad information set by identifying a smaller group of variables that can serve as early-warning indicators of emerging imbalances. Since financial crises in Canada have been rare, international data are used to help establish numerical thresholds for each domestic indicator. For example, if international evidence suggests that credit growth above a certain rate tends to be associated with increased risk, then a period with credit growth above the threshold would suggest an elevated probability of financial stress. Selecting the level of thresholds involves a difficult trade-off between false alarms and failure to signal an event, so in practice the early-warning indicators are used mainly to identify areas where more detailed investigation may be warranted. They provide an objective, practical starting point to detect the buildup of imbalances in the financial system. One early-warning indicator that we regularly track is the deviation of the aggregate private sector credit-to-GDP ratio from its trend (the credit-to-GDP gap), which serves as a rough measure of excessive leverage across the financial system (Chart 1).



This indicator has been shown to provide some leading information as a predictor of banking crises, and has been proposed by the Basel Committee on Banking Supervision (BCBS) as a useful guide for decisions about when to activate the countercyclical capital buffer – an important macroprudential policy instrument in the Basel III agreement. Given the complexity of systemic risk, it is unrealistic to expect a single measure or indicator to serve all purposes. Combining indicators can produce better signals with fewer false alarms and undetected crises. For example, research shows that combining the Credit - to - GDP gap with a measure of real estate prices produces an indicator that performs better than either variable on its own. Our own work at the Bank reinforces findings elsewhere that aggregate private sector credit and real estate prices are among the most reliable indicators of financial stress.



Identifying sources of risk is essential, but so is determining the likelihood that these risks will materialize. Therefore, another important aspect of ongoing research is the development of statistical models to help us forecast the probability that a crisis will occur based on a group of indicators.

Macro stress tests Early-warning indicators are useful to gauge the probability of financial stress, but a thorough assessment also requires an analysis of what could happen if the risk materializes. This is the goal of macro stress testing. A good part of the Bank’s efforts in recent years has been devoted to developing and refining stress-testing models. This class of models takes a large but plausible macroeconomic shock as a starting point and analyzes its impact on the balance sheets of banks or other sectors of the economy. The Bank now has two main stress-testing models to help monitor risks to the financial system. These models can also be used to assess the potential impact of policy tools or regulatory actions in mitigating financial system risks.

Assessing risks from elevated household debt The first, the Household Risk Assessment Model, or HRAM, is a microsimulation model that assesses how the debt burden of Canadian households can affect financial stability.



Using microdata from household balance sheets, the model allows us to estimate how various shocks would affect the distribution of debt within the household sector. The simulations take into account changes over time in individual debt levels, as well as changes in household wealth from savings and fluctuations in the value of financial assets. Tracking the asset side of household balance sheets gives us a more accurate picture of systemic risk since changes in wealth affect households’ ability to pay their debt. Household vulnerabilities depend not only on the average level of debt, but also on how debt is distributed across individuals. One strength of the model is precisely its ability to account for this distribution. For instance, while record-low interest rates in recent years have contributed to a relatively low aggregate household debt-service ratio, the share of Canadian households that are considered most vulnerable – those with a debt-service ratio equal to or higher than 40 per cent – has climbed to above-average levels, as has the proportion of debt held by these vulnerable households (Chart 2).



Using HRAM, we estimate that if interest rates were to rise to 4.25 per cent by mid-2015, the share of highly indebted households would rise from slightly above 6 per cent in 2011 to roughly 10 per cent by 2016, while the proportion of debt held by these households would rise from 11.5 per cent to about 20 per cent over the same period. So while the aggregate household debt-service ratio paints a somewhat rosy picture, taking into account distributions gives us a clearer and more cautionary indication of how vulnerable our financial system actually is to household debt. Another strength of the model is that it provides a flexible tool for simulating the impact on household solvency of a wide range of potential shocks, such as an increase in unemployment. HRAM indicates that household loans in arrears would more than double under a severe labour market shock similar to that observed in the recession of the early 1990s.



Despite the model’s strengths, we continue to enhance our analysis by improving HRAM. Expanding the behavioural aspects of the model is one way to do this. For instance, the model currently allows distressed households to pay their debts by selling their liquid assets, but not their homes. Work is also under way to improve the design of the shock scenarios. Results of stress tests using HRAM are regularly reported in the Bank’s Financial System Review and constitute an important element of our overall assessment of the risks associated with household finances.

Assessing contagion effects in the banking system HRAM provides invaluable information on vulnerabilities in the household sector, but the Bank is also interested in assessing risks more broadly within the Canadian financial system. To this end, we have been working for several years on developing a Macro Financial Risk Assessment Framework (or MFRAF). Drawing on detailed data from bank balance sheets, MFRAF is a quantitative model that tracks the contribution of individual banks to systemic risk. Traditional stress-testing models focus exclusively on solvency risk, and estimate the overall risk to the financial system by simply aggregating credit (or other asset) losses that would materialize at individual banks in the event of a severe shock. MFRAF goes beyond this traditional approach by taking into account linkages among banks arising from counterparty exposures – or network spillover effects – as well as funding liquidity risk, that is, the risk of market-based runs on banks.



The financial crisis illustrated the significant risks associated with a deterioration of funding liquidity. The collective reactions of market participants led to mutually reinforcing solvency and liquidity problems at banks around the world. As funding liquidity evaporated, many well-capitalized institutions had to take writedowns on illiquid assets, or sell them at a loss, creating uncertainty in the market about their solvency and adding to the downward pressure on asset prices. MFRAF has been built to integrate funding liquidity risk as an endogenous outcome of the interactions between solvency concerns and the liquidity profiles of banks. This strong microeconomic foundation constitutes a major innovation in macro stress-testing models. MFRAF also incorporates network externalities caused by the defaults of counterparties, with the size of a counterparty’s interbank exposures increasing the likelihood of spillover effects. A key lesson from the model is that failure to account for either funding liquidity risk or interbank exposures could lead to significant underestimation of the risks to the financial system as a whole if the banking system is undercapitalized and relies extensively on the short-term funding market. Importantly, the loss distributions generated by the model exhibit fat tails, a key feature of the actual distribution of financial system risks (Chart 3).



The fact that the model is able to replicate this important stylized fact demonstrates that it has significant potential as a tool for assessing systemic risk. Nevertheless, while MFRAF is already somewhat complex, the layers of interaction will need to be further augmented. For instance, the model misses any negative feedback that could occur between heightened risks to the banking system and the real economy. The model could also be expanded over time to include other types of financial institutions and markets. Compared with other approaches that use market-based data, such as the asset-pricing approach, the transmission channel in models like MFRAF is transparent, and this improves our interpretation of results. Because of this “story-telling” ability, many central banks have begun to use this type of framework in their financial stability analysis.



In addition to assessing risks, MFRAF can be used to examine the merits of policy or regulatory initiatives such as capital and liquidity rules. As the model becomes more refined, the objective is to use it more to complement other existing macro stress-testing exercises and to sharpen our analysis and communication of risks in the Bank’s Financial System Review.

Conclusion Let me conclude. The Bank of Canada is conducting extensive research into finding methodologies and tools to identify and measure systemic risk. While work in this area is extremely complex, the Bank has made substantial progress in recent years. We now have two state-of-the art models. And with HRAM, the Bank of Canada is one of the few central banks at the leading edge of using microsimulation models to assess vulnerabilities in the household sector. Our efforts to build these models have provided us with important lessons. First, distributions matter – we cannot rely solely on aggregate data: distributional features and complex interactions are very important for assessing risks. This means developing models that capture these effects. Our household simulation model is aimed directly at understanding how the distribution of debts, assets and income affects financial stability.



MFRAF uses information about the interconnections of individual financial institutions because these can lead to non-linear network effects that are also important for assessing systemic risks. Second, predicting behaviour under stress conditions is very difficult. Models need to be able to handle a variety of “what-if” scenarios corresponding to different assumptions about behaviours under stress. Finally, we need to consider the many different sources of risk to the financial sector and take into account their cumulative effects and interactions; otherwise we may underestimate risks. Obviously, quantitative measures alone will never be enough to get a complete picture, especially since the financial system evolves rapidly. Intelligence gathered from discussions with the financial sector, as well as information shared with other policy-makers and supervisors here in Canada and in the international community, will always be critical to the overall assessment of the risks. While we are making progress, it is important to remember that financial system modelling is still in its infancy. The goal – understanding, preventing, and reducing systemic |risk – deserves our attention, diligent research and hard work. It has been my pleasure to share some of the Bank’s efforts with you today. Thank you very much.



Progress note on the Global LEI Initiative This is the first of a series of notes on the implementation of the legal entity identifier (LEI) initiative. The G-20 in Los Cabos endorsed the FSB recommendations and asked the Board to take forward the work to launch the global LEI system by March 2013. Progress reports on the LEI initiative will be prepared approximately every three weeks. Implementation Group: The FSB set up an Implementation Group (IG) to take forward the work. The IG comprises 55 experts from the global regulatory community, and includes members from 20 jurisdictions, as well as representatives from standard setters and international financial institutions. There are three main workstreams: - legal and governance; - operations; and - corporate hierarchy data.

A co-ordination group of 5-7 members guides each work stream, providing a geographic balance. Private Sector Preparatory Group (PSPG): A call for members of a private sector expert group to collaborate on the work solicited widespread interest – about 170 members from almost 30 jurisdictions are participating actively in the group.



Following an inaugural meeting in New York on 25 July, working groups have been set up to provide input in each of the three main areas, facilitated by members of the IG. A dedicated secure web based forum has been launched for communication and knowledge sharing, hosted by the Cleveland Federal Reserve. Charter for the Regulatory Oversight Committee (ROC) and other Governance Issues: A key task for the IG is to prepare a draft Charter for the ROC for approval by the FSB in October and G20 in November. A first full draft will be reviewed by the IG in early September, prior to review by the Steering Committee in mid - September. The IG is working through a number of challenging issues, including: delivery of adequate regulatory enforcement power over the global system by the ROC; membership criteria (including the treatment of sub-national regulatory bodies and international bodies); decision making if consensus cannot be reached; what is an appropriate minimum regionally balanced quorum of support from authorities to launch the system that ensures balanced representation of early, medium and late movers; and the structure of the not-for-profit Global LEI Foundation (the legal form of the operational element of the LEI system). The choice of location and hence jurisdiction for the Foundation will have an important influence on the legal framework for the LEI system, including possibly the legal form of the ROC and the means available for expressing governance: the FSB Secretariat is seeking pro bono advice from legal experts on the location issue by early September. To facilitate the ultimate acceptance of the Charter by the FSB Plenary, IG members are seeking feedback from legal staff on the document as work proceeds.



Operations: The private sector has a key role in the operational implementation of the system: the Central Operating Unit (COU) of the system will be formed via the establishment of a not-for-profit global LEI foundation under the oversight of the ROC. A number of the PSPG Working Groups are focusing on operational aspects – a structured framework (Enterprise Architecture) is being used to organise the work. Early results will be reviewed in October. A number of potential Local Operating Units (LOUs) are involved in the analysis of operational solutions to ensure that the proposed model is acceptable to participants around the world. Ownership and Hierarchy data: An important short term objective is to develop concepts and plans for extending the basic data on entity identification (which will be available when the system is launched) to include information on corporate ownership and other relationships. The extension is necessary to support risk aggregation and consolidation and thus capture the full benefits of the LEI system. Additional data, however, implies an expansion of scope and thus the benefits and costs of any particular extension must be considered carefully. The IG is working closely with the PSPG to develop preliminary recommendations by end-2012. Early movers: The CFTC announced on July 24 that DTCC/SWIFT had been designated as the provider of CFTC Interim Compliant Identifiers (CICIs) for a limited period of two years. The CFTC also confirmed that the Commission plans to adopt the



governance principles and LEI reference data requirements endorsed by the FSB, and that once these steps are completed the CICI system will subsequently transition into the global LEI. IG members are currently reviewing a number of technical issues to ensure that decisions by early movers do not have an adverse impact on the costs or operational flexibility of the global system, for instance by locking the future global LEI system into early, local technical system design choices.



OCC Updates Stress Testing Implementation Timeline

WASHINGTON — The Office of the Comptroller of the Currency (OCC) today announced it is considering changes to the implementation timeline for the company-run stress testing required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The changes under consideration would delay implementation until September 2013 for covered institutions with total consolidated assets between $10 billion and $50 billion. On January 24, 2012, the OCC published in the Federal Register a notice of proposed rulemaking to implement section 165(i) of the Dodd-Frank Act, which would require certain financial companies, including certain national banks and federal savings associations, to conduct annual stress tests in accordance with regulations prescribed by the OCC. In the notice of proposed rulemaking, the OCC stated that “[a] national bank or federal savings association that is a covered institution shall be subject to this part on [the effective date of the rule] and will conduct its first stress test under this part using financial statement data as of September 30, 2012, with results reported as required under this part in January 2013.” The OCC received a number of comments on the proposed immediate effective date identifying concerns about resources, readiness, and ability to conduct stress tests given the likely short period between publication of a final rule and the start of the stress-testing process. A key priority in implementing this section of the Dodd-Frank Act is to ensure that banks have robust systems and processes to conduct the stress tests. In response to the concerns expressed in comments, the OCC is considering delaying the effective date of the rule to conduct the annual stress tests for certain institutions.



The proposed delay would help ensure that all covered institutions have sufficient time to develop sound stress testing programs. Specifically, the OCC is considering a timeline under which covered institutions with assets from $10 to $50 billion would be required to conduct initial stress tests in accordance with the rule in late 2013. The OCC is considering requiring covered institutions with assets greater than $50 billion to begin conducting annual stress tests under the rule this year, although the OCC would maintain its reservation of authority to allow covered institutions above $50 billion to delay implementation on a case-by-case basis where warranted. As part of efforts among the federal banking agencies to coordinate the implementation of Dodd-Frank stress test requirements, the OCC has consulted on this proposed implementation delay with the Federal Reserve Board (Board) and the Federal Deposit Insurance Corporation (FDIC). The Board and FDIC are considering similar changes to timelines included in their proposed rules implementing Dodd-Frank stress test requirements. The final implementation timeline for all covered institutions will be specified in the final rule.

Note:

Section 165(i) of the Dodd-Frank Act created two types of stress testing requirements: stress tests conducted by the company and stress tests conducted by the Board of Governors of the Federal Reserve System (“Board”). Section 165(i)(2) requires certain financial companies, including national banks and Federal savings associations, to conduct stress tests and requires the primary financial regulatory agency of those financial companies to issue regulations implementing the stress test requirements.

https://www.federalregister.gov/articles/2012/01/24/2012-1274/annual-stress-test#footnote-1




A national bank or Federal savings association is subject to the stress test requirements if its total consolidated assets are more than $10 billion. Under section 165(i)(2), a financial company is required to submit to the Board and to its primary financial regulatory agency a report at such time, in such form, and containing such information as the primary financial regulatory agency may require. The primary financial regulatory agency is required to define “stress test,” establish methodologies for the conduct of the company - conducted stress test that must include at least three different sets of conditions (baseline, adverse, and severely adverse), establish the form and content of the institution's report, and compel the institution to publish a summary of the results of the Dodd-Frank institutional stress tests. In general, section 165 of the Dodd-Frank Act sets forth a number of requirements and responsibilities for the Board related to supervision and prudential standards for nonbank financial companies and bank holding companies with total consolidated assets equal to or greater than $50 billion. In addition to the company stress tests required under section 165(i)(2), section 165(i)(1) requires the Board to conduct annual analyses of nonbank financial companies supervised by the Board and bank holding companies with total consolidated assets equal to or greater than $50 billion to determine whether such companies have the capital, on a total consolidated basis, necessary to absorb losses as a result of adverse economic conditions. The Board published a proposed rule implementing this supervisory stress testing on January 5, 2012. As required by section 165(i)(2), this proposed rule implements the company-conducted stress test requirements for national banks and Federal savings associations.





Under this proposed rule, a national bank or a Federal savings association with total consolidated assets of more than $10 billion, defined as a “covered institution,” would be required to conduct an annual stress test as prescribed by this proposed rule. The OCC is developing this rule in coordination with the Board and the Federal Insurance Office, as required by section 165(i)(2)(C). The Board and Federal Deposit Insurance Corporation (“FDIC”) are planning to issue separate proposed rules with respect to their supervised entities. For purposes of this rule, the proposed rule defines a stress test as a process to assess the potential impact of hypothetical economic conditions (“scenarios”) on the capital of a covered institution over a set period (the “planning horizon”), taking into account the current condition of the covered institution including its material risks, exposures, strategies, and activities.

The Purpose of Stress Tests

The OCC views the stress tests conducted by covered institutions under the proposed rule as providing forward-looking information to supervisors to assist in their overall assessments of a covered institution's capital adequacy and to aid in identifying downside risks and the potential impact of adverse outcomes on the covered institution's capital adequacy. In addition, the OCC may use stress tests to determine whether additional analytical techniques and exercises are appropriate for a covered institution to employ in identifying, measuring, and monitoring risks to the financial soundness of the covered institution, and may require a covered institution to implement such techniques and exercises in conducting its stress tests.



Further, these stress tests are expected to support ongoing improvement in a covered institution's stress testing practices with respect to its internal assessments of capital adequacy and overall capital planning. The OCC expects that the annual stress tests required under the proposed rule would be only one component of the broader stress testing activities conducted by covered institutions. In this regard, the OCC notes that the federal banking agencies have recently issued for public comment proposed joint guidance on “Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets.” These broader stress testing activities should address the impact of a range of potentially adverse outcomes across a set of risk types affecting aspects of the covered institution's financial condition other than capital adequacy. In addition, a full assessment of a covered institution's capital adequacy must take into account a range of factors, including evaluation of its capital planning processes, the governance over those processes, regulatory capital measures, results of supervisory stress tests where applicable, and market assessments.



FSA statement regarding CRD IV implementation

The draft European Union legislation to update the

capital requirements framework, known as CRD IV, has

been under discussion between the European Parliament,

European Commission and Council of Ministers.

These discussions originally aimed to finalise an agreed position by end

June 2012 enabling adoption by the European Parliament plenary in early

July 2012.

Following the delay of the Parliament’s plenary vote and the recent

statement by the Rapporteur of the European Parliament and the

discussion of the Council of Economic and Finance Ministers, it is clear

the legislation will not be adopted earlier than autumn 2012.

Following adoption it is necessary for verification, translation and

signature of the EU legislation to take place before it can be published in

the Official Journal of the European Union.

Publication in the Official Journal is a necessary pre-cursor of EU

legislation entering into force.

On this basis it does not appear feasible that the legislation can enter into

force in line with the implementation date of 1 January 2013 as included in

the original European Commission proposal of July 2011.

No alternative date has yet been communicated by the EU institutions.

Furthermore, reflecting the delay in the negotiation process, the

European Banking Authority (EBA) issued a press release on 31 July

setting out the potential need to phase-in or flexibly apply certain

technical standards to ensure a practical approach to implementation.



In light of these developments the FSA will keep the situation under

active review and continue to support the European institutions in their

efforts to reach a conclusion on the final version of the legislation.

The FSA will continue to undertake all preparatory work that is possible

in the absence of finalised legislative text, in full expectation that the EU

legislation will follow the Basel III implementation timetable.

We expect all firms in scope of CRD to do likewise.

Banks must remain mindful of the vital importance of the direction set by

Basel III for banking system stability.

In particular the FSA will continue to undertake its supervision of banks

in a manner consistent with the recommendations of the 22 June meeting

of the interim Financial Policy Committee (FPC) of the Bank of England.

The interim FPC recommended that: taking into account each

institution’s risk profile, the FSA works with banks to ensure they build a

sufficient cushion of loss-absorbing capital in order to help to protect

against the currently heightened risk of losses; that cushion may

temporarily be above that implied by the official transition path to Basel

III; and banks should continue to restrain cash dividends and

compensation in order to maximise the ability to build equity through

retained earnings.

The FSA reminds those investment firms that are currently subject to the

Capital Requirements Directive that they will be impacted by the CRD IV

legislation and that they too should prepare accordingly.

The introduction of Common Reporting, which is incorporated into the

requirements in CRD IV, is dependent on delivery of the necessary

technical systems and on implementing technical standards to be drafted

by EBA under CRD IV and adopted by the European Commission.



The FSA is proceeding with the necessary preparatory work to be ready to

begin collecting data under Common Reporting for the period beginning

1 July 2013, should the legislation and related standards be finalised by

this date.

In line with the press release issued by EBA, the FSA will take account of

any phase-in plans incorporated into the implementing technical

standards on supervisory reporting.



An interesting article about China. We will be glad to discuss other opinions in our next newsletter.

China’s Slowdown May Be Worse Than Official Data Suggest

by Janet Koech and Jian Wang

In the months following the 2008–09 economic crisis, emerging-market economies robustly rebounded.

Output in China and India expanded more than 10 percent in 2010, and Brazil’s gross domestic product (GDP) growth of 7.5 percent was its best performance in 25 years.



Emerging-market economies retraced their precrisis level of industrial production by 2009, while advanced economies remained below their precrisis levels in 2012 (Chart 1). But the strong emerging-market rebound—most significantly in China— hasn’t endured. When China’s average GDP growth remained above 9 percent in 2011, hopes rose that a sustained recovery would prop up the world economy amid the European sovereign debt crisis and subpar growth in the U.S. However, China’s economy deteriorated rapidly in 2012, with GDP growth slowing to 8.1 percent in the first quarter from 8.9 percent at year-end 2011. Second quarter GDP growth slid further, to 7.6 percent, the lowest reading since the height of the global financial crisis in early 2009. Even with the decline, there is speculation that these figures may still understate economic slowing. Economists have long doubted the credibility of Chinese output data. For example, some studies indicate that GDP growth was overstated during the 1998–99 Asian financial crisis, when official figures reported that China’s GDP grew on average 7.7 percent annually. Alternative estimates using economic activity measures such as energy production, air travel and trade data ranged from 2 percent to 5 percent. The dubious character of the official figures is no secret in China. Senior government officials, including Vice Premier Li Keqiang, dismiss official GDP data as “man-made” and “for reference only” because of political influence, particularly at the local level, on data reporting.



Data Reliability To get a more accurate picture of China’s economy, economists examine other measures of activity that closely track growth but are less prone to political interference than output data. Industrial electricity consumption, a major production input, serves as such a proxy. If industrial output grows at a slower pace, electricity consumption should behave similarly. China’s year-over-year growth rates of industrial electricity consumption and industrial production are shownfor 2011 and 2012 in Chart 2.



Red dots, illustrating 2012 activity, are below the blue dots, depicting 2011, which indicates that the growth rate of industrial electricity consumption is relatively lower this year. This is consistent with China’s recent economic slowdown. The chart also shows fitted linear trends—a way of extrapolating activity over a longer period—computed using 2011 data only (solid line) and 2011 and 2012 data (dashed line). This depiction relies on just these two years because of limited electricity-consumption reporting by the China Electricity Council. Hence, these results should be viewed with caution. As expected, Chart 2 shows that there is a tight relationship between industrial electricity consumption and industrial output. As industrial production growth expands, China’s industries consume more electricity, and vice versa. However, a closer look at the chart raises questions. Consider a scenario in which electricity consumption doesn’t increase. To illustrate this, we extend the linear trend lines to the horizontal axis (representingno change in electricity consumption). The lines intercept the axis at 5 and 7.5, implying that China’s industrial production continues to grow 5 percent or 7.5 percent annually (depending on which trend line we use) even when electricity consumption remains constant. Although heightened electricity consumption efficiency could induce positive industrial production growth, a 7.5 percent growth rate seems too large to attribute to efficiency gains alone.



The solid line computed using just 2011 data is flatter than the dashed line computed using both 2011 and 2012 data. Extrapolating from the trend line that includes just 2011 data points yields a lower, more reasonable industrial production growth rate of about 5 percent when the electricity consumption growth rate is zero. The same data are shown in Chart 3, with only the 2011 trend line depicted.

Suspiciously, all 2012 data (red dots) lie below the trend line. This suggests that given the amount of electricity consumed, China’s official industrial production figures for 2012 are higher than those implied by the 2011 data trend.



For instance, China’s industrial electricity consumption grew 5.6 percent on a year-over-year basis in March 2012. Using the trend from 2011 data, the estimate for March’s industrial production growth is about 9.3 percent rather than the 11.9 percent reported in the official data. This discrepancy could be due to unintentional, random survey errors. However, it is hard to imagine that all available 2012 data erred on the side of overstating industrial production growth. Rather, it suggests that China might have overstated its 2012 industrial production data to mask the economy’s weakness. In other words, the slowdown in China could be worse than the official data indicate.

Composition of Production Of course, other factors may explain why all red dots lie below the trend line in Chart 3. For example, growth of industrial production varied across sectors whose consumption of electricity per unit of output differs. For a unit of output, a company involved in steel production will generally consume more electricity than a factory making T-shirts. If the growth rate of the steel industry slowed more than that of the textile industry, we would expect to see the growth in electricity consumption decline faster than the growth of total industrial output. To address this industry composition effect, we include output growth of two different sectors in our data: the heavy and light industrial sectors.



The heavy industrial sector (for example, the steel industry) usually consumes more electricity than the light sector (the textile industry). The relationship between electricity consumption and industrial output can be more accurately estimated by analysing the two sectors separately than by using aggregate industrial output data. Accounting for the sectoral difference yields more sensible results when 2011 data are analyzed. When industry electricity consumption remains constant—that is, it shows a zero growth rate—light industrial sectors grow at an annual rate of 2.8 percent, a much smaller reading than the 5 percent for aggregate output. On the other hand, the heavy industrial sectors contract 1.9 percent, reflecting this industry’s relatively heavy reliance on electricity.



Chart 4 plots actual electricity consumption growth in China (purple line) together with estimated electricity consumption using 2011 output data for light and heavy industries (orange line). The two lines track each other closely, indicating a tight relationship between electricity consumption and output in the heavy and light industries. The blue line shows the forecast growth of electricity consumption in 2012, computed from the relationship estimated from 2011 data. The official industrial production data square well with electricity consumption in March 2012; predicted consumption data almost perfectly match the reported data.



During March, growth in heavy industries declined sharply to 11.2 percent from 13 percent in December 2011, while growth in the light industries increased to 13.9 percent from 12.6 percent over the same period. The difference in growth between the heavy and light industries explains the overall sharp decline in electricity consumption, while overall industrial output growth remained strong in March 2012. In the subsequent months, however, the out-of-sample forecasts diverge substantially from the actual data. Given the official industrial production numbers, our model suggests that China should have consumed about twice as much electricity as it actually did. This is not surprising after closer examination of the data. From April to June, growth in the light industries declined more than in the heavy industries, a reversal of March’s activity. Given such a pattern in China’s official industrial production data, electricity consumption growth should have dropped only moderately. However, China’s actual electricity consumption continues to decline sharply from April to June, raising doubts about the accuracy of the official industrial production figures.

Improving Data Reporting Although China’s economic growth has slowed sharply in recent months, evidence suggests that the situation may be worse than reported. Several factors contributed to China’s slowdown.



Demand for China’s exports in Europe and the U.S. has weakened amid the deepening European sovereign debt crisis and sluggish U.S. economic activity. Additionally, China’s policy response following the global financial crisis is having unintended effects on its economy. China loosened monetary policy and undertook a massive fiscal stimulus program in response to 2008–09 developments. These policies, which cushioned the economy from the impact of falling demand for exports, had the unintended consequence of generating higher inflation and rising asset prices, particularly in the real estate sector. These developments forced China to reverse course and institute tighter monetary policy last year, creating another round of effects on the economy that continue this year. China’s abrupt policy changes during the past two years are not historically unusual and have been criticized as a source of the country’s big economic swings, which hurt long-run growth. Future policymakers will need more, high-quality quantitative (as opposed to qualitative) economic research to avoid overshooting policy targets and to better stabilize the economy. A critical first step is acquiring highquality economic data, a process already in the works. China’s National Bureau of Statistics started a new data-collecting system under which businesses report industrial production data online directly to the national statistics agency in Beijing, reducing the chance of manipulation by local authorities. As the world’s second largest economy, China plays an increasingly important role in the global economy.



Acquiring accurate economic data isnot only useful to China’s policymaking, but also helpful to other nations, allowing them to better understand China’s current economic conditions and design their policies accordingly. Koech is an assistant economist and Wang is a senior research economist in the Research Department at the Federal Reserve Bank of Dallas.



Some Thoughts on Global Risks and Monetary Policy

Charles L. Evans, President and Chief Executive Officer Federal Reserve Bank of Chicago

Introduction

Thank you for the invitation to speak to you today. I am very happy for the opportunity to participate in Market News International seminar and to offer my thoughts on the U.S. and world economies.

We live in an amazingly interconnected world — a world in which financial markets are linked by the instantaneous transmission of information and business activity is intertwined among nations.

For a long time, U.S. consumers and firms have been an important source of demand for Asian economies.

This comes with pluses and minuses: Without the robust growth in the U.S. in 1997–98, the Asian financial crisis may well have been much worse than it actually was; in contrast, the recession and sluggish growth in the U.S. over the past five years have weighed heavily on the demand for products from Asia.

My comments today will focus primarily on the outlook for the U.S., but with an eye on its potential impact on Asian economies.

Of course, here I have to cover the substantial downside risks to the forecast stemming from both the European debt situation and the U.S. fiscal cliff.

I will also discuss how this outlook and other economic analyses shape my views for the appropriate stance of monetary policy.



Before I turn to the focus of today’s discussion, I would like to remind you that the views expressed are my own and do not necessarily represent those of the Federal Open Market Committee (FOMC) or the Federal Reserve System.

Outlook

Let’s start with the economic outlook.

We are all too familiar with the fact that the financial crisis that unfolded in 2007 and 2008 precipitated a global recession that was unusually deep and lengthy in the U.S. and other advanced economies.

Perhaps this shouldn’t have been surprising.

The detailed analysis by Carmen Reinhart and Kenneth Rogoff (2009) concludes that recessions caused by financial crises generally are severe and are followed by anemic recoveries.

By any yardstick, this certainly describes the U.S. recovery to date:

Output growth has averaged only 2-1/4 percent annually, and resource gaps remain huge.

In particular, the unemployment rate remains over 8 percent — well above the 5-1/4 to 6 percent rate most FOMC participants view as being consistent with a fully employed labor force over the longer run.

Both public and private sector forecasts see relatively modest rates of growth over the next few years.

For example, most recent forecasts by the private sector have 2012 gross domestic product (GDP) growth at less than 2 percent; a pace that may not even be enough to keep up with potential.

Growth in 2013 is expected to be only moderately higher.

Moreover, both the European debt situation and the looming U.S. fiscal cliff impart substantial downside risks to the forecast.



Even absent any negative shocks, such tepid growth rates would close the large existing resource gaps only very gradually.

Indeed, I expect that we will face unemployment well above sustainable levels for some time to come.

Implications for Asia

In the aftermath of the Great Recession, most Asian economies enjoyed a return to solid levels of growth.

Today, however, growth in Asia faces some new challenges.

One of these challenges is that Asian economies will not be immune to the tepid growth prospects facing the world’s advanced economies.

Forecasts for growth in Asia have been marked down over the past year, reflecting in part the impact of the downgrade in the outlook for Asian exports for the U.S. and the euro area.

For example, the U.S. and the euro area account for about one-third of China’s merchandise exports.

The recession and weak recoveries in those economies were big factors in the Chinese current account surplus falling from about 10 percent of GDP in 2007 to less than 3 percent in 2011.

This weakness remains a consideration as we look forward; indeed, it is an important reason why the International Monetary Fund (IMF) is projecting that the Chinese current account surplus will fall even more by 2013.

International trade is an excellent thing: Exploiting comparative advantages raises living standards for all nations.

However, all countries can’t simultaneously export their way out of their problems. For the world as a whole, the current account has to balance.

Thus, countries with large external surpluses face risks to their economies posed by slowdowns in their trading partners.



Aggregate world growth must reflect aggregated domestic demands. So if demand is going to be sluggish in a large share of the world economy, other nations must take up the slack, or world growth will fall.

Inflation

With regard to inflation, as you know, the FOMC’s long-run inflation objective is 2 percent as measured by the price index for personal consumption expenditures (PCE).

For a number of reasons, I don’t foresee much risk that inflation will rise above reasonable tolerance levels relative to this objective.

First, we see evidence of low expectations for inflation and growth in the today’s historically low Treasury yields.

If there were warning signs of dangerous inflationary pressures, the ten-year rate wouldn’t be in the neighborhood of 1-3/4 percent!

Second, even with the latest increase in oil prices, energy and commodity prices remain well off their recent peaks as the global outlook dims.

Third, as I just noted, the output gap remains large and is likely to close only slowly.

In this economic environment, wage pressures are practically nonexistent.

And it is hard to envision how major persistent inflation pressures will emerge without a parallel increase in wage costs. Such parallel price and wage increases were a big part of the 1970s inflation, a scenario some fear repeating today.

Fourth, inflationary dynamics depend in large part on the momentum generated by people’s expectations of future inflation; currently, inflation expectations are well anchored, which will tend to keep inflation from moving either up or down.

Putting all of these factors together along with the fact that core inflation averaged 1.8 percent over the past year, I conclude that inflation will likely remain near or below our 2 percent target over the medium term.



Sources of Risk and Their Implications

I would now like to turn to two important downside risks to the outlook for growth.

This will be a bit of a U.S.-centric view, but clearly these risks also have important implications for growth here in Asia and the rest of the world.

Europe

Let me begin with the European debt situation.

Obviously, the developments in Europe pose a significant downside risk to the U.S. economy and world economic growth more broadly.

The direct effects of slower European growth on the U.S. economy would be relatively small.

The eurozone nations account for less than 15 percent of U.S. merchandise exports.

Thus, according to standard elasticity estimates, even a moderate eurozone recession would reduce U.S. exports by only a couple of tenths of GDP.

The indirect effects of eurozone developments could, however, be more severe, both in the U.S. and Asia. One possible channel would be through financial contagion.

If losses on euro-centric assets put a large enough dent in the balance sheets of financial institutions that lend to U.S. households and businesses, the increases in the cost and availability of credit would reduce growth in the U.S. with possible spillover effects into Asia as well. Clearly, this is a risk worth monitoring.

Fortunately, though, U.S. financial institutions are in much better shape to handle such potential losses than they were in 2008.

Recognizing the risks posed by the European debt situation, U.S. institutions have reduced their direct exposure to European assets and tightened lending standards to European banks.



On the regulatory front, the most recent stress tests made large U.S. banks demonstrate that they would have adequate capital even in the event of a sharp European recession with contagion to global financial markets.

A second possible channel would be through the effects of uncertainty on current demand.

Throughout the recovery, U.S. business and household sentiment has been very fragile.

Every hint of bad news seems to generate a wave of increased caution and an associated pullback in spending as firms and families seek to protect their individual balance sheets.

After what the U.S. economy went through in the Great Recession, this skittishness is understandable — particularly if one can envision a very large downside to the news event.

And, as I just noted, given developments in Europe, there certainly are some serious downside scenarios one can envision, even if they are not the most likely outcomes.

So it would be no surprise if yet another wave of uncertainty put a further dent in consumption and investment.

U.S. fiscal cliff

Another risk to the U.S. economy comes from the so-called fiscal cliff.

Under current U.S. law, numerous tax and spending provisions enacted in various stimulus packages dating as far back as 2001 are scheduled to expire on January 1, 2013.

In addition, if no budget agreement is reached by Congress, there will be significant automatic spending sequestration and other spending cuts in January.

According to projections made by the Congressional Budget Office (CBO), if all these things took place, real GDP growth would be reduced by about 4 percentage points in 2013.



I’m not saying that a pullback of this magnitude should be the base-case scenario.

The orders of magnitude are just too big to be a base case.

But when you go through the various items and make guesses at which may stay and which may go, it is easy to envision scenarios that include a marked increase in fiscal restraint in 2013.

In addition, given the political process, it seems unlikely that we will know much about the size or composition of the cuts until late in the process.

It’s also easy to see how the rhetoric of public negotiating stances could produce an atmosphere that causes already jittery households and businesses to put some spending plans on hold.

In sum, a messy resolution to the fiscal cliff problems presents an important downside risk to U.S. growth prospects and, by extension, to world economic growth.

And even the possibility of such an outcome could be a drag in the second half of the year.

Policy Choices

Let me now switch gears and talk about my views regarding the choices facing monetary policymakers in the U.S.

Yes, we have substantial liquidity already in place in our financial system.

On the surface, this looks like substantial monetary accommodation.

But as a large body of economic theory tells us, for this liquidity to be sufficiently accommodative, the public needs to expect that we will keep it in place for as long as is necessary to restore the economy to a sound footing.

This is why I believe we should clarify the Fed’s forward guidance with regard to the future course of policy. Let me now go into the details behind these thoughts.



An explicit economic state-contingent policy

In weighing alternative policy approaches, I think the best way to provide forward guidance is by tying our policy actions to explicit measures of economic performance.

There are many ways of doing this, including setting a target for the level of nominal GDP.

But recognizing the difficult nature of that policy approach, I have a more modest proposal: I think the Fed should make it clear that the federal funds rate will not be increased until the unemployment rate falls below 7 percent.

Knowing that rates would stay low until significant progress is made in reducing unemployment would reassure markets and the public that the Fed would not prematurely reduce its accommodation.

Based on the work I have seen, I do not expect that such policy would lead to a major problem with inflation.

But I recognize that there is a chance that the models and other analysis supporting this approach could be wrong.

Accordingly, I believe that the commitment to low rates should be dropped if the outlook for inflation over the medium term rises above 3 percent.

The economic conditionality in this 7/3 threshold policy would clarify our forward policy intentions greatly and provide a more meaningful guide on how long the federal funds rate will remain low.

In addition, I would indicate that clear and steady progress toward stronger growth is essential.

Because we are not seeing that now, I support further use of our balance sheet to provide even more monetary accommodation.

In June we decided to continue our Maturity Extension Program, which puts downward pressure on long-term interest rates by extending the average maturity of the Federal Reserve’s securities portfolio.



I thought that was a useful step.

However, I believe it is time to take even stronger steps, such as the purchase of more mortgage-backed securities, to increase the degree of monetary support for the recovery.

As suggested recently by my colleagues Eric Rosengren and John Williams, these could be open-ended purchases, meaning that they would continue at a certain rate until there was clear evidence of improvement in economic conditions.

To me, one example of clear evidence would be a resumption of relatively steady monthly declines in unemployment for two or three quarters.

Once this momentum was confidently established, the Fed could stop adding to our balance sheet but keep the funds rate at zero.

The funds rate would remain unchanged in my thinking, until the unemployment rate hit at least 7 percent or the medium-term inflation outlook deteriorated dramatically and rose above 3 percent.

Later, reductions in the Fed’s balance sheet assets would occur sometime after the first increase in the funds rate.

This corresponds to the general exit principles the FOMC agreed upon last year.

Presumably, the pace of asset reductions would be measured and consistent with a continued, robust recovery in the context of price stability.

Accommodation in the Context of a Symmetric Inflation Target and Balanced Policy

I can’t tell you how often people look at me in horror when I say that we should adopt a conditional policy that tolerates the risk of inflation exceeding our target by as much as 1 percentage point.

How can I accept inflation rising above our stated target? Isn’t this blasphemy for a central banker?



In January, in the same framework document that announced our 2 percent inflation target, we also stated a number of principles for the conduct of monetary policy.

One was that policy would take a balanced approach in achieving the two legs of the Federal Reserve’s dual mandate — maximum employment and price stability.

An explicit real-side mandate makes the Federal Reserve different than most central banks.

While just about all central banks follow a flexible inflation targeting approach, in which they seek to minimize real-side fluctuations in pursuit of their inflation objective, most are explicitly charged only with an inflation objective.

But for the Fed, maximum employment is an explicit part of our policy mandate.

I strongly support the policy principles document we released in January. But we’re still hearing questions about whether our inflation goal is symmetric and about the specifics of how policy will be implemented under the balanced approach articulated in this framework.

As Chairman Bernanke (2012) stated at his April press conference, the 2 percent inflation goal is a symmetric objective and not a ceiling on inflation.

Symmetry means that inflation below 2 percent should be viewed as the same policy miss as if inflation overran 2 percent by equal amount.

We need to take symmetry seriously.

If we disproportionately recoil at inflation a little above 2 percent versus a little below, then we are not symmetrically weighing policy misses.

And we will not average 2 percent inflation, which is our goal.

There is some risk of this misperception taking hold. Consider the FOMC’s latest Summary of Economic Projections (SEP), which includes the projections of all FOMC participants, voters and non-voters alike.



In it, several forecasts have the funds rate rising before 2014, even though throughout the projection period most see inflation at or below 2 percent and unemployment well above the sustainable rate indicated by the long-run projections.

Without further explanation, it’s difficult to see how this is consistent with a symmetric inflation goal and a balanced approach to achieving the two legs in our dual mandate.

I believe the FOMC can do better at describing our thinking with respect to tolerance bands around our long-run inflation and unemployment goals.

Clarification would increase both transparency and accountability.

Importantly, it would reassure economic agents that Fed policy would not tighten prematurely.

To me, a symmetric inflation goal and a balanced approach to policy mean that if we are missing our employment mandate by a large amount, but are close to our inflation target, then we should be willing to undertake policies that could substantially reduce the employment gap even if they run the risk of a modest, transitory rise in inflation that remains within a reasonable tolerance range of our target.

I believe such actions, such as the 7/3 threshold policy I have been advocating, would produce smaller net losses relative to our dual mandate goals than would current policy.

Conclusion: The Need for a Vibrant Economy to Cushion Risks

Finding a way to deliver more accommodation — whether it is monetary or fiscal — is particularly important now because delays in reducing unemployment are costly.

An unusually large percentage of the unemployed have been without work for quite an extended period of time; their skills can become less current or even deteriorate, leaving affected workers with permanent scars on their lifetime earnings.



And any resulting lower aggregate productivity also weighs on potential output, wages and profits for the economy as a whole.

The damage intensifies the longer that unemployment remains high.

Failure to act aggressively now could lower the capacity of the economy for many years to come.

Such potential costs would come with the continuation of a subpar pace of economic recovery.

The significant risks I discussed earlier – financial disruption from a worsening of the situation in Europe or a messy resolution of U.S. fiscal policy – raise the specter of an even more worrisome outcome.

At the moment economic growth is not much above stall speed.

Another negative shock could send the economy into recession.

And if a recessionary dynamic takes hold, it would be especially difficult to regain momentum.

I have outlined some policy actions that I think can take us in the direction of a more vibrant and resilient economy.

Given the risks we face, I think it is vital that we make such moves today. I don’t think we should be in a mode where we are waiting to see what the next few data releases bring.

We are well past the threshold for additional action; we should take that action now.

Thank you.

Note

Charles L. Evans is the ninth president and chief executive officer of the Federal Reserve Bank of Chicago. In that capacity, he serves on the Federal Open Market Committee (FOMC), the Federal Reserve System's monetary policy-making body.



The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banks across the country. These 12 banks — along with the Board of Governors in Washington, D.C. — make up our nation's central bank.

As head of the Chicago Fed, Evans oversees the work of roughly 1400 employees in Chicago and Detroit who conduct economic research, supervise financial institutions, and provide payment services to commercial banks and the U.S. government.

Before becoming president in September of 2007, Evans served as director of research and senior vice president, supervising the Bank's research on monetary policy, banking, financial markets and regional economic conditions. Prior to that, Evans was a vice president and senior economist with responsibility for the macroeconomics research group.

His personal research has focused on measuring the effects of monetary policy on U.S. economic activity, inflation and financial market prices. It has been published in the Journal of Political Economy, American Economic Review, Journal of Monetary Economics, Quarterly Journal of Economics, and the Handbook of Macroeconomics.

Evans is active in the civic community. He is a board member at Chicago Metropolis 2020 and the Metro Chicago Information Center, and a trustee at Rush University Medical Center.

Evans has taught at the University of Chicago, the University of Michigan and the University of South Carolina. He received a bachelor's degree in economics from the University of Virginia and a doctorate in economics from Carnegie-Mellon University in Pittsburgh.



EBA, EIOPA and ESMA Joint Consultation Paper on Draft Regulatory Technical Standards on the uniform conditions of application of the calculation methods under Article 6.2 of the Financial Conglomerates Directive (JC/CP/2012/02)

I. Responding to this Consultation EBA, EIOPA and ESMA (the ESAs) invite comments on all matters in this paper and in particular on the specific questions stated in the attached document “Overview of questions for Consultation” at the end of this paper. Comments are most helpful if they: - respond to the question stated;

- indicate the specific question to which the comment relates;

- contain a clear rationale;

- provide evidence to support the views expressed/ rationale proposed; and

- describe any alternative regulatory choices EBA should consider.

II. Executive Summary The CRR/CRD IV proposals (the so-called Capital Requirements Regulation - henceforth ‘CRR’- and the so-called Capital Requirements Directive – henceforth ‘CRD’) set out prudential requirements for banks



and other financial institutions which are expected to apply from 1 January 2013. In anticipation of the finalisation of the legislative texts for the CRR/CRD IV, the EBA, EIOPA and ESMA (hereafter the ESAs) through the Joint Committee, have developed the draft RTS in accordance with the mandate contained in Article 46(4) of the CRR and Article 139 of CRDIV (amending Article 21 a (2a) of the Directive 2002/87/EC) on the basis of the European Commission’s proposals. This Article provides the ESAs through the Joint Committee, to develop draft Regulatory Technical Standards (RTS) with regard to the conditions of the application of the Article 6(2) of the Directive 2002/87/EC (hereafter the Directive). Further the ESAs have developed the draft RTS having regard to Article 230 in connection with Articles 220 and 228 of the Directive 2009/138/EC2. To the extent that the texts may change before their adoption, the ESAs shall adapt its draft RTS accordingly to reflect any developments. The RTS included in this consultation have to be submitted to the EU Commission by 1 January 2013. Please note that the ESAs have developed the present draft RTS based on the European Commission’s legislative proposals for the CRR/CRD IV. They have also taken into account major changes subsequently proposed by the revised texts produced by the Council of the EU and the European Parliament, during the ordinary legislative procedure (co-decision process). Following the end of the consultation period, and to the extent that the final text of the CRR/CRD IV changes before the adoption of the RTS, the ESAs will adapt the draft RTS accordingly to reflect any developments.



Main features of the RTS This consultation paper puts forward draft RTS in order to ensure that institutions that are part of a financial conglomerate apply the appropriate calculation methods for the determination of required capital at the level of the conglomerate. They are based in particular on the following elements:

General Principles o Elimination of multiple gearing; o Elimination of intra-group creation of own funds; o Transferability and availability of own funds; and o Coverage of deficit at financial conglomerate level having regard to definition of cross-sector capital.

Technical calculation methods 1. Method 1: “Accounting consolidation method”:

The FICOD provides in relation to Method 1 that the own funds are calculated on the basis of the consolidated position of the group. According to this general provision, the calculation of own funds should be based on the relevant accounting framework for the consolidated accounts of the conglomerate applicable to the scope of the Directive. The use of “consolidated accounts” eliminates all own funds’ intra-group items, in order to avoid double counting of capital instruments. According to the Directive provisions, the eligibility rules are those included in sectoral provisions.



2. Method 2: “Deduction and aggregation method”.

This method calculates the supplementary capital adequacy requirements of a conglomerate based on the accounts of solo entities. It aggregates the own funds, deducts the book value of the participations in other entities of the group and specifies treatment of the proportional share applicable to own funds and solvency requirements. All intra-group creation of own funds shall be eliminated.

3. Method 3: “Combination of methods 1 and 2”. The use of combination of accounting consolidation method 1 and deduction and aggregation method 2 is limited to the cases where the use of either method 1 or method 2 would not be appropriate and is subject to the permission by the competent authorities.

III. Background and rationale The supplementary supervision of financial entities in a financial conglomerate is covered by the Financial Conglomerates Directive 2002/87/EC, hereafter known as the Directive. This Directive provides for competent authorities to be able to assess at a group-wide level the financial situation of credit institutions, insurance undertakings and investment firms which are part of a financial conglomerate, in particular as regards solvency (including the elimination of multiple gearing of own funds instruments).

The nature of RTS under EU law Draft RTS are produced in accordance with Article 10 of the ESAs regulation.



According to Article 10(4) of the ESAs regulation, they shall be adopted by means of Regulations or Decisions. According to EU law, EU regulations are binding in their entirety and directly applicable in all Member States. This means that, on the date of their entry into force, they become part of the national law of the Member States and that their implementation into national law is not only unnecessary but also prohibited by EU law, except in so far as this is expressly required by them. Shaping these rules in the form of a Regulation would ensure a level-playing field and would facilitate the cross-border provision of services.

Background and regulatory approach followed in the draft RTS These draft RTS are produced in accordance with CRD IV/CRR proposals, which provide that the EBA, ESMA and EIOPA (hereafter the ESAs), through the Joint Committee, shall develop draft regulatory technical standards with regard to the conditions of the application of the calculation methods with regard to Article 6(2) of the Directive and shall submit those draft regulatory technical standards to the Commission by 1 January 2013. The proposed draft RTS covers the uniform conditions for the use of the methods for the determination of capital adequacy of a financial conglomerate under the Directive. They elaborate on Technical principles applying to all of the three methods provided for by Directive; and also contain an Annex providing further detail for Method 2. The requirements contained in the draft RTS are mainly directed at institutions, although some of them are directed at competent authorities.



IV. Draft Regulatory Technical Standards on the uniform conditions of application of the calculation methods under Article 6.2 of the Financial Conglomerates Directive

Commission Delegated Regulation (EU) No XX/2012 supplementing Directive xx/XX/EU [CRD] of the European Parliament and of the Council of [date], Regulation (..) No xx/XXXX [CRR] of the European Parliament and of the Council of [date] and Directive 2002/87/EC [Financial Conglomerates Directive] of the European Parliament and of the Council of [date] with regard to regulatory technical standards for the uniform conditions of application of the calculation methods under Article 6.2 of the Financial Conglomerates Directive of XX Month 2012

THE EUROPEAN COMMISSION, Having regard to the Treaty on the Functioning of the European Union, Having regard to the [proposal for a] Regulation (...) No xx/xxxx of the European Parliament and of the Council of dd mm yyyy on prudential requirements for credit institutions and investment firms Regulation xx/xxxx [CRR] and in particular Article 46 (4) thereof. Having regard to the [proposal for a] Directive (...) No xx/xxxx of the European Parliament and of the Council of dd mm yyyy on the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms [CRDIV] and in particular Article 139 thereof. Having regard to the Directive 2002/87/EC, as amended, of the European Parliament and of the Council on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate (hereinafter “the Directive”) and in particular to Article 6(2) and Annex 1 thereof. Whereas:



(1) Directive 2002/87/EC provides in Chapter II, Section 2, rules on capital adequacy of financial conglomerates, such that the elements of own funds are available at the level of a Financial Conglomerates are always at least equal to the capital adequacy requirements as calculated in accordance with Annex I of the Directive. (2) Regulation (...) No xx/xxx (‘CRR’) provides in Article 46, within Part II, Chapter 2, Section 3, Sub-Section 2 and in the context of common equity Tier I rules, requirements for deduction where consolidation or supplementary supervision are applied. This section of the CRR provides empowerments to the European Commission to adopt delegated acts (regulatory technical standards) in accordance with articles 10-14 of the Regulation (EU) No 1093/2010 establishing the European Banking Authority (‘EBA’), Articles 10-14 of the Regulation (EU) No 1094/2010 establishing the European Insurance and Occupational Pensions Authority (‘EIOPA), and Articles 10-14 of the Regulation (EU) No 1095/2010 (‘ESMA), establishing the European Securities and Markets Authority. These acts will complete the EU single rulebook for institutions in the area of own funds. (3) Directive (...) No xx/xxx (‘CRDIV’) provides in Article 139 that the Directive 2002/87/EC shall be amended, such that the EBA, EIOPA and ESMA through the Joint Committee, to develop draft Regulatory Technical Standards (RTS) with regard to the conditions of the application of the Article 6(2) of the Directive. (4) For effective supervision of Financial Conglomerates, supplementary supervision should be applied to all such conglomerates, the cross-sectoral financial activities of which are significant, which is the case when certain thresholds are reached, no matter how they are structured.



Supplementary supervision should cover all financial activities identified by the sectoral financial legislation and all entities principally engaged in such activities should be included in the scope of the supplementary supervision, including asset management companies and alternative investment fund management companies. (5) Without prejudice to sectoral rules, supplementary supervision of the capital adequacy rules is necessary to bring more convergence in the application of the calculation methods listed in Annex 1 of the Directive. (6) For financial conglomerates which include significant banking or investment business and insurance business, multiple use of elements eligible for the calculation of own funds at the level of the financial conglomerate (multiple gearing) as well as any inappropriate intra-group creation of own funds must be eliminated. (7) The financial conglomerate should seek an acceptable timeframe for the transferability of funds across entities within the financial conglomerate, which shall depend on whether the specific entity is subject to the Directive 2009/138/EC or the CRDIV/CRR. Moreover for an entity subject to the CRD IV/CRR this timeframe should be expediated based on the fact that due to the nature of their activities, they are more vulnerable to a rapid deterioration in confidence and/or sudden resolution situation. (8) In addition any non-sector-specific own funds, in excess of sectoral requirements, need to originate from entities which are not subject to transferability/availability impediments. (9) It is important to ensure that own funds are only included at conglomerate level if there are no impediments to the transfer of assets or repayment of liabilities across different conglomerate entities, including across sectors.



(10) If there is a deficit of own funds at the level of the financial conglomerate, the financial conglomerate should inform the coordinator on the measures taken to cover this deficit. (11) Further convergence in the way that financial conglomerates apply these rules shall ensure the robust and consistent application of the methods of calculation. (12) For bank-led conglomerates it is necessary to apply the most prudent method of calculation for the treatment of insurance holdings to avoid regulatory arbitrage. (13) It is important that sector-specific own funds cannot cover risks above sectoral requirements. The financial conglomerate should first count sector-specific own funds against their requirements (while respecting sectoral rules and limits) for each relevant entity or group of entities. If there is an excess of sector-specific own funds, this should not be recognised at conglomerate level. (14) When calculating supplementary capital adequacy of a financial conglomerate, in respect to non-regulated financial entities within the financial conglomerate, both a notional capital requirement and a notional level of own funds shoud be calculated. (15) Under Solvency II, method 1 is applied on the basis of consolidated data which are set out at Level 2 and not on the basis of consolidated accounts. (16) Further changes to the capital adequacy rules may be addressed in the European Commission’s review of Directive 2002/87/EC. (17) It is necessary that the new regime for treatment of methods of consolidation enters into force the soonest possible following the entry into force of the CRR/CRD IV and Solvency II.



(18) This Regulation is based on the draft regulatory technical standards submitted jointly by the EBA, EIOPA and ESMA to the Commission. (19) The EBA, EIOPA and ESMA have conducted open public consultations on the draft regulatory technical standards on which this Regulation is based, analysed the potential related costs and benefits, in accordance with Article 10 of Regulation (EU) No 1093/2010, Article 10 of Regulation (EU) No 1094/2010, Article 10 of Regulation (EU) No 1095/2010,and requested the opinion of the Banking Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1093/2010, Insurance Stakeholder Group and the Occupational Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1094/2010, and the European Securities and Markets Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1095/2010.

HAS ADOPTED THIS REGULATION:

TITLE I Subject matter and definitions Article 1 Subject matter This Regulation lays down rules of the uniform conditions of application of the calculation methods under Article 6.2 of the Directive.

Article 2 Definitions 1. Definitions of the CRD IV/CRR, Directive 2002/87/EC and Directive 2009/138/EC shall apply to this Regulation.



2. Capital instruments are those capital instruments eligible under CRR (Regulation 2012/…./EC) and those capital instruments referred to as “own funds” in Directive 2009/138/EC. 3. Ultimate responsible entity is the entity within the financial conglomerate that is responsible for determining the capital for the financial conglomerate having regard to the following minimum criteria: control, the dominant entity from the market’s perspective (market listed entity) and the ability to fulfill specific duties towards its subsidiaries and its supervisor. 4. ‘indirect holding’ as defined under definition 17 of Article 22 of CRR [to be added if not in final CRR text].

5. Insurance-led financial conglomerate is a financial conglomerate whose most important sector is insurance as defined under Article 3(2) of the Directive. 6. Bank-led financial conglomerate is a financial conglomerate whose most important sector is banking as defined under Article 3(2) of the Directive. 7. Investment firm-led financial conglomerate is a financial conglomerate whose most important sector is investment services as defined under Article 3(2) of the Directive.

TITLE II Technical Principles Article 3 Elimination of multiple gearing and the intra-group creation of own funds The ultimate responsible entity shall ensure that own funds, which have been created by intra-group transactions, be it direct or indirect, shall be



eliminated for the purpose of determining the required capital on a consolidated basis.

Article 4 Transferability and availability of own funds 1. For all entities of a financial conglomerate, own funds, in excess of sectoral solvency requirements, shall be considered available to absorb losses elsewhere in the financial conglomerate provided that all of the following conditions are fulfilled: (a) There are no practical, legal, regulatory, contractual or statutory impediments to the transfer of funds or repayment of liabilities across conglomerate entities in due course. This is the case when the transfer of own funds from one conglomerate entity to another is not barred by a restriction of any kind and there are no claims of any kind from third parties on these assets. The ultimate responsible entity of the financial conglomerate shall confirm to the satisfaction of the coordinator that the conditions set out in this point are met. (b) For the purpose of assessing the transferability of funds to entities subject to 2009/138/EC, “in due course” shall mean no later than 9 months; for the purpose of assessing the transferability of funds to entities subjected to CRR, “in due course” shall mean no later than, three calendar days with no impediments on the coordinator requiring a faster transfer if necessary. 2. Own funds, in excess of sectoral solvency requirements, which do not meet the criteria under point 1 shall be excluded from the conglomerate’s own funds.



3. The financial conglomerate shall demonstrate that measures have been taken to mitigate the risk that transfer of funds would have a material effect on the transferor’s solvency.

EXPLANATORY TEXT for consultation purposes This text is consistent with Annex 1 of the Directive which states “when calculating own funds at the level of the financial conglomerate, competent authorities shall also take into account the effectiveness of the transferability and availability of the own funds across the different legal entities in the group, given the objectives of the capital adequacy rules”. Point 1(a) aims to ensure that own funds are only included at conglomerate level if there are not impediments to the transfer of assets or repayment of liabilities across different conglomerate entities, including across sectors. If the conglomerate cannot confirm to the satisfaction of the coordinator that there are no inherent impediments in relation to a given entity, that entity’s own funds in excess of its sectoral requirements cannot be included at conglomerate level. The impediments to be considered include practical, regulatory, contractual or statutory ones. Point 1(b) establishes an acceptable timeframe for the transferability of funds across conglomerate entities. There is a differentiation based on the fact that entities subject to CRR, due to the nature of their activities, are more vulnerable to a rapid deterioration in confidence and/or sudden resolution situation.

Article 5 Deficit of own funds at the financial conglomerate level



1. When the difference calculated according to method 1, 2 or 3 as detailed in Annex 1 of the Directive is negative, the financial conglomerate shall ensure that the deficit is remedied with cross-sector own funds elements as defined in point 2 below. 2. When calculating own funds at the level of the financial conglomerate, cross sector own funds are elements eligible for: (a) Common Equity Tier 1 in accordance with Regulation …/2012/EC [or Tier 1 Unrestricted Basic Own Funds in accordance with Directive 2009/138/EC], or (b) Elements that meet both sets of rules for Additional Tier 1 in accordance with Regulation …/2012/EC and Tier 1 [Restricted Basic Own Funds in accordance with Directive 2009/138/EC], or (c) elements that meet both sets of rules for Tier 2 in accordance with Regulation …/2012/EC and for Tier 2 in accordance with Directive 2009/138/EC. 3. Cross-sector own funds elements mentioned in point 2 shall only be taken into account if their transferability and availability across the different legal entities in the financial conglomerate meet the conditions set out in Article 4.

EXPLANATORY TEXT for consultation purposes The text is based on the Technical principles in Annex 1 of the Directive “Whichever method is used, when the entity is a subsidiary undertaking and has a solvency deficit, or, in the case of a non-regulated financial sector entity, a notional solvency deficit, the total solvency deficit of the subsidiary has to be taken into account. Where in this case, in the opinion of the coordinator, the responsibility of the parent undertaking owning a share of the capital is limited strictly and unambiguously to that share of the capital, the coordinator may give permission for the solvency deficit of the subsidiary undertaking to be taken into account on a proportional basis.”



In line with the Directive only cross-sector own funds are allowed as a remedy to a conglomerate deficit. That is, from the point at which a conglomerate deficit is observed, that shortfall amount shall be covered by the issuance of cross-sector own funds, regardless of the cause of the conglomerate deficit. The financial conglomerate shall inform the coordinator about the deficit and the measures to cover this deficit without delay.

Article 6 Consistency 1. The Method of Calculation selected from those methods defined in Annex 1 of the Directive shall be applied in a consistent manner over time. 2. For the purpose of Article 6(2) and Annex 1 of the Directive, for a banking led conglomerate, where Article 46 (1) of the CRR is applied, the coordinator, after consulting with other competent authorities concerned, shall decide the most prudent method to be applied by the financial conglomerate.

Article 7 Consolidation For the purpose of Art 6(2) and Annex 1 of the Directive, Method 1 of the Directive 2009/138/EC shall be considered as equivalent to the consolidation as defined under Method 1 of the Directive, for insurance-led financial conglomerate. The equivalence assessment is valid provided that the scope of the group under Solvency II is the same under the Directive or the difference in the scope is not material.

EXPLANATORY TEXT for consultation purposes



This text is based on the Directive 2009/138/EC, Article 230 in connection with Articles 220 ss. The Solvency II Implementation measures will need to be considered once they have been published. According to Directive 2009/138/EC, for the calculation of group own funds all the multiple use of eligible own funds and intra-group creation of capital should be eliminated. Moreover, own funds of other financial sectors should be calculated according to the relevant sector rules. As a result, both Method 1 of the Directive 2009/138/EC and Method 1 of the Directive are consistent with the main objectives of the supplementary supervision since they ensure that: all double-counting is removed; own funds are calculated in accordance with the definitions and limits established in the relevant sectoral rules. The equivalence assessment is valid provided that the scope of the group under Solvency II is the same under the Directive or the difference in the scope is not material.

Article 8 Solvency requirement 1. For the purpose of the calculation of the supplementary capital adequacy requirements of the regulated entities in a financial conglomerate, a solvency requirement shall satisfy either of the points laid down in (a) and (b): (a) Where the rules for the insurance sector are to be applied, solvency requirement means the Solvency Capital Requirement as defined by Article 100 or 218 of Directive 2009/138/EC as applicable, including any capital add-on applied in accordance with Articles 37, 231(7) or 232 of the



same directive as applicable, and any other capital or own funds requirement applicable under Union legislation. (b) Where the rules for the banking or investment services sector are to be applied, solvency requirement means the sum of own funds requirements as defined by Articles 87 to 93 of CRR, combined buffer requirements as defined by Article 122 of CRD IV, and specific own funds requirements as defined by Article 100 of [CRDIV], and any other requirement applicable under European Union law.

Article 9 The financial conglomerate's own funds and capital requirements 1. Except where expressly stated in this Regulatory Technical Standard, the financial conglomerate's own funds and capital requirements shall be calculated in accordance with the definitions and limits established in the relevant sectoral rules. 2. The own funds of asset management companies shall be calculated according to Article 2 (l) of Directive 2009/65/EC; the capital requirements are calculated according to Article 7(1) (a) of Directive 2009/65/EC. 3. The own funds of alternative investment fund managers shall be calculated according to Article 9 of Directive 2011/61/EU.

Article 10 Sector specific own funds 1. Sector specific own funds, are recognised for the coverage of risks at the sectoral level only and cannot be used to cover risks of another sector and shall not be included (above or) beyond the sectoral level. Sector specific own funds are own funds recognised under sectoral rules that do not fall within one of the following categories:



(a) Common Equity Tier 1, Additional Tier 1 and Tier 2 own funds under [CRR]; or (b) Tier 1 unrestricted basic own funds, Tier 1 restricted basic own funds, and Tier 2 basic own funds under Directive 2009/138/EC. 2. Risks originating from the other sector shall not be covered by sector specific own funds.

EXPLANATORY TEXT for consultation purposes Article 10 sets out that sector-specific own funds cannot cover risks above sectoral requirements. In practice, this means that, for each relevant entity or group of entities, conglomerates need to first count sector-specific own funds against their requirements (while respecting sectoral rules and limits). If there is an excess of sector-specific own funds, this shall not be recognised at conglomerate level. In addition, as stated in Article 4, any non-sector-specific own funds in excess of sectoral requirements need to originate from entities which are not subject to transferability/availability impediments.

Article 11 Treatment of cross sector holdings for the calculation of capital requirements Where an insurance holding of a bank-led financial conglomerate or an investment firm-led financial conglomerate is eliminated pursuant to Articles 14.3 and 14.4 or Article 15.2 or the application of these Articles as part of Method 3, no capital charge for that holding shall be applied at the financial conglomerate level for the purpose of supplementary supervision, even if a capital charge is applied at sectoral level.



EXPLANATORY TEXT for consultation purposes At sectoral level, holdings may receive a risk weight or capital charge. At the financial conglomerate level, the same holding may be deducted or eliminated from own funds through consolidation, making the risk weight or capital charge superfluous. This capital charge shall thus not be applied for the purposes of the calculation of the conglomerates solvency requirements.

Article 12 Non-regulated financial entities 1. For a non-regulated mixed financial holding company and for a non-regulated entity held by a mixed financial holding company, the own funds and the capital requirements attributable to the non-regulated financial sector entities shall be calculated according to the most important sector in the financial conglomerate in accordance with Article 3(2) of the Directive. 2. The own funds and the solvency requirements attributable to other non-regulated financial entities shall be calculated according to the sectoral rules of the sector (insurance or banking) to which the non regulated entity is designated.

EXPLANATORY TEXT for consultation purposes A “mixed financial holding company” is defined under Article 2(15) of the Directive. Whichever method is used, for the purpose of the calculation of the supplementary capital adequacy of a financial conglomerate, both a notional capital requirement and notional level of own funds should be calculated for non-regulated financial entities.



These should be calculated according to the rules of the sector to which the non regulated entity belongs, or according to the most important sector in the conglomerate, having regard to Annex 1 of the Directive “In the case of a non-regulated financial sector entity, a notional solvency requirement is calculated in accordance with section II of this Annex, notional solvency requirement means the capital requirement with which such an entity would have to comply under the relevant sectoral rules as if it were a regulated entity of that particular financial sector; the notional solvency requirement of a mixed financial holding company shall be calculated according to the sectoral rules of the most important financial sector in the financial conglomerate”.

Article 13 Transitional and grandfathering arrangements The sectoral rules applied in the calculation of conglomerate own funds and solvency requirements shall take into account any transitional or grandfathering arrangements in force at sectoral level.

TITLE III Technical calculation methods Article 14 Method 1 Calculation criteria 1. The own funds of a financial conglomerate shall be calculated on the basis of the consolidated accounts (according to the relevant accounting framework) applied to the scope of supplementary supervision of the Directive. 2. The calculation of own funds shall take into account the removal of intra group balances, transactions and income and expenses related to the process of accounting consolidation. 3. For bank-led and investment firm-led conglomerates, unconsolidated



significant investments in a financial sector entity pursuant to Article 40 of the CRR shall be fully deducted, if the entity belongs to the insurance sector as defined in Article 2(8) of the Directive. 4. Unconsolidated non significant investments are deducted in accordance with the treatment described in Article 43 of CRR. 5. For bank-led and investment firm-led conglomerates, the sectoral treatment in Part 2, Title II of the CRR shall apply to all unconsolidated investments, participations and holdings of a conglomerate entity, provided that: (a) The conglomerate entity is a credit institution or an investment firm; and (b) The investment, participation or holding is in a credit institution or in an investment firm. 6. Without prejudice to points 3 and 4, any other own funds issued by one conglomerate entity and held by another, if not already eliminated in the accounting consolidation process, shall be deducted. 7. Joint controlled entities shall be treated in accordance with sectoral rules. 8. The valuation of assets and liabilities calculated for the purposes of Directive 2009/138/EC shall be used at the level of the financial conglomerate. 9. Where asset or liability values are subject to the calculation of prudential filters and deductions in accordance with those required under CRR, the asset or liability values used shall be those attributable to the relevant entities under CRR, excluding assets and liabilities attributable to other entities of the financial conglomerate. Where calculation of a threshold or limit is required in order to respect sectoral rules, the threshold or limit shall be calculated on the basis of the



consolidated data of the financial conglomerate and after the removal of holdings called for by these standards. 10. Where credit institutions/investment firms and related entities are consolidated under CRR, the same entities shall be considered together. 11. Where insurance and related entities are consolidated under Directive 2009/138/EC, the same entities shall be considered together. 12. Conglomerate entities that are not consolidated under CRR or Directive 2009/138/EC shall be treated separately. 13. For the purpose of the calculation of solvency requirements, each sector shall respect the requirements as calculated under the relevant sectoral rules. When summing the relevant sectoral solvency requirements there shall be no adjustment other than as foreseen by Article 11 of Title II or as caused by adjustments to sectoral thresholds and limits pursuant to point 9 of this Article 14.

EXPLANATORY TEXT for consultation purposes ACCOUNTING CONSOLIDATION AND JOINT CONTROLLED ENTITIES (Points 1, 2 and 7) Under Method 1, the Directive requires the calculation of the own funds of the conglomerate on the basis of the consolidated position of the group. In addition, any inappropriate intra-group creation of own funds must be eliminated. In order to ensure these provisions are respected, points 1 and 2 of Article 14 requires the conglomerate to use consolidated accounts (applied to the scope of the conglomerate) as the starting point for the calculation of the



own funds. In doing so, the conglomerate must allow all eliminations of own funds arising from the process of accounting consolidation to take place. Joint-controlled entities are to be proportionally consolidated in line with point 6.

OTHER INTRA-GROUP CREATION OF OWN FUNDS (Point 6) In line with the Directive’s principles, Article 3 of this Regulation calls for the elimination of all own funds that have been created by intra-group transactions, be it direct or indirect. For the avoidance of doubt in the context of Method 1, point 5 further specifies that all intra-group creation of own funds should be eliminated on top of accounting consolidation, if not already eliminated as part of the accounting consolidation process. Such additional elimination may be required in particular where the treatment of the participation called for by the Directive is different from that provided for by accounting rules, considered that accounting rules doesn’t consider the multiple gearing issue.

CROSS SECTOR HOLDINGS AND OTHER HOLDINGS (Points 3, 4 and 5) For bank-led and investment firm-led conglomerates, the calculation of own funds at the level of the conglomerate should also take into account that the sectoral rules allow institutions to risk weight and not deduct some cross-sector holdings. For this reason, in order to ensure the elimination of multiple gearing at the level of conglomerate, point 3 of Article 14 requires the deduction of holdings that are neither consolidated nor eliminated (by deduction) at sectoral level, where those holdings are in entities belonging to the



insurance sector. Point 4 describes the treatment of unconsolidated non-significant investment holdings where those holdings are in entities belonging to insurance entities. Point 5 describes the treatment of other holdings, specifying that other holdings are treated according to sectoral rules (see the table in Annex II).

SOLVENCY 2 VALUATION CRITERIA (Points 8) For insurance parts of the conglomerate, given that Article 75 of Directive 2009/138/EU sets out specific valuation rules for assets and liabilities, point 8 of Article 14 specifies that assets and liabilities for those entities within the conglomerate should follow the valuations calculated for the purpose of Directive 2009/138/EU. This point is aimed at ensuring that the calculation of the elements of own funds at the level of conglomerate is consistent with sectoral rules.

RECALCULATION OF LIMITS AND THRESHOLDS, TAKING INTO ACCOUNT REMOVAL OF HOLDINGS (Points 9) Once the accounting consolidation has been carried out, as well as the other provisions already mentioned, amounts of CET1 attributable to conglomerate entities that are subject to CRR at sectoral level, as well as amounts of holdings belonging to such entities that are neither deducted nor consolidated, will change. So the calculations based on CET1 in Article 45 of CRR, which measure the threshold for the deduction of deferred tax assets and significant investments, should be recalculated. The recalculation should take into account the effect on CET1 of the



conglomerate accounting consolidation process, proportional consolidation in accordance with point 7, the removal of holdings in point 3, and any other factors stemming from the conglomerate calculation that have led to a change in CET1 . In the calculation according to Article 45 of CRR for an entity or group of entities, the deferred tax assets and significant investments to be taken into account are only those belonging to that entity or group of entities within the conglomerate. These rules are provided for in point 9.

MULTI-LAYER CONGLOMERATES (Points 10, 11 and 12) This Regulation recognises that financial conglomerate structures may be very complex and involve different layers (see graph example below).

In cases like this, where a banking group controls an insurance group, which – in turn – controls a bank, in order to calculate the limits or thresholds provided at sectoral level, the data of the banking group at the



top of the group shall not be calculated jointly with the data belonging to the bank (B) controlled by the insurance group. In this case, bank (B) calculates a threshold on its Deferred Tax Assets. Bearing in mind that the Directive states the elements eligible for the calculation of the own funds are those that qualify in accordance with the relevant sectoral rules, point 10 calls for the relevant groupings at sectoral level to be maintained also at the conglomerate level for the purposes of calculating limits and thresholds.

SOLVENCY REQUIREMENTS (Point 13) Finally, point 13 specifies that the calculation of solvency requirements is based on the sum of sectoral and notional requirements, except for the provision included in Article 11 (no capital charge for holdings that are consolidated or deducted at the conglomerate level). See also the Annex - Summary of the treatment of holdings and participations for the purpose of the calculation of the own funds of the conglomerate.

Article 15 Method 2 Calculation criteria 1. For the purpose of calculating Method 2 as set out in Annex I part II of the Directive: (a) The proportional share applicable to own funds and solvency requirements shall relate to the proportion of the subscribed capital which is directly or indirectly held by the parent undertaking or undertaking which holds a participation in another entity of the group; (b) The book value of participations in other entities of the group shall be the book accounting value for the parent undertaking or for the undertaking that holds a participation in another entity of the group;



(c) Where the own funds of a holding is subject to a prudential filter, the filtered amounts shall be: i) Added to the book value mentioned in b), if the filtered amount increases regulatory capital; or ii) Deducted from the book value mentioned in b), if filtered amount decreases regulatory capital. (d) For the purpose of point (c), the filtered amounts pertains to the net amount affecting own funds of the holding. 2. For bank-led and investment firm-led conglomerates, significant investments in a financial sector entity pursuant to Article 40 of the CRR, if the entity belongs to the insurance sector as defined in Article 2(8) of the Directive, shall be: (a) Fully deducted, where the holding is not a participation as defined in Article 2(11) of the Directive, and (b) Treated according to Method 2, where the holding is a participation as defined in Article 2(11). 3. For insurance-led conglomerates, participation as defined in Article 2(11) of the Directive shall be considered for the application of point 1. 4. For the purpose of the first point, to eliminate the intra-group creation of own funds, the eligible amount of intra-group investments in any capital instruments that are eligible as regulatory capital, respecting relevant sectoral limits, shall be eliminated.

EXPLANATORY TEXT for consultation purposes Point 1(c) addresses cases where prudential filters affect the own funds of a participation for prudential purposes by adding back unrealised losses or subtracting unrealised gains, for example in the case of a holding held



in the Available For Sale category. If this is the case, the effect of the prudential filter should be reversed [by adjusting the book value of the participation to be deducted]. Without this reversal the filtering of unrealised gains would unduly reduce own funds after deduction of accounting book value, while the filtering of unrealised losses would unduly flatter own funds after the deduction of accounting book value. Referring to the formula in the Annex: if, because of the application of a prudential filter the Own Funds term xi(OFi-REQi) changes, then its effect should be neutralized by an offsetting adjustment in the book value term: BVi. See also the Annex - Summary of the treatment of holdings and participations for the purpose of the calculation of the own funds of the conglomerate.

Article 16 Method 3 Calculation criteria 1. The competent authorities may permit the financial conglomerate to use a combination of methods 1 and 2, only where the financial conglomerate can demonstrate to the competent authorities that its request has been made: (a) Further to its best effort to apply either, Methods 1 or 2; and (b) Having regard to the cases in Article 6 (5) of the Directive. 2. If several entities are collectively of non neglible interest, the competent authorities shall take this into account in assessing the request to use Method 3. 3. The application of the specific combination of Methods 1 and 2 to



entities within the financial conglomerate that was permitted by competent authorities shall be applied in a consistent manner over time. 4. The coordinator shall consult the other relevant competent authorities before taking a decision on whether to permit the use of the combination of methods 1 and 2.

EXPLANATORY TEXT for consultation purposes

Article 6 (5) (a) (b) and (c) of the Directive states: “(a) If the entity is situated in a third country where there are legal impediments to the transfer of the necessary information, without prejudice to the sectoral rules regarding the obligation of competent authorities to refuse authorisation where the effective exercise of their supervisory functions is prevented; (b) If the entity is of negligible interest with respect to the objectives of the supplementary supervision of regulated entities in a financial conglomerate; (c) If the inclusion of the entity would be inappropriate or misleading with respect to the objectives of supplementary supervision. However, if several entities are to be excluded pursuant to (b) of the first subparagraph, they must nevertheless be included when collectively they are of non-negligible interest.”

TITLE IV Final provisions Article 17 This Regulation shall enter into force on the twentieth day following that of its publication in the Official Journal of the European Union.



This Regulation shall be binding in its entirety and directly applicable in all Member States. Done at Brussels, For the Commission The President [For the Commission On behalf of the President [Position]

ANNEX I Calculation methodology for Method 2 – Deduction and aggregation method 1. General principles The calculation of method 2 shall be carried out on the basis of the regulatory reporting required under the applicable accounting framework of each of the entities in the group following the formulaic expression below:

where own funds (OFi) exclude intra-group capital instruments. The supplementary capital adequacy requirements (scar) shall thus be calculated as the difference between: (1) The sum of the own funds (OFi) of each regulated and non-regulated financial sector entity (i) in the financial conglomerate; the elements eligible are those which qualify in accordance with the relevant sectoral rules; and



(2) The sum of the solvency requirements (REQi) for each regulated and non-regulated financial sector entity (i) in the group (G); the solvency requirements shall be calculated in accordance with the relevant sectoral rules; and the book value (BVi) of the participations in other entities (i) of the group. In the case of non-regulated financial sector entities, a notional solvency requirement shall be calculated according to Article 11. Own funds and solvency requirements shall be taken into account for their proportional share (x) as provided for in Article 6(4) and in accordance with Annex I. The difference shall not be negative.

ANNEX II- Summary of the treatment of holdings and participations for the purpose of the calculation of the own funds of the conglomerate



V. Accompanying documents a. Draft Cost- Benefit Analysis / Impact Assessment 1. Introduction According to CRDIV/CRR proposals, the EBA, EIOPA and ESMA (hereafter the ESAs) through the Joint Committee, shall develop draft regulatory technical standards with regard to the conditions of the application of the Article 6(2) of the Directive, and shall submit those draft regulatory technical standards to the Commission by 1 January 2013. The Technical Standard describes how institutions following the consolidation methods set out in this Directive shall calculate own funds in the parent institution in a financial conglomerate. The standard introduces restrictions on which elements of own funds in



subsidiaries and other participated entities of a financial conglomerate can be used in the calculation of own funds. The main rationale underpinning this Technical Standard is to avoid an “inflated” calculation of own funds of cross-sector financial conglomerates. This Technical Standard focuses on harmonising the calculation of financial conglomerates’ own funds.

2. Problem definition A lesson learned from recent financial crises is that the regulation of supplementary supervision, in particular the current set of rules on determining own funds at the conglomerate level, deserves a thorough rethink. For example, in the recent past it became clear that parent institutions could report strong levels of own funds, giving an impression of a robust solvency. In some cases that impression turned out to be misleading as significant amounts of own funds were, in practice, locked-in in the subsidiaries. This consequently rendered the Directive’s assumption of availability of funds at the conglomerate level rather uncertain - because of a lack of harmonisation of rules on conglomerate own funds. This affects the ability of conglomerates’ own funds to absorb losses, which makes financial conglomerates more fragile than figures on own funds would suggest.

Multiple gearing Uncertainties in the application of the methods for determining own funds at the conglomerate level may have led to undesirable levels of



multiple gearing. This Technical Standard therefore builds upon the Directive and contributes to achieving its objective to eliminate the multiple use of elements eligible for the calculation of own funds at the level of the financial conglomerate (see for example Recital 7, Article 31 point 2, and Annex I, section I of the Directive).

Methods to determine Own funds at the Financial Conglomerate Level. Uncertainties in the guidance about the choice of methods for determining own funds at the conglomerate level may have led to an arbitrary combination of the methods that are offered under Annex I of the Directive. This Technical Standard therefore provides additional clarity on the calculation methods for conglomerate own funds.

3. Objectives of the Technical Standard The objective of this Technical Standard is to achieve a more consistent harmonisation of the calculation methods of Own Funds listed in Annex I of Directive. This should translate in increased efficiency and effectiveness of conglomerate supervision by competent authorities, more clarity on the availability and transferability of own funds for the conglomerate, as well as tightly controlled levels of multiple gearing.

4. Options Annex I of the Directive, describes three methods to calculate a conglomerate’s own funds. This Technical Standard concentrates on the application of these



methods. There is not a wide selection of options available for this Technical Standard. Any choice made with respect to this Technical Standard derives from the text of relevant Directives, predominantly the sectoral directives, CRR/CRD4 and Solvency II. The guiding principles used by this Technical Standard to achieve more consistent harmonisation of calculation methods mentioned in Annex I of the Directive are: 1. To offer clarity in rules regarding transferability and availability of conglomerate own funds, 2. To eliminate the multiple use of elements eligible for the calculation of own funds at the level of the financial conglomerate, 3. To avoid double deduction of items and amounts from own funds, and 4. To respect sectoral rules.

Method 1 Method 1 is based on consolidated position of the conglomerate in order to avoid multiple gearing. For this purpose, the RTS requires the elimination of all intra-group creation of own funds; the scope of the group is defined according to article 2, point 12 of the Directive. Adjustments are required to sectoral rules in the treatment of banking cross holdings and some instructions not included in the Directive are provided for unregulated entities. According to the Directive provisions, the capital requirements are calculated as sum of sectoral requirements without the elimination of



intra-group transactions.

Method 2 The description of this method in its current form is already quite prescriptive and unambiguous. However, this Technical Standard elaborates on two issues that may lead to disharmonised interpretations: i. The proportional share applicable to own funds and solvency requirements; ii. The interpretation of the book value of participations in other entities of the group. With respect to the latter issue, this Technical Standard uses the book value from the accounts of the parent as a starting point, but applies adjustments to any book values subjected to prudential filters in order to safeguard consistency in the calculation of this method’s deduction of book value. The method requires, according to the general principle of avoiding inappropriate creation of intra-group own funds, the deductions of all the intra-group investments in capital instruments eligible according to sectoral rules. This provision ensure also an equivalence between this method of calculation of the own funds and the others allowed according to the Directive.

Method 3 The use of combination of methods 1 and 2 is limited only to the cases where the use of either method 1 or method 2 solely would not be appropriate due, for example, to the lack of information on specific



entities within the group. The use of method 3 shall need the permission of the competent authorities or the coordinator after consultation of the relevant other competent authorities. The combination method 3 shall be applied in a consistent manner over time. The supervisory consent is needed in order to prevent regulatory arbitrage.

5. Impacts This technical standard’s objective is to achieve a more consistent harmonization of the methods mentioned in Annex I of the Directive. This may limit the degree of freedom with respect to the ways of calculating own funds of conglomerates. The expected impact compared to the sectoral rules for insurance-led conglomerate that apply method 1 of the Directive, where the scope of the insurance group under Solvency II is not the same as the financial conglomerate under the Directive (see Article 7), is due mainly to the line by line consolidation of the items of the banking subsidiaries and banking joint controlled entities instead of the consolidation procedures provided under the Solvency 2 framework. In the case the scope is the same or difference is not material, insurance-led conglomerate applies Solvency 2 rules as they will be defined in the implementing measures Solvency 2. For banking-led and investment firm-led conglomerate the main expected impact compared to the sectoral rules is due to the consolidation of the insurance subsidiaries and joint controlled insurance entities that are risk weighted or deducted according to CRR.



Both insurance and banking group shall also adjust, where applicable, the amount of the threshold and parameters used for their eligibility limits (for example, thresholds on Deferred Tax Assets and on deduction of holdings under Article 45 of CRR), considering the effect of the consolidation of cross sector holdings at conglomerate level. Insurance, bank and investment firm-led conglomerates shall take into account of limits to transferability and availability of own funds as foreseen in the Technical Standard. A cost factor relates to the alignment of the entities to the requirements of this Technical Standard. Such costs may arise if current national regulations need to be amended to comply with the Technical Standard. Another cost factor may arise in the cases where competent authorities are called upon to approve the use of Method 3. Lastly, this Technical Standard may also affect the business model for a group to organize itself as a financial conglomerate. There are a number of expected benefits related to this Technical Standard. They are: i. More consistency in the selection and application of the methods of Annex I of the Directive; ii. Increased efficiency and effectiveness of conglomerate supervision; iii. More clarity on the amount, availability, and transferability of own funds within a financial conglomerate; iv. More effective loss absorption of the capital held by conglomerates; v. An increased standardization of the use of the methods, leading to lower costs of their application; and



vi. A contribution to greater financial stability.

b. Overview of questions for Consultation 1. What are the cost implications of a requirement for conglomerates to follow the clarifications for calculating own funds and solvency requirements described in this paper? If possible, please provide estimates of incremental compliance cost that may arise from the requirements, relative to following the Directive in the absence of the Regulatory Technical Standards. 2. How, in your opinion would the proposed clarifications impact on conglomerates’ business models? 3. How far would the suggested clarifications change current market practices? 4. Are the Technical Principles in Title II sufficiently clear? If not, what areas require further clarification? 5. Are there any areas of ambiguity in the way that the Technical Principles in Title II apply to the three consolidation methods? 6. Are there any areas of ambiguity in the way that Method 1 needs to be carried out? 7. How much of an operational burden is the use of consolidated accounts of the conglomerate as a starting point for Method 1? Is there an alternative more straightforward method/way to eliminate the intra-group creation of own funds? 8. Do you foresee any problems in applying sectoral rules to own funds under Method 1? If so, what refinements to the method would you propose?



9. Are they any areas of ambiguity in the way that Method 2 needs to be carried out? 10.For the purpose of assessing the transferability of “funds” to entities subject to CRR, under Article 4, is “three calendar days” a sufficient timeframe in a period of stress?



Dr Andreas Dombret

Member of the Executive Board of the Deutsche Bundesbank

Foreign banks between financial crisis and financial stability

Speech held to mark the 30th anniversary of the Association of Foreign Banks in Germany

1 Introduction

Ladies and gentlemen

Let me begin by offering the Bundesbank’s warm congratulations to you, Mr Winter, and all the members of the Association of Foreign Banks in Germany on its jubilee 30th anniversary.

Thirty years is quite a long period of time – nearly one-third of a century – and something of a landmark.

As the old saying used to go, “Never trust anyone over 30”.

That catchphrase was popularised by the 1968 student movement – the students who used it are now themselves over 60!

Trust is indeed the key word. Its importance is being learned by governments and banks alike as the sovereign debt and financial crisis tightens.

So it is a good thing that the day-to-day dealings between the banking associations and individual banks, on the one hand, and central banks and supervisory authorities, on the other, are characterised by mutual confidence and trust – notwithstanding the necessary arm’s-length relationship between central banks and supervisory authorities, on the one hand, and banks and their associations, on the other.



I can say that because I have worked in both camps.

I was once a foreign banker myself. Since joining the Bundesbank in 2010, I have had a chance to see things from the other perspective.

I would like to take this opportunity to thank you for the constructive cooperation I have been privileged to enjoy with all banking associations over the past two years.

I hope that this cordial relationship will continue in future – including after the possible emergence of a new, overarching single European supervisory body.

If it is carefully conceived and constructed, it could make an important contribution to safeguarding financial stability.

And it might well refashion the current triangular relationship between banks, supervisors and central banks.

Let me nail my colours to the mast right away: I do not believe that it is absolutely essential for the central bank to have ultimate supervisory responsibility in order to capitalise on the synergies provided by central banks’ macroeconomic and macroprudential expertise.

The crucial requirement is the efficient exchange of information.

2 Stimulating competition

In his book Fault Lines - How Hidden Fractures Still Threaten the World Economy, former IMF chief economist Raghuram Rajan argues that a fault line is created when two different financial systems based on different principles interact.

He is referring to the contrasting cultures of the capital markets and relationship banking.

Financial market integration has certainly increased the possibilities of contagion.

However, I do not believe that the “fault line” necessarily runs along the border between the capital market and relationship banking.



Seen from the perspective of a universal bank, drawing a rigid distinction between capital market orientation and a banking philosophy seems a huge oversimplification.

Germany’s universal banks came through the financial crisis pretty well on the whole.

And the contacts between foreign banks and German banks have stimulated and enlivened competition, benefiting both groups of banks.

Moreover, it should be noted that the foreign banks operating in Germany, which each bear the specific hallmarks of their home country, are probably the most heterogeneous group of banks included in the Bundesbank’s statistics.

How important are foreign banks in Germany’s banking system? For many foreign banks, traditional banking activities account for just a small part of their business.

This makes their market share – currently 12.9% measured in terms of total assets – all the more remarkable.

This trend has been driven by the arrival of new banks through mergers as well as growth, particularly in deposit business and instalment loans.

The approximately 30,000 members of staff employed by foreign banks at the German financial centre do make quite a meaningful impact on employment.

These figures point to a significant influence.

In some business lines, especially those involving the capital markets, foreign banks have a much more prominent position than in traditional banking fields.

Today, it is hard to imagine M&A activity in Germany without the influence of the Anglo-American banking culture.

Foreign banks play an important role in advising and assisting on German corporate bond issues; the same goes for IPOs and capital increases.



The financial crisis has naturally also led to the market withdrawal of individual foreign banks.

On the whole, however, it has thankfully not triggered a mass exodus of foreign banks from Germany – unlike in some other countries.

For a long time, foreign banks struggled to gain a foothold in the German market.

Banks that accept deposits and grant loans normally had to begin by setting up a branch network as a prerequisite for winning new customers.

The creation of the single market in Europe has made things much easier.

The European Passport made it possible to set up branches anywhere in the EU without requiring additional authorisation.

However, barriers to market entry still remained.

These included the high overhead costs of creating a branch network, the challenge of finding skilled staff, the continued strong importance of brand names, and the justifiably high reputation of German banks among German clients.

In this tough business environment, foreign banks wanting to expand into Germany had to rely on innovation and cost-efficiency.

They were given a helping hand by liberalisation and the technological advances of the internet in the 1990s; this gave foreign banks a fast and low-cost channel for communicating with customers.

And they seized their chance. Some foreign banks therefore set up shop as online banks to conduct deposit business but also to engage in business with standardised consumer loans.

For retail customers this translated directly into a larger product range at lower prices.

That is good both for customers and for competition.



Providing advice and expertise to enterprises is a key investment banking service, and one from which German firms have benefited.

That requires putting down roots in the real economy and offering a real service.

And the last few years have taught us that foreign banks with roots in the real sector are unlikely to pull out in times of financial crisis.

Integrated financial markets per se enhance economic growth and our prosperity.

Foreign banks in Germany constitute a part of this financial market integration.

The downside of integration is that market players are much more interconnected, which means that crises spill over more quickly from one country to another.

This can lead to dislocations. However, that is simply the reality of today’s financial world.

3 Capital: the key to greater trust

Having, or building up, sufficient capital is essential, particularly in the current climate. And it is also crucial to restoring confidence and trust.

In its last Financial Stability Review, the Bundesbank wrote that, in times of systemic stress, “the task of restoring confidence is not merely the responsibility of an individual bank but also a call to arms for the system as a whole.”

This demands not just adequate capitalisation of national banking systems but also convincing Europe-wide solutions.

I’ll make no bones about it: a level of capitalisation that just meets the minimum supervisory requirements would fall far short of what is needed, in my view.

I think it was the UK economist Charles Goodhart who told the following tale to illustrate the dangers of minimalist compliance.



A weary traveller arrives at a rural railway station.

To his delight, he sees exactly one taxi waiting there and asks the driver to take him to his destination.

To his amazement, the cabdriver tells him: “I would love to take you there but cannot, I’m afraid.”

“Why not?”, he asks, flabbergasted.

“There is a local bye-law that says a taxi has to be here at all times.”

“But a taxi is here.”

“Ah yes, but if I take you home, there would no longer be a taxi waiting here. That would violate the bye-law.”

This is what can happen with statutory minimum requirements.

Only capital in excess of the minimum requirements is available to truly and independently absorb business risk.

In an actual crisis, it is only this capital that can be used to buy the time needed, for instance, to write down impaired assets, adjust portfolios or restructure business units.

In an ideal world, of course, such buffers should be built up before systemic events occur.

That is the rationale behind capital cushions. They provide a certain breathing space before institutions are forced to unload risky assets and curb their lending.

If the buffers are too small, however, the pressure to deleverage during a shock can become overwhelming and cyclical movements may be amplified.

This is where public capital assistance comes into play. In theory, it provides a counterweight and reduces deleveraging pressure.



4 Getting the basics right: aspects of a European system of banking supervision

The reality can be much rougher, however, for a euro-area country that is struggling to cope with the close interlinkages between the sovereign debt crisis and the banking crisis.

The stability of the banking sector is then called into question because the country is no longer regarded as being fully capable of resolving its banking crisis unassisted.

For such cases, the EFSF has clear rules according to which other euro-area countries can step in to help that country. The affected country remains the partner for the donor countries’ assistance.

By providing such assistance, the donor countries are already taking on considerable risks.

Extending this risk-sharing role, as is being proposed in connection with a banking union – in the form, for example, of a European restructuring fund or a European deposit insurance scheme – would necessitate far more extensive intervention in countries’ national sovereignty and in their fiscal and economic policies.

I hope you will agree with me that joint liability must not be allowed to be introduced covertly through the back door.

Instead, joint liability must be predicated on two basic principles. One is the unity of liability and control.

As long as control rests with nation-states, liability must rest there, too. This is important to avoid promoting excessively risky business models that threaten financial stability.

Moreover, no incentives should be created to build a bloated financial industry in individual countries that is way out of proportion to the size of the real economy.

The other principle that must be observed is taking the appropriate steps in the right order.



The logical sequence requires, first, further moves towards European control, which in turn necessitate democratic legitimacy and accountability.

I am firmly convinced that all concrete proposals must be informed by these considerations and guided by these principles.

Moreover, many important details remain to be clarified. These remaining uncertainties have perhaps contributed to the intensity of the recent public debate on this topic.

In a situation marked by uncertainty it can even happen that one or two economics professors sign both a petition and the corresponding counter-petition.

And this does not even have to be a contradiction if the two countervailing positions depart from different assumptions concerning the principles and the details of their implementation.

One of the questions regarding a possible pan-European banking supervision regime that still needs to be clarified is the range of countries that will be subject to it: should it cover all EU member-states or only the euro-area countries?

Given the interlinkages between financial institutions throughout the EU and against the background of the single market, I see merits in integrating all EU member-states in a European supervisory structure.

This would strengthen the single market, it would be consistent with the Single Rule Book, and it would help to create a level playing field.

Taking this logic further, it would make sense in principle for all banks to be supervised by this European authority.

In line with the principle of subsidiarity, the European supervisory authority could then delegate the supervision of systemically unimportant banks to national authorities, subject to the proviso that such banks could then be brought back into the fold of European supervision on a case-by-case basis.



I believe a Europe-wide prudential regime would definitely benefit from the operational involvement of national supervisory agencies.

Such involvement, in fact, may well be essential.

A key issue for central banks is the precise nature of their involvement in European banking supervision.

There can be little doubt that they ought to play a role, given their wealth of macroeconomic and macroprudential expertise, as this is the only way to exploit synergies.

The question, however, is how this can be best accomplished. I believe that central banks do not necessarily need to assume ultimate responsibility for supervision.

The key imperative is, rather, for supervisory agencies and central banks to cooperate efficiently and, above all, to exchange information.

In my view, this would be consistent with central bank involvement in operational supervision.

In this manner, potential conflicts with ensuring the independence of monetary policy can be avoided and the credibility of central banks maintained.

It follows from this that an agency other than the ECB could be given ultimate responsibility for supervision. Supervisory powers imply extensive rights of intervention which, in turn, require direct democratic legitimacy and accountability.

Thus if the central bank were to have ultimate sovereign responsibility, its independence would have to be constrained.

And let us not forget either that monetary policy decisions can also impact on banks’ robustness.

This might well cause a conflict of objectives.

All of these arguments are, I believe, sound reasons not to transfer ultimate responsibility to the ECB but, instead, to a different authority



headed by a council in which the banks’ home countries are adequately represented.

Such representation should reflect the size of each country’s banking industry.

In such a set-up, the ECB would undoubtedly play a particularly important and wide-ranging advisory role.

Whatever solution is ultimately implemented, I am firmly convinced that monetary policy and prudential supervision should be kept as far apart as possible.

If a European supervisory regime is based on the right principles and its detailed workings are well thought out and implemented, it has a good chance of making a major contribution to financial stability.

5 Conclusions

Those are a few thoughts that I wanted to share with you going forward.

Your anniversary has undoubtedly come at a critical juncture for the world of finance.

The sovereign debt and banking crisis will probably keep us occupied for quite some time to come.

The problems are deep rooted. The future will tell how well we have been able to cope with the challenges of our time.

However, of this I am convinced: if the right measures are taken, a very good solution will emerge in the end.

On this note, I would like to congratulate you once again on your landmark anniversary and thank you for being such an attentive audience.



Market intelligence, market information and statistics in central banking Keynote Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, to the 6th Irving Fisher Committee Conference, Bank for International Settlements, Basel, 29 August 2012.

1. Introduction: statistics, market information and Irving Fisher It is a privilege for me to address this keynote speech before the distinguished members of the Irving Fisher Committee. I am particularly thrilled, since the name Irving Fisher strikes a chord in my heart. Irving Fisher is an iconic figure at Yale University, where I earned my doctorate. In fact, he received the first Ph.D. in economics ever granted by Yale, in the year 1891. I vividly remember his life-size portrait hung above the mantelpiece of the 19th century mansion house, gazing solemnly at faculty members and graduate students. No new words are needed to attest to his monumental contributions to microeconomics, macroeconomics and monetary theory. He was also influential in laying the foundations of economic statistics, as exemplified in his popular The Making of Index Numbers. In fact he was not content with just theory: he went on to found by himself the Index Number Institute that engaged in computing commodity price



indices, and thus became one of the most popular providers of market information at the time. Unfortunately, however, he failed to recognize the significance of the Stock Market Crash of 1929. Just three days before the crash, he wrote that stock prices were at a permanently high plateau. And even after the crash, he continued to assure investors that a recovery was just around the corner. This might testify to his failure in “market intelligence”, in detecting the signs of a fundamental change in the market place. In his latter days, though not immediately appreciated by the public and the profession, he presented a remarkable theory of debt deflation as an explanation of the Great Depression. In fact, this masterful piece of work is the precursor of the vast literature concerning financial stability, which is especially relevant in economic policy making in the aftermath of the financial crisis of 2008. What then can we central bank statisticians learn from these dramatic ups and downs in the life of Irving Fisher? In fact, this is the subject of this speech. In particular, I argue that, although reliable macroeconomic statistics are of course necessary for policy making, even good statistics are sometimes grossly insufficient to guide economic policy, especially when a seismic change occurs in the market and the economy. The recent financial crisis is an example of such change.



Thus, central bankers should incorporate “market intelligence”, which I will explain later, and non-statistical market information, into their arsenal of statistics. So a central bank statistician should be more than simply a compiler of well-defined statistics: they should become a sort of sleuth or intelligence agent, detecting signs of future developments that may change the world. I proceed as follows. Section 2 outlines the value of economic information from the perspective of policy decision making. A key theme here is “market intelligence”, which is the active gathering and analysis of market information through central banking activities. To understand the importance of market intelligence, I present three examples, with respect to the past, the present, and the future. Section 3 presents a lesson from the past. I examine the so-called Paribas Shock of 2007, and argue for the absolute necessity of “proactive” market intelligence to avoid this type of financial crisis. Section 4 describes the current achievements of market intelligence in an area of pressing importance: property price statistics. I show that it is possible to get reliable, unbiased information by combining various existing market information sources, even though individually they may have their own biases. Section 5 concerns the future: detecting problems in shadow banking. Shadow banking involves a complicated structure, so it is necessary to grasp its “interconnectedness” to gauge the magnitude of potential problems.



As an example, I explain the Bank of Japan’s attempt to reveal the interconnectedness of the Tokyo money markets. Section 6 contains some concluding remarks on market intelligence and central bank statistics.

2. Economic information and policy making Contemporary central banking faces two major challenges; one related to accountability, and the other to effective communication. First, central banks should be accountable for their policies. This is all the more important for those central banks that have independence in determining their monetary policy. Accountability means policy should be evidence-based, that is, based on clear reasoning relying on substantiated data. Second, central banks should be effective communicators. Markets and economies have become increasingly susceptible to changes in economic agents’ expectations. To ensure that policy is effective, central banks must communicate with the public in a persuasive manner. Here again, data supporting policy decisions become important. Thus, for accountability and effective communication, “numbers” or statistics become increasingly important. Moreover, data here means not only quantitative data; qualitative data are equally as important.



Knowns and unknowns in Central Bank policy To understand the nature of the economic information central banks want to know, the following three-way classification may be helpful. The first type of information concerns “known knowns”. Here “knowns” are whatever happened in the past. Thus, known knowns are information about what happened, and typical known knowns are contained in statistics. The second type is “known unknowns”. Here unknowns are those things that are happening at present or that will emerge in the future. They are known unknowns, since we already know that they are happening or will happen. You may have come across the word “now-cast”, which is an “estimate” of what is happening now, used in contrast with a “forecast” which predicts future events. A “now-cast” is a typical example of a “known unknown”. Finally, there is the third type, called “unknown unknowns”, things previously unknown but potentially having a significant effect on the economy. Here I quote Donald Rumsfeld, the former U.S. Secretary of Defense, whose enigmatic statement gives perhaps some indication of their nature: “But there are also unknown unknowns – the ones we don’t know we don’t know.



And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” Keeping in mind this three-way categorization, let me ask the following question: What kind of information does a central bank policy maker want to know when he or she decides on policy? And, in what way is it related to the three-way categorization? First of all, in contemplating appropriate aggregate demand management policy, the central bank policy maker wants to know the momentum of activity in the economy and financial markets. However, this is not in itself sufficient. The experience of the recent financial crisis has shown that the central bank policy maker should also be aware of the signs of previously unknown factors, unknown but potentially significant changes in the economy and financial markets. In fact, with respect to the former, i.e. macroeconomic momentum, we have made significant progress. There have been improvements in the comprehensiveness, accuracy and timeliness of macroeconomic statistics related to aggregate demand management. We now have a rich array of data, both quantitative as in GDP and CPI figures, and qualitative as in business surveys. Not only public but also private institutions produce and disseminate their own data. These are either known knowns (type 1), or known unknowns (type 2).



Statistics provide valuable information about known knowns, and they become the foundation for estimating known unknowns. However, statistics are grossly insufficient when it comes to detecting unknown unknowns (type 3). Central-bank policy makers are frequently frustrated by deficiencies in the statistics available, which they find inadequate in helping them detect potential problems in the economy. Perceived deficiency is especially keen in financial information. It should be noted that financial stability is now seen as a prerequisite for economic stability. Moreover, policy makers are alarmed by the increasingly strong negative feedback seen in recent years between financial malaise and economic stagnation. The rapid development of financial factors confounds the problem of detecting malign symptoms. Thus, guarding against previously unknown but potentially devastating factors has become one of the most important issues for policy makers. Thus, in November 2009, the G20 Finance Ministers and Central Bank Governors requested statisticians to fill the so-called data gaps. Twenty recommendations were submitted in the G20 Data Gaps Initiative (DGI) in order to establish timely reporting schemes for detecting both known unknowns (type 2), and unknown unknowns (type 3) .

The key to guarding against unknown unknowns



A central bank’s intelligence activities are the key to guarding against unknown unknowns. These consist of two parts. The first is so-called “market intelligence”: the central bank’s daily transactions with financial institutions, which provide various kinds of information about market participants, developments in financial products, as well as other “news”. These pieces of market information are valuable in creating a timely and accurate view of particular institutions and the market as a whole. The gathering and analyzing of this information is the core of “market intelligence”. The second part of the central bank’s intelligence activities is monitoring and feedback. Qualitative or supervisory information can be obtained from regular supervisory dialogue with regulated entities. They have valuable information, and by analyzing it thoroughly we get a grasp of the details of market information, which is then fed back to these institutions if necessary. It should be noted here that information coming from individual financial institutions may include subjective or in some cases biased content, regardless of whether it is market information or information acquired through regulatory monitoring. We should be aware of these biases, and good market intelligence is needed to gauge the extent of such bias and to compensate for it.

3. Lessons from the past: necessity of proactive market intelligence



Let me now turn to three examples of central bank intelligence. The first example is its failure in the past. This is the so-called Paribas Shock of August 9, 2007, the precursor of the global financial crisis of 2008. On July 10, 2007, S&P and Moody’s announced that they would be reviewing the ratings of several residential mortgage-backed securities (RMBS) backed by subprime housing loan assets. As a consequence, the AAA ratings of asset-backed commercial paper (ABCP) backed by these RMBS would also be downgraded accordingly. This looked like a minor change in a marginal market of the US financial system. Unfortunately however, within just one year, it became the epicenter of a global financial crisis. To understand the problem, we should be aware of the special role of money market funds (MMFs) in the United States. US MMFs were considered to be extremely safe financial assets. One of the primary reasons for this was that MMFs were only allowed to invest in AAA-rated assets. Therefore, when ratings were downgraded for ABCP, MMFs did not reinvest in ABCP. Then, funds that originated ABCP and used it to raise money found themselves in fund-raising difficulties: funds under the Bear Stearns umbrella went bankrupt; BNP Paribas moved to freeze its affiliated funds’ new applications and redemptions.



These funds were the structured investment vehicles (SIV) created by banks to issue ABCP. When these SIVs were unable to find funding sources, their parent banks were forced to provide liquidity enhancement instead. At that time, nobody knew for certain which banks’ SIVs were on the brink of extinction, and which banks had serious liquidity problems. Banks, which frequently lend each other money, suddenly became aware of counterparty risk, the risk that the other party in a transaction might suddenly go belly up. They began to worry that some bank somewhere might suddenly be unable to secure liquidity and fail. Indeed, on August 9, a liquidity crisis actually occurred, with liquidity drying up quickly in the interbank market. Many European banks were among those facing liquidity difficulties. Chart 1 shows an unprecedented spike in the three month LIBOR-OIS spread, showing the heightened risk premium in the European interbank market.



A liquidity crunch in interbank markets started, and it spread immediately to the United States (Chart 2). Confronted with this situation, the European Central Bank (ECB) promptly announced that it was prepared to supply massive amounts of liquidity into the short-term money market. This was the event that came to be known as the Paribas Shock.



Lesson: necessity of proactive market intelligence The circumstances surrounding the Paribas Shock naturally beg the question: Was this event avoidable? Or at least, was there any telling sign that this type of event was just around the corner? As the description of the event shows, there are four important pieces of information that the policy makers should have known and which would have helped prevent this event. The first is the asset position of the MMFs: their composition and quality. MMFs held a large amount of AAA-rated ABCPs of SIVs whose parents were European as well as US banks. These ABCPs were backed by US subprime loans, so that if the subprime loans were downgraded then these ABCPs would also be downgraded. The second vital information is possible side effects of the legal constraints upon the MMFs.



MMFs could hold only AAArated assets so that, if US subprime loans were downgraded, MMFs could not reinvest in ABCPs of the SIVs. The third and most crucial information policy makers should have had is knowledge of banks’ involvement in their SIVs. To what extent were those banks obliged to support their SIVs with liquidity injections? Here it was not only a question of contractual arrangements, but reputations were also at stake. The fourth piece of vital information is knowledge about the inter-connectedness among banks in the interbank market. It is clear that existing statistics and routine market intelligence were grossly insufficient to gather the above four pieces of vital information. To my knowledge, few, if any, market participants flagged the alarms that should have been raised by any of these four points. No statistics ever pointed out the danger. However, there were several, though obscure, signs flagging a possible problem, so that a market intelligence unit alarmed by these signs might have detected the problem and could have helped policy makers avoid the disaster. In particular, there was a telling sign in the statistics about US MMFs. Chart 3 shows an upward trend in the total assets of the US MMFs in the first half of 2007. The growth rate of MMFs was fast, though it did not look extraordinary. However, if you look at the share of “safe assets”, it actually declined from the start of the year.



So, this chart shows that by looking into these figures, one might have found some sign of abnormal risk taking in non-safe assets, including ABCP. Thus, if in addition, the market intelligence unit had detected the heavy involvement of banks in their SIVs issuing these ABCP, the unit might have sensed a possible danger of liquidity crisis in the interbank market, and might have been able to help the authorities prevent the crisis. In fact, after the Paribas Shock, the safe asset share jumped considerably and the total assets also skyrocketed, showing the strong flight to safety that devastated the ABCP market, and the ABS market in general. To sum up, it is not clear whether the liquidity crisis in the summer of 2007 could have been avoided. However, proactive market intelligence, that is, detection of possible problems in the market based on careful monitoring of market developments and thorough analysis of market statistics, might have



helped contain if not avoid the turmoil in the interbank market, and thus might have ultimately lessened if not negated the severity of the financial crisis of the following year. Bearing this in mind, the Fed and other central banks, as well as private institutions, have begun to collect and compile a wide range of statistics that capture securitization. In particular, Chart 4 shows details of the asset composition of US MMFs.

The chart indicates that MMFs may have already increased investment in commercial papers in 2006, the year before the Paribas Shock.

4. Present achievement: best use of existing market information Let me now turn to the second example, which is the present achievement of market intelligence. This is about property prices, and the issue is the timing of the availability of market information.



The financial crisis of 2008 was triggered by the bubble and subsequent bust in US house prices. There is a wealth of evidence detailing the close relationship between property price bubbles and financial crises. International panel studies show more than two-thirds of 46 systemic banking crises were preceded by house price boom-bust patterns, while 35 out of 51 house price-bust episodes were followed by a crisis. However, we have not had access to good property price indexes, based on sound economic foundations and comparable between countries and jurisdictions. Frustrated by this deficiency, in November 2009, the G20 Ministers and Central Governors designated property price indexes as one of the most important data gaps to be filled. To rectify the problem, several conferences were held under the leadership of Eurostat, which gathered a wide range of experts on property prices from theory to data compilation. Based on these conferences and public comments, the Handbook on Residential Property Price Indices has been drafted, and the finalized version of the Handbook will be published very soon. Moreover, many countries and jurisdictions are now preparing their own property price indexes in accordance with the recommendations of the Handbook. In fact, I have learned that Japan’s Ministry of Land, Infrastructure, Transport and Tourism has almost completed the development of a new series of residential property price indexes using the procedure recommended in the Handbook, and the Ministry is about to start publishing new statistics just this morning.



Issue of timeliness This is a great leap forward indeed towards having reliable and accurate property price information. However, from the policy maker’s viewpoint, the situation is still far from satisfactory. It should be emphasized that, for a policy maker, timely information is as important as, or in some cases more important than, reliable and accurate information. According to this criterion, many property price indexes are not helpful in immediate policy making, since they inevitably lag behind market movements. To see why, let me give you the example of a typical Japanese property transaction. Property transactions follow a series of stages several weeks apart from each other, and each stage usually entails different prices, namely: the initial asking price, P1; the offered price, P2; the contract price, P3; and the price that is filed with the land registry office, P4. My collaborators and I have been able to get a unique data set of a large number of property transactions in Greater Tokyo which illustrates these four stages. Here I will present the results based on this data set.



Chart 5 depicts the timeline graphically. From P1 to P2 takes on average ten weeks, form P2 to P3 five and a half weeks, and finally from P3 to P4 fifteen and a half weeks. Thus, from P1 to P4 takes almost thirty one weeks, more than a half year. We should also take into account the time taken to collect and compile the information, which is itself likely to be substantial, as in the case of GDP and CPI data.

Thus, if the authorities use the most reliable transaction price data of P4, it will probably take almost a year. From the policy maker’s viewpoint, this is often too late. To get the timeliest information about property market conditions, earlier reporting of P1, the initial asking price, is preferable. However, this is the asking price, not the transaction price.



There might be a substantial bias in this asking price data because a seller wants to sell at a higher price, even though it may take much longer to strike a deal or he is never able to sell. In fact, Chart 6 shows the price distribution of P1, P2, P3 and P4. As expected, the initial asking price P1 has a higher average than the price P4 at the registry office (though there is the caveat that the sample population of P1 is not exactly the same as that of P4). Thus, we face an apparent trade-off: if you want timely information then you use P1, but it has non-negligible bias.

If you want accurate information, then you use P4, but it has already become somewhat stale information by the time it is available.

Best use of market information There is, however, an important way around this dilemma. It should be noted that the Handbook recommends hedonic quality adjustment in property price indexes based on detailed micro and macro market information.



There are various ways to conduct hedonic quality adjustment, among which a hedonic quantile regression approach is one of the most sophisticated and robust. Remarkably, after applying this quality adjustment to both P1 and P4 of our data set, we find the quality-adjusted price distribution based on P1 is very close to, and almost indistinguishable from, the quality-adjusted price distribution based on P4. Let us look at Chart 7, the quantile-quantile plots of two distributions. In the quantile-quantile graph, if two distributions are identical then the plotted line is on the 45 degree line.

The upper chart illustrates the result of raw or unadjusted data of P1 (initial asking price) and P4 (registered transaction price). This chart clearly shows the upward bias in the initial asking price relative to the registered transaction price.



However, when quality is adjusted using a hedonic quantile regression method, the bias seems almost to have vanished, as shown in the lower chart. In a nut-shell, the result of this study shows that the initial asking price data, the timeliest of all price information, can be used as reliable information about property prices, so long as quality is appropriately adjusted using a hedonic quantile regression method. So we can benefit from the best use of market information, with respect to both reliability and timeliness.

5. Guarding against future problems: shadow banking and basic information gathering So far, we have examined the importance of market intelligence and the best use of market information in the past and the present. I am now looking towards the future, and considering what is needed to guard against future problems. The pressing problem that comes first to mind is that of shadow banking, a problem in the past, but still a potential problem in the future. Since regulations on banks are to be tightened further, new types of shadow banking may appear, little known at present but potentially threatening to financial stability in the future. Modern shadow banking activities are largely based on financial markets, and hence are likely to create innovation there. They change themselves rapidly in response to changes in market conditions and regulations. Moreover, they have broad interconnectedness with banks and other financial institutions.



Given this situation, in what way should central banks gather valid and vital information about them? Here again, I believe that the key is to utilize various sources of market intelligence alongside other sources of information. Furthermore, I would like to stress that the intelligence work should be properly followed by the establishment of new statistics about shadow banking.

Various approaches of market intelligence Let me explain the efforts of the Bank of Japan in this respect. The Bank monitors shadow banking entities and activities through various channels. The nature and scope of the Bank’s monitoring are depicted in Chart 8.



Amongst these channels, direct monitoring of major shadow banking entities is of course the most significant. Thus, the bank has increased the number of staff directly monitoring major securities companies. However, it is practically impossible to conduct dialogues with all financial institutions of a shadow banking nature, and moreover, shadow banking activities tend to change rapidly with developments in financial markets. It should be noted that shadow banking entities are deeply involved in funding and investment with various financial institutions. So indirect monitoring through banks, monitoring through the payments and settlements system, and market intelligence through market participants all become important. The Bank also closely watches shadow banking activities in securitization, securities lending and repos. For instance, we have started direct monitoring of hedge funds and investment trusts as well using market intelligence through market participants much more than before. Furthermore, although we do not directly monitor finance companies, since large finance companies are owned by banks, we monitor them by monitoring the banks. It is then crucial to cross-check the information gathered.



Chart 9 illustrates the point. In this regard, it is important to monitor banks as counterparties of shadow banking entities. This is because bank activities are interconnected with shadow banking activities. Market information in the financial markets is also particularly valuable. Central banks are especially well-positioned to collect valuable information on the activities of participants in financial markets, since they not only gather information relevant to monetary policy, but they also operate payment and settlement systems. Information on market practices and financial innovations can often provide early warning of risks, and hence are especially important among the various kinds of market intelligence.



The case in point is found in the subprime mortgage crisis in the United States. Securitized products were originated with financial engineering and distributed without appropriate risk assessment. This was partly due to an overly optimistic assessment of risk diversification. However, this risk became increasingly visible in the market as the market evolved into a new phase.

Feedback of market intelligence Another important role of market intelligence is to feed information back to the market, and thus to find potential information gaps to be filled. For example, based on market intelligence, the Bank of Japan designs and compiles the “Tokyo Money Market Survey”, which provides an overall quantitative assessment of the money markets. The survey depicts, among other things, the current interconnectedness among financial institutions through repo transactions, as is shown in Chart 10.



This chart shows that securities companies borrow specific JGBs through SC repos mainly to cover their short position in bond trading. Most of their short-term money is funded through GC repos from trust banks, while some funds come from banks and money market dealers. This kind of quantitative understanding provides both new perspectives for central bank business and wider grounds for dialogue with financial institutions and market participants. In fact, the result of these dialogues will be examined and used by financial institutions to develop more sound business practices. Also, the feedback of any relevant information will be reflected in the next survey data. Starting this year, we will begin to conduct this survey regularly. Overall, market intelligence is absolutely crucial for central banks in maintaining the stability of the financial system.



I believe that this flexible system of monitoring shadow banking entities and activities, based on market intelligence, can provide a good pilot study for other central banks to consider when they want to identify emerging risks and vulnerabilities in their own countries and jurisdictions.

6. Concluding remarks Let me now come to my conclusion. As we all know and feel, central banks around the world have faced serious challenges, especially since the financial crisis of 2008. Financial stability is now clearly marked as an essential prerequisite for economic stability, and it is thus the responsibility of central banks to maintain this stability. Moreover, the financial turmoil following the collapse of Lehman Brothers, and still lingering somewhat in the global market, has clearly proved that existing statistics are not sufficient for policy making, in particular policy making involving financial markets. Financial markets are fast moving and “mutate” in many ways in a relatively short period of time. Therefore, I have argued in this speech that gathering and thoroughly analyzing market information, which is often described as market intelligence, is of the utmost importance and should be utilized proactively alongside conventional economic statistics. The reason I have stressed market intelligence, or more specifically, central bank intelligence, is that central banks have a clear comparative advantage in extracting valuable and vital information, especially from financial markets.



Central banks are the unique organization that transacts with the widest range of financial market participants. I have explained how this market intelligence works in the case of shadow banking in Japan. The most important point is to extend these intelligence activities to new financial institutions and products to detect possible problems. The existing framework at the Bank of Japan is versatile and can incorporate new elements relatively easily. However, problems remain about the depth or intensity of these intelligence activities: that is, the quantity and quality of information currently available may not be sufficient for detecting possible risks. Thus, we are only at the starting line, and there is still a long way to go. Finally, I should emphasize that market intelligence has significantly improved central banks’ economic statistics, and will continue to do so in the future. We have learned from the failures in the summer of 2007, that we must extend the coverage and improve the quality of statistics concerning non-depository financial institutions. We can also take advantage of new methods and new information sources to get the best use of market information in constructing timely statistics, as shown in the case of property prices. In closing, I would like to emphasize again the point I stated in the Introduction, the point that I would most like to convey to you. Central bank statisticians should be more than good statisticians, simply maintaining the quality of existing statistics.



They should also be good sleuths or intelligence agents, detecting signs of future developments that may change those statistics, and thus may change our world. Thank you for your kind attention.



News Release - The dog and the frisbee – paper by Andrew Haldane

31 August 2012

In a paper given at the Federal Reserve Bank of Kansas City’s 36th economic policy symposium in Jackson Hole, Wyoming, Andrew Haldane – Executive Director for Financial Stability and member of the Financial Policy Committee – explores why the type of complex financial regulation developed over recent decades may be sub-optimal for crisis control.

In doing so, he draws out a number of public policy lessons.

The paper is co-written with a Bank colleague, Vasileios Madouros.

Andrew Haldane presents evidence from a range of real-world settings to demonstrate that decision-making in a complex environment can benefit from the use of simple decision rules of thumb.

He argues that complex rules often: have punitively high costs of information collection and processing; rely on “over-fitted” models that yield unreliable predictions; and can induce defensive behaviour by causing people to manage to the rules.

He argues that regulatory responses to financial crises, past and present, have been to increase complexity with: “...a combination of more risk management, more regulation and more regulators”.

As the Basel Accords have evolved over time, he notes, so has opacity and complexity associated with increasingly granular, model-based risk-weighting.

Meanwhile, detailed rule-writing in the form of legislation has increased dramatically, as has the scale and scope of resources dedicated to regulation.

Andrew Haldane uses a set of empirical experiments to measure the performance of regulatory rules, simple and complex.



He finds that simple rules such as the leverage ratio and market-based measures of capital outperform more complex risk-weighted models and multiple-indicator measures in their crisis-predictive performance.

He says that: “The message from these experiments is clear and consistent.

Complexity of models or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes.

More than that, simplicity rather than complexity may be better capable of solving these robustness problems.”

Andrew Haldane considers five policy lessons that financial regulation can draw from these findings.

First, he suggests that the Basel framework could take: “...a more sceptical view of the role and robustness of internal risk models in the regulatory framework...simplified, standardised approaches to measuring credit and market risk, on a broad asset class basis, could be used.”

Second, he says the leverage ratio could be placed on an equal footing with capital ratios, an approach taken by the Bank of England’s Financial Policy Committee, and market-based indicators of capital adequacy added to regulators’ and investors’ indicator set.

Third, Andrew Haldane calls for a fresh approach to financial supervision, one which is less rules-focussed and more judgment-based.

He notes that this approach: “...will underpin the Bank of England’s new supervisory model when it assumes prudential regulatory responsibilities next year.”

To be effective, he says that will require more experienced regulators working to a smaller, less detailed rulebook.

He adds that greater simplicity and consistency in disclosure practices could also strengthen market discipline.

Fourth, he considers the case for tackling complexity directly and at source.



He says that recent events have re-demonstrated the problems that arise in risk-managing large, complex banks: “At present, no explicit regulatory charge is levied on those complexity externalities.

Doing so would help protect the system against failure, while providing explicit incentives to simplify balance sheets.”

Finally, Andrew Haldane notes that, while quantity-based restrictions such as the Independent Commission on Banking proposals in the UK and the Volcker rule in the US are robust to complexity and uncertainty, they risk being mired in detail in their implementation.

He argues that cleaner solutions could be considered, or that the market could lead by encouraging banks to sell-off assets and reduce complexity.

Andrew Haldane says that: “Modern finance is complex, perhaps too complex...As you do not fight fire with fire, you do not fight complexity with complexity.

Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.”

That would require “...an about-turn from the regulatory community from the path followed for the better part of the past 50 years.”

But when it comes to financial regulation, concludes Andrew Haldane, “...less may be more”.



Policymaking in an interconnected world Luncheon speech by Jaime Caruana General Manager, Bank for International Settlements The Federal Reserve Bank of Kansas City’s 36th Economic Policy Symposium on “The changing policy landscape” Jackson Hole Let me extend my thanks to President George and the organisers for the opportunity to address this gathering – at an event that is more keenly anticipated by policymakers and journalists with every passing year. My question today is: Is there scope for more international cooperation in monetary policy? After all, we see international cooperation as essential for financial regulation. Why do we reject keeping one’s own house in order as a precept for financial regulation but accept it for monetary policy? The question is not a new one. In his famous Critical essays on monetary theory, Sir John Hicks argued that individual central banks have only limited influence because: “… they have been national central banks. Only in a national economy that is largely self-contained, can a national central bank be a true central bank; with the development of world markets, and (especially) of world financial markets, national central banks take a step down, becoming single banks in a world-wide system …. Thus the problem that was



(partially) solved by the institution of national central banks has reappeared …. on the world level”. That was in 1967, during the waning days of Bretton-Woods. And financial integration over the past 45 years has made the problem that Hicks identified even more intractable. The burden of my remarks today is that central banks need to take a more international perspective, recognise their collective influence and take into account monetary policy spillovers. Monetary policy that contributes to financial stability needs more of the cooperation that we already practise in financial regulation. Let me break my main question into four questions and then turn to each: 1. What was the state of cooperation in financial regulation and monetary policy before the crisis?

2. Where does cooperation stand after the crisis?

3. Why is the scope for international cooperation in monetary policy often underestimated? 4. Do we need to improve the institutional framework for monetary policy cooperation?



Q1. What was the state of international cooperation in financial regulation and monetary policy before the crisis? Since the financial liberalisation of the 1970s, the cooperation on regulatory standards for large international banks as embodied in Basel I and II extended well beyond any cooperation in monetary policy outside the euro area. This cooperation involved: (i) Exchange of information; (ii) Information-sharing based on a common understanding of how the world works; (iii) Joint decision-making; and (iv) Standards set by an international committee. The very first papers circulated to the Basel Committee on Banking Supervision (BCBS) in 1975 surveyed the “Rules and practices to protect the banks’ solvency and liquidity”. It turned out that these varied a great deal. Subsequently, regulators evolved a common intellectual framework and came to speak a common language. In 1988, Basel I went one step further, to joint decision-making. It set definitions of capital, risk weights for assets, and, crucially, a minimum ratio of capital to assets. These formulations were based on consensus, not enshrined in a treaty or in international law.



Instead, the original Basel accord was enacted in national law and enforced by national regulators. In fact, market pressure quickly made Basel I the standard even for banks in countries not represented on the BCBS. The driving forces for this cooperation are well known. As countries liberalised their capital accounts and moved to floating exchange rates, banks seized the opportunity to intermediate international capital flows. Soon after, Bankhaus Herstatt and Franklin National collapsed. These banks were not globally systemically important financial institutions, in today’s parlance, but their messy failures did help to drive forward international cooperation on bank regulation. When, in August 1982, the big banks suddenly stopped lending to Latin America, Congress increased the IMF’s resources but demanded higher capital levels for big US banks. Concerns about competitive neutrality then prompted the Federal Reserve to pursue joint action in what became Basel I. Basel III, to be discussed in a moment, has marked an even more explicit shift towards internalising the externalities imposed by big banks and banks’ collective behaviour.

By contrast, monetary policy remained mainly national after the breakdown of Bretton Woods.

Attempts at cooperation were episodic, mainly relating to exchange rates.

This gave monetary cooperation a bad name – especially in countries with current account surpluses, which came under pressure to expand demand.

At the level of theory, monetary policy shifted from the 1930s focus on competitive devaluation, first to the post-war treatment of monetary



policy as just one instrument in overall macroeconomic stability policy, and then in the past 25 years to the guardian of domestic price stability.

Flexible exchange rates, it was thought, would provide buffers against external shocks while policymakers kept their own house in order.

In fact, the largest economies not only remained relatively closed but also had banking systems with very low proportions of foreign currency assets.

To be sure, the quality of global monetary policy discussions has advanced over the past generation, as a common intellectual framework evolved. Indeed, one could argue that monetary policymakers shared a more thoroughly elaborated intellectual framework than did their counterparts in financial regulation. Even so, this shared framework could be indifferent (or even hostile) to cooperation in monetary policy.

Q2. Where does cooperation stand after the financial crisis? The short answer is that we have agreed to cooperate more deeply on the regulatory/financial stability front. But on the monetary policy front, the pre-crisis convergence of views has become strained. There is little doubt that, since the crisis, we have had the widest, deepest and most far-reaching regulatory cooperation in history. Participation has broadened, coordination has intensified, and implementation will be peer-reviewed. Institutionally, all G20 members have joined the BCBS. Similarly, the Financial Stability Board’s membership has become more inclusive.



Emerging market representatives bring useful macroprudential experience to the table. And attention is being paid to vulnerabilities in the shadow banking system, outside the narrow scope of the regulated sector. Cooperation has intensified with Basel III’s requirement for more and better capital, backstopped by a simple leverage ratio and international oversight of weights and implementation. Cooperation has also widened with the inclusion of international standards on liquidity management. Recognition of potential procyclicality in the operation of capital standards has led to the adoption of mutual recognition in the new countercyclical capital requirement, which empowers host country authorities. Tougher solvency standards have been set for banks whose failure could have system-wide effects. We should not minimise the challenges ahead. I am acutely aware that, even as intended regulatory cooperation has reached an all-time high, the risks of fragmenting banking along national lines have grown. While there are long-standing differences in the tax treatment of loan-loss provisions, national bank bonus taxes have been imposed and now financial transaction taxes are being discussed regionally. While Dodd-Frank is improving the funding model of US-chartered banks, other banks that rely on wholesale funding have gained markets share in dollar intermediation. While important advances have been made, serious obstacles remain in concerting resolution regimes given different bankruptcy laws.



A particularly troubling source of fragmentation along country lines is the inclination to put up national barriers against contagion. As Mario Draghi has said, “even though each of them may be right, collectively they have been wrong”. While regulatory cooperation is the prerequisite for open financial markets and the free flow of funds, capital controls seem to be gaining acceptance as a response to the challenge of managing currencies when yields are zero in most major money markets. These developments threaten to segment financial markets, not only in the euro area but around the world. Nevertheless, I remain hopeful that the movement towards global consistency and more harmonisation will prevail over the forces working to fragment international banking regulation and supervision. On monetary policy cooperation, there were notable steps during the crisis. Widespread, and ultimately in some cases, open-ended, cooperation in foreign-currency funding through central bank swaps had both the monetary goal of controlling the relevant market rates like Libor and the financial-stability goal of providing emergency funding. Such arrangements are temporary. But the willingness of central banks – not least the Federal Reserve – to act quickly and massively averted what could have been a meltdown. The global nature of the crisis also saw episodic cooperation in policy rate setting. For instance, on 8 October 2008, interest rates were simultaneously cut by the Bank of Canada, the Bank of England, the ECB, the Federal Reserve,



the Riksbank, the Swiss National Bank and the People’s Bank of China, in a concerted move that was strongly backed by the Bank of Japan. But a number of issues have strained the pre-crisis convergence of views on monetary policy. What can monetary policy contribute to financial stability? And how does monetary policy work alongside macroprudential action?

Q3. Why is the scope for international cooperation in monetary policy often underestimated? This question raises three more. First, do flexible exchange rates insulate economies as some theory suggests? Second, are bond markets so globally integrated that policies affecting yields in major countries now have a bigger impact on yields in other countries than they once did, possibly exerting an even larger effect than local policies and conditions? And third, can central banks properly assess the aggregate impact of their actions on global outcomes, or do they suffer from a fallacy of composition? Starting with exchange rates, flexible rates do of course help to insulate a country from inflationary or deflationary shocks coming from abroad. But they do it imperfectly. First, since major currencies are used internationally, the policy rates set by their issuers directly affect monetary conditions elsewhere. Borrowing in foreign currencies may be rare in the biggest economies, but it can be significant elsewhere.



And common monetary and risk factors affect the flow of international bank credit and portfolio capital. Since the crisis, while credit to US households and businesses has barely resumed its growth, dollar loans to such borrowers in the rest of the world has grown at up to 20% and has reached about $7 trillion. Second, the foreign exchange market’s behaviour does not always satisfy the textbook interest rate or purchasing power parity conditions. Exchange rate movements do not merely compensate for interest or inflation differentials. Instead, most of the time, currencies with an interest rate advantage actually appreciate against lower yielding currencies and can do so for some time, making the domestic industry less competitive. The depreciation of higher-yielding currencies tends to happen fast during episodes of stress in global asset markets, and many emerging market economies have found this destabilising. Next, there is the issue of international bond markets. As policy interest rates and official bond purchases affect bond yields, their effects ripple across globally integrated bond markets. This happens even with independent setting of policy rates and floating exchange rates. Large-scale bond purchases can have global effects whether they are part of an explicit monetary policy or a side-effect of currency intervention. There is evidence that the large Japanese interventions of 2003–04 lowered global bond yields, as dollars purchased in the foreign exchange market were invested in bonds.



There is also evidence that the Federal Reserve’s recent large-scale bond-buying has also reduced global bond yields. So the integration of global bond markets makes for a global interest in policies that, intentionally or not, affect bond yields in major markets. Turning to the possibility of a fallacy of composition, I believe that an international perspective is essential if we are to correctly assess the impact of central bank policies on global outcomes. The price dynamics in commodity markets – which are increasingly similar to those in financial markets – could be taken as a signal of global demand pressure rather than being considered by central banks as a supply shock for each of them. Similarly, each emerging market central bank might hesitate to raise interest rates out of concern for capital inflows, given the very low interest rates prevailing in major currencies. Indeed, if central banks were to take an international perspective, they might discover that they would all be better off by raising rates, thereby setting global average interest rates more appropriately. These questions are not easy to answer. How can we cope with these spillovers: the interconnections arising from the behaviour of exchange rates, the globalisation of bond markets, and the collective impact of policies? John Hicks knew that the one simple answer to the limitations he identified – a global central bank – would be totally unrealistic. National central banks have national mandates, and meeting these is already difficult enough. We know less about the workings of international linkages than we do about domestic linkages.



How interest rates will affect the major centres in other countries depends in part on those countries’ own policies and institutions. And it would not be difficult to add to this list. A number of factors combine to make nation states less than willing to cooperate on monetary policy. For instance, monetary policy can be redistributional, shifting wealth and income between creditors and debtors. This makes it even more politically charged than regulatory policy – if that is possible. Nevertheless, I do not believe that monetary policy can be restricted to keeping one’s “house in order” at all times. While such house-keeping is necessary, monetary policy does require international perspective and cooperation, particularly when it provides the backing for financial stability.

Q4. Do we need to improve the institutional setting for monetary cooperation? We hope that the structural trend that deepens interdependence, namely the globalisation of financial markets, continues. If it does, there will be periods, in good times and bad, when international spillovers will be substantial and highly relevant for monetary policy. If this notion and the underlying analysis are accepted, then the question arises of how to strengthen cooperation in monetary policy. This does not necessarily mean monetary policy coordination at the global level, but it does require central banks to better appreciate,



internalise and share the side effects that arise from individual monetary policies. This will require a shift to a more global analytical approach, one that seeks to factor in collective behaviour, interactions and feedback effects. This would also help us to better frame international cooperation. I therefore tend to agree with the recent call from prominent academics and practitioners for global considerations to play a more explicit role in monetary policy frameworks. But I am more sceptical about their proposal to formalise cooperative arrangements. The major central banks would not be able to publicly outline the mutual consistency of their policies. Drawing attention to areas of inconsistency and dissent would probably undermine effective cooperation. Traditionally, the BIS and the various Basel committees have always sought to complement the domestic analysis at central banks with a more global perspective. The informal but structured nature of the meetings that take place at the BIS has often facilitated analysis and discussion of the many international dimensions of monetary policies. For example, after providing support to a central bank review of global liquidity we are working on regular indicators that seek to capture global financial conditions. These and other global measures also serve as inputs to vulnerability analysis and the early warning exercise conducted by the Financial Stability Board and the IMF.



The IMF is playing a role as well, with its spillover reports and macroeconomic policies consistency analysis Let me conclude by saying that much needs to be done. Moving towards a more cooperative approach makes more sense than reversing the internationalisation of markets and segmenting those markets in the hope of protecting them against spillovers. We need more research on these questions and I hope that some of the powerful analytic talents represented here at Jackson Hole will be brought to bear on them.



Gabriel Bernardino, Chairman of EIOPA

Creating a global insurance supervisory Language Conference on Global Insurance Supervision Good evening, ladies and gentlemen, On behalf of EIOPA I would like to thank the International Center for Insurance Regulation for the cooperation and efforts in organising together with us this Conference on Global Insurance Supervision. I am very happy to see today so many colleagues from the supervisory authorities as well as prominent experts and executive officers of the insurance industry. Our purpose with this Conference is to create a platform of discussion and exchange of views about the international context of insurance supervision. Your presence and contribution to this event is key to its success and will certainly contribute to a better understanding of the different regimes and will foster further convergence of practices of insurance supervision worldwide. Insurance markets are increasingly global. Many insurance groups have nowadays a huge part of their revenues coming from business outside their home countries. This creates new opportunities but also new challenges for insurers, but also for supervisors. The promotion of sound and stable insurance markets calls for more international cooperation.



We firmly believe that the best way to reinforce financial stability and consumer protection is to develop strong global regulatory and supervisory standards. This will create a level playing field for international players, foster a common language between supervisors and improve international cooperation and information exchange. I would like to share with you some views on the ways of improving the efficiency of supervision from a global perspective. ComFrame ( Common Framework for the Supervision of Internationally Active Insurance Groups (IAIGs) - ComFrame is an integrated, multilateral and multidisciplinary framework for the group(wide supervision of internationally active insurance groups. ComFrame was initiated in response to the recognition that, despite the growing relevance of IAIGs in the global insurance marketplace, no internationally coherent framework exists for the supervision of such large, global groups. I would like to stress that EIOPA is highly committed to contribute to the establishment of such standards and, in this regard, we consider our participation in the IAIS very important. EIOPA is actively contributing to the work of ComFrame. We consider it necessary to enhance regulatory capital requirements in order to achieve adequate consumer protection on a global level. Of course, while calling for this measure, we take into account different perspectives and developments worldwide.



Seen historically, the EU had experienced comparable discussions a decade ago. We fully support the move to enhanced group-wide supervision. Cooperation between supervisors in colleges is essential for the proper supervisory approach to Internationally Active Insurance Groups. We believe that information sharing and supervisory cooperation under conditions of professional secrecy is a key, determinative element of effective supervision. We need more shared supervision. Furthermore, Comframe should comprise a capital element, establishing strong principles for group capital calculations concerning the risks included, the metrics used to assess them and the overall level of confidence. Without this consistency, there is no level playing field internationally. It is not about one unique system, but about a set of strong principles that would deliver a range of closer and compatible systems. Comframe should not be another regime on top of the already existent ones. The local regimes should evolve to comply with Comframe. This is my vision. I recognize that we cannot deliver this immediately, but at the IAIS we need to set a timetable and concrete milestones to develop this concept in a step by step approach. We need to be courageous and open-minded. We need to be open to change and evolution because the industry reality is also evolving and changing.



An extra effort needs to be done by all of us because like Charles Kettering (a famous American inventor) said one day: “People are very open minded about new things as long as they're exactly like the old ones.”

Systemic risk in insurance The crisis prompted a new look at systemic risk, including in the insurance sector. The identification and regulation of Globally Systemically Important Insurers is currently being discussed under the umbrella of the Financial Stability Board and the IAIS. EIOPA is keen to contribute to a robust identification process of G-SIIs and to develop appropriate regulatory and supervisory tools to deal with their characteristics. Traditionally, systemic risk was a banking concept. However, the recent crisis showed us that certain activities developed under the insurance sector can also pose systemic risk. Insurance companies or groups that engage in non-traditional, or non-insurance, activities (for example: CDS, financial guarantees or leveraging assets to enhance investment returns through securities lending are more vulnerable to financial market developments and, importantly, more likely to amplify, or contribute to, systemic risk. Of course, this assessment may change over time, depending on the innovations and changes in insurance business models, especially in life insurance, as well as in the complex interactions between insurance groups and financial markets. We should be especially attentive to any kind of maturity transformation and leveraging occurring in the insurance sector.



As a consequence, the identification of a systemically important insurer as such, should be a direct reflection of its source of systemic importance. While the size of traditional insurance activity is still an important factor, it should not be the dominant factor in the identification process. Clearly, the non-traditional and non-insurance activities and the degree of interconnectedness with other components of the financial system are more relevant from a systemic point of view. Consequently, the differences between insurers and banks in the impact of failures suggest that requirements for loss absorbency and resolution regimes for insurers should accept these salient differences and propose solutions that differentiate accordingly. As a conclusion I would like to underline that we should have no illusions: the creation of global insurance supervisory standards is a very long process that is complicated by the difference of cultures and uneven development of supervisory systems in different countries. But it is important that the regulators all over the world are willing to reach mutual understanding and to develop a common supervisory language, which will help us to promote stability of the financial markets, to enhance their transparency and to foster consumer protection.

Together we can achieve these objectives.



Quarterly Banking Digest, Q2 Important parts and Highlights

- Capitalisation improved slightly as system-wide leverage declines. The aggregate risk asset ratio (RAR) increased to 22.1% during the quarter due to a decline in risk-weighted assets (down 0.7%) and an increase in capital (up 0.6%).

- Some banks continue to experience significant asset quality challenges driven by the recessionary environment. Although non-performing loans (NPLs) relative to total loans declined from 8.3% to 8.1%, large exposures to the real estate sector have led to a rise in specific provisioning and charge-offs, which has affected the banks’ earnings capacity.

- Sector earnings have been impacted by higher provisions. Provisions to NPLs increased from 16.2% to 26.2% in Q2 2012 as a result of prudent efforts aimed at mitigating the impact of future asset impairments. As a result, the annualised RoE declined from 8.9% in Q1 2012 to 1.2% in Q2 2012, and the annualised RoA fell from 1.0% in Q1 2012 to 0.1% in Q2 2012.

- The Bermuda dollar funding gap widens further. The BD$ loan-to-deposit ratio increased to 154.0% (up from 151.0% in Q1 2012 and 142.0% a year earlier) as BD$-denominated customer deposits declined (down 1.3%). However, the large FX-denominated deposits, which declined by 5.1% during the quarter, continues to supplement the BD$ funding gap.

- Lower investment activity and interbank lending have mitigated negative effects on domestic credit supply thus far. Lending remained stable despite de-leveraging during the quarter resulting from decreases in investment activity and deposits with other financial institutions.



Table V shows the liquidity condition of the banking sector over the last five quarters.

Profitability Quarterly returns declined sharply as banks start absorbing non-performing loan balances aggressively. Despite stable net interest income over the quarter, increases in provisions resulted in lower profitability in the sector on average. Annualised RoE and RoA decreased to 1.2% (Q1 2012: 8.9%) and 0.1% (Q1 2012: 1.0%), respectively.



Government lays new Money Laundering regulations before Parliament On 10 September the Government introduced legislation to Parliament to implement important changes to the Money Laundering Regulations 2007. The changes will reduce the regulatory burden imposed by the current regulations, while strengthening the overall anti-money laundering regime. These proposals were set out in July 2012 following extensive consultation and are expected to save firms around £3 million a year. The changes to the Regulations will come into force on 1 October.

Notes

The Government announced the changes it was bringing forward to Money Laundering regulations in July 2012.The Money Laundering Regulations 2007 require regulated businesses to have appropriate systems and controls in place to identify and verify the identity of their customers and carry out ongoing monitoring as appropriate, based on their own assessment of the risk from money launderingand terrorist finance. The Government’s approach to money laundering regulation is designed to make the UK financial system a hostile environment for money laundering and terrorist finance, while minimising the regulatory burden imposed on UK businesses.

Changes to Money Laundering Regulations to reduce burden on British businesses

On 17 July 2012 the Government published its response to a consultation on changes to the Money Laundering Regulations 2007 and the impact assessment of the proposed changes.



Following the consultation the Government will now take forward proposals to reduce the regulatory burden imposed by the current regulations, while strengthening the overall anti-money laundering regime.

The proposed changes to the regulations will apply to businesses that are at low risk of money laundering and terrorist financing and are therefore not required to be regulated to the same extent as other institutions, under current global standards.

The aim of the changes is to make the UK’s money laundering regime more effective and proportionate, with the proposed changes saving firms around £3 million a year.

The Government committed to performing a post-implementation review of the 2007 Regulations, which implement the European Union Third Money Laundering Directive, two years after they came into force.

This review was undertaken in 2009-10, in conjunction with the Better Regulation Executive, and entailed an extensive call for evidence, meetings, conferences and interviews.

The Government’s response to the review was published in June 2011 and contained a consultation on seventeen proposals to improve the regime, reducing the impact of the regulations.

The changes to the Regulations are intended to come into force on 1 October.



Jumpstart Our Business Startups Act Frequently Asked Questions

In these Frequently Asked Questions (“FAQs”), the Division of Trading and Markets (“staff”) is providing guidance on certain provisions of the Jumpstart Our Business Startups Act (“JOBS Act”) as they affect firms and their obligations with respect to securities analysts (“analysts”) and research reports.

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

The Commission has neither approved nor disapproved these FAQs.

The staff may update these questions and answers periodically.

Background

These FAQs address questions about certain research provisions in Title I of the JOBS Act.

These provisions include:

Analyst Communications. Section 105(b) of the JOBS Act amends Section 15D of the Securities Exchange Act of 1934 (“Exchange Act”) to prohibit the Commission or a national securities association registered under Section 15A of the Exchange Act from adopting or maintaining any rule or regulation in connection with an initial public offering (“IPO”) of the common equity of an emerging growth company that:

- Restricts, based on functional role, which associated persons of a broker, dealer, or member of a national securities association, may arrange for communications between an analyst and a potential investor; or

- Restricts an analyst from participating in any communications with the management of an emerging growth company that is also attended by any other associated person of a broker, dealer, or

http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf

http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf



member of a national securities association whose functional role is other than as an analyst.

Testing the Waters. Section 105(c) of the JOBS Act amends Section 5 of the Securities Act of 1933 (“Securities Act”) to permit an emerging growth company or any person authorized to act on behalf of an emerging growth company to engage in oral or written communications with potential investors that are qualified institutional buyers or institutions that are accredited investors as defined in Securities Act Rules 144A and 501(a) (or any successors to such rules) either prior to or following the date of filing of a registration statement with respect to such securities with the Commission, subject to the requirement of Section 5(b)(2) of the Securities Act. Section 5(b)(2) of the Securities Act makes it unlawful for any person to, directly or indirectly, carry or cause to be carried through the mails or in interstate commerce any such security for the purpose of sale or for delivery after sale unless accompanied or preceded by a prospectus that meets the requirements of Section 10(a) of the Securities Act.

Post Offering Communications. Section 105(d) of the JOBS Act prohibits the Commission or any national securities association registered under Section 15A of the Exchange Act from adopting or maintaining any rule or regulation that prohibits any broker, dealer, or member of a national securities association from publishing or distributing any research report or making a public appearance, with respect to the securities of an emerging growth company, either:

- Within any prescribed period of time following the IPO date of the emerging growth company; or

- Within any prescribed period of time prior to the expiration date of any agreement between the broker, dealer, or member of a national securities association and the emerging growth company or its shareholders that restricts or prohibits the sale of securities held by the emerging growth company or its shareholders after the IPO date.



Responses to Frequently Asked Questions

Question: Does the ability of an emerging growth company to “test the waters” under Section 105(c) of the JOBS Act conflict with Rule 15c2-8(e) under the Exchange Act?

Answer: Section 105(c) of the JOBS Act allows emerging growth companies to continue to “test the waters” after a registration statement has been filed under the Securities Act.

As described below, we believe that this activity can take place in a manner consistent with the requirements of Rule 15c2-8(e).

Rule 15c2-8(e) states that it is a deceptive act or practice for a broker or dealer to participate in the distribution of securities with respect to which a registration statement has been filed under the Securities Act unless, among other things, the broker or dealer takes reasonable steps to make available a copy of the preliminary prospectus relating to such securities to each of that broker or dealer’s associated persons who are expected, prior to the effective date, to solicit customers’ orders for such securities before sales efforts by such associated persons.

A broker or dealer participating in such a distribution also is required to take reasonable steps to make available to these associated persons a copy of any amended preliminary prospectus promptly after the filing thereof.

The JOBS Act did not change the meaning of the term “solicit customers' orders” for purposes of Rule 15c2-8(e).

Whether an activity falls within the meaning of that term is based on the relevant facts and circumstances.

An underwriter, for example, may wish to seek non-binding indications of interest from its customers in relation to a potential offering for the purpose of gathering information from prospective investors.

This information can assist in the underwriter’s determination of the appropriate price, volume and market demand for a potential offering.



In such circumstances, the underwriter might ask its customers how many shares they might seek to purchase in the potential offering at various price ranges without requiring the customer to make any commitment to order.

Generally, if an underwriter is requesting from a customer a non-binding indication of interest that includes the amount of shares the customer might purchase in the potential offering at particular price levels – but does not ask the customer to commit to purchase the relevant securities – the underwriter, absent other factors, would likely not be soliciting a customer order for purposes of Rule 15c2-8(e).

Finally, Rule 15c2-8 is applicable only where a registration statement has been filed with the Commission under the Securities Act. Submitting a confidential draft registration statement for staff review in accordance with Section 106(a) of the JOBS Act does not constitute a “filing” of a registration statement for these purposes.

Question: In 2003 and 2004, the Commission, self-regulatory organizations (“SROs”), and other regulators instituted settled enforcement actions against 12 broker-dealers to address conflicts of interest between the firms’ research and investment banking functions (“Global Settlement”). Does the JOBS Act affect the structural reforms mandated by Global Settlement or any other part of that court order?

Answer: The JOBS Act does not amend or modify the Global Settlement. If the settling firms were to seek an amendment or modification of the Global Settlement in light of the JOBS Act, one or more of the settling firms would have to make an application to the court.

Under the terms of the Global Settlement, the Commission would have an opportunity to consider any such request and the Commission could support or oppose a proposed amendment or modification after considering whether it would be in the public interest.

Any amendment or modification to the Global Settlement would have to be approved by the court overseeing the Global Settlement.



The Global Settlement also provides that a provision of the Global Settlement can be modified or removed if the Commission adopts a rule (or approves an SRO rule) “with the stated intent to supersede” that provision.

Question: Section 105(b) of the JOBS Act prohibits the Commission or a national securities association from adopting or maintaining any rule or regulation in connection with an IPO of common equity of an emerging growth company restricting, based on functional role, which associated persons of a broker, dealer, or member may arrange for communications between an analyst and a potential investor. Does this “arranging” provision of the JOBS Act affect any existing Commission or SRO rule?

Answer: Under Section 105(b) of the JOBS Act, an associated person of a broker-dealer, including investment banking personnel, may arrange communications between analysts and investors.

This activity would include, for example, an investment banker forwarding a list of clients to the analyst that the analyst could, at his or her own discretion and with appropriate controls, contact.

In turn, an analyst could forward a list of potential clients it intends to communicate with to investment banking as a means to facilitate scheduling. Investment bankers can also arrange, but not participate in, calls between analysts and clients.

Although neither the Commission nor the SROs have a rule that directly prohibits this activity, the staff has been asked whether we would consider such arranging activity, without more, to be a method for investment banking personnel to direct a research analyst to engage in sales or marketing efforts or any communication with a current or prospective customer regarding an investment banking services transaction in violation of NASD Rule 2711(c)(6) and NYSE Rule 472(b)(6)(ii). The staff would not read NASD Rule 2711(c)(6) and NYSE Rule 472(b)(6)(ii) to prohibit such activity.

Firms should be mindful that other provisions of the Exchange Act and Commission and SRO rules were not changed by the JOBS Act, such as the requirement that communications with current or prospective



customers related to an investment banking services transaction be fair, balanced, and not misleading taking into consideration the overall context in which the communication was made.

Firms subject to the Global Settlement should also be mindful of the requirements of that court order as they remain in place, including the requirement to create and enforce firewalls between research and investment banking personnel reasonably designed to prohibit all communications between the two except as expressly permitted.

Firms are also reminded that they need to have appropriate policies and procedures to ensure compliance with the federal securities laws and SRO rules.

Question: Does Section 105 of the JOBS Act now allow analysts to attend meetings with company management in the presence of investment banking personnel in connection with the IPO of an emerging growth company?

Answer: Section 105(b) of the JOBS Act permits analysts to participate in any communication with the management of an emerging growth company concerning an IPO that is also attended by any other associated person of a broker, dealer, or member of a national securities association whose functional role is other than as an analyst.

The staff interprets this section as primarily reflecting a Congressional intent to allow analysts to participate in emerging growth company management presentations with sales force personnel so that the issuer’s management would not need to make separate and duplicative presentations to analysts at a time when senior management resources are limited.

This approach is consistent with a recommendation in the October 20, 2011 “Rebuilding the IPO On-Ramp” report issued by the IPO Task Force.

The Global Settlement was not affected by the JOBS Act.



Accordingly, analysts of Global Settlement firms are still subject to the provisions of that court order, including the requirement to create and enforce firewalls between research and investment banking personnel reasonably designed to prohibit all communications between the two except as expressly permitted in the court order.

Unless an exception to this requirement is applicable, the analyst is not permitted to participate in a communication in the presence of investment banking personnel.

In addition, other Commission and SRO rules regarding analysts continue to apply.

Prior to enactment of Section 105(b), SRO rules prohibited analysts of non-Global Settlement firms from attending meetings with issuer management that are also attended by investment banking personnel in connection with an IPO, including pitch meetings.

Pursuant to Section 105(b), analysts may now attend such meetings, provided that the issuer qualifies as an emerging growth company.

Section 105(b) does not, however, permit analysts to engage in otherwise prohibited conduct in such meetings. Section 105(b) does not, for example, affect SRO rules that otherwise prohibit an analyst from engaging in efforts to solicit investment banking business.

Section 105(b) also does not affect other prohibitions as discussed below.

Therefore, before a firm is formally retained to underwrite an offering, analysts of non-Global Settlement firms in attendance at such meetings could, for example, introduce themselves, outline their research program and the types of factors that the analyst would consider in his or her analysis of a company, and ask follow-up questions to better understand a factual statement made by the emerging growth company’s management.

In addition, after the firm is formally retained to underwrite the offering, analysts at non-Global Settlement firms could, for example, participate in presentations by the management of an emerging growth company to educate a firm’s sales force about the company and discuss industry



trends, provide information obtained from investing customers, and communicate their views.

Firms and analysts should be mindful of the antifraud provisions of the federal securities laws, the Global Settlement, and any other Commission or SRO rule that governs research analyst conflicts.

An analyst, for example, remains prohibited from changing his or her research as a result of a communication in an effort to obtain investment banking business.

In addition, an analyst continues to be prohibited from giving tacit acquiescence to overtures from the management of an emerging growth company that attempt to create an expectation of favorable research coverage if the analyst’s firm is chosen to underwrite the emerging growth company’s IPO.

Further, an analyst remains prohibited from providing views that are inconsistent with the analyst’s personal views about the emerging growth company or its securities, or from making a statement that is misleading taking into consideration the overall context in which the statement was made.

Moreover, investment banking personnel remain prohibited from directly or indirectly directing a research analyst to engage in sales or marketing efforts related to an investment banking services transaction.

Firms should ensure that they have instituted and enforce appropriate controls to make sure that analysts are not engaging in prohibited conduct, such as solicitation, at any meetings with company management that are also attended by investment banking personnel, or otherwise.

The examples given above are not exhaustive.

Question: Does the JOBS Act permit an analyst to participate in a roadshow or otherwise engage in communications with a current or prospective customer in the presence of investment banking department



personnel or the management of an emerging growth company about an investment banking services transaction?

Answer: As discussed above, Section 105(b)(2) of the JOBS Act allows a firm to avoid the ministerial burdens of organizing separate and potentially duplicative meetings and presentations among an emerging growth company’s management team, investment banking personnel, and research analysts.

Section 105(b)(2) did not address communications where investors are present together with company management, analysts and investment banking personnel.

This provision of the JOBS Act thus does not affect NASD Rules 2711(c)(5)(A) and (B) and NYSE Rules 472(b)(6)(i)(a) and (b), which prohibit analysts from participating in roadshows or otherwise engaging in communications with customers about an investment banking transaction in the presence of investment bankers or the company’s management.

These rules – which are intended to reduce the pressure on analysts to give overly optimistic assessments of investment banking deals and guard against analysts being perceived as part of the sales and marketing team for a transaction – apply to communications with customers and other investors and do not depend on whether analysts, investment bankers, and management are participating jointly in such communications.

Moreover, as noted above, the Global Settlement is not affected by the JOBS Act, so firms subject to that court order must be mindful of its provisions.



Question: Does Section 105(d) of the JOBS Act affect the SRO rules that establish quiet periods after the expiration of a lock-up agreement? What about the SRO rules that establish quiet periods before and after the termination or waiver of a lock-up agreement and the SRO rules that apply to quiet periods for secondary offerings?

Answer: The JOBS Act permits the publication or distribution of a research report or public appearances with respect to the securities of an emerging growth company at any time after an IPO or prior to the expiration date of any lock-up agreements.

Although the JOBS Act does not explicitly permit publication or distribution of a research report or public appearance relating to an emerging growth company before the termination or waiver of a lock-up agreement, the staff believes that the intent of Congress in adopting this provision was to fully address the quiet periods imposed by the SRO rules on research relating to emerging growth companies prior to the end of a lock-up agreement.

Therefore, the staff interprets Section 105(d)(2) of the JOBS Act to apply equally to NASD Rule 2711(f)(4) and NYSE Rule 472(f)(4) no matter by which method the lock-up agreement ends – by termination, expiration, or waiver – prior to the termination, expiration, or waiver of the agreement.

The JOBS Act did not explicitly permit publication or distribution of a research report or public appearance relating to an emerging growth company after the expiration, termination, or waiver of a lock-up agreement.

It also did not expressly address quiet periods after a secondary offering of an emerging growth company’s securities.

The staff believes that the policies underlying the change in Section 105(d) are equally applicable to quiet periods during these other time periods. We understand that FINRA is considering filing with the Commission a proposal to eliminate the remaining quiet periods imposed by NASD Rules 2711(f)(1), (2), and (4) and NYSE Rules 472(f)(1) through (4) with regard to an emerging growth company and its securities.



We expect this filing would eliminate these other quiet periods related to emerging growth companies not addressed by Section 105(d).

Question: Does the definition of research report under the JOBS Act affect the analysis of the types of communications that constitute a research report for purposes of Regulation Analyst Certification (“Regulation AC”)?

Answer: No. In general, under Regulation AC the following communications would not be research reports if they do not include an analysis of, or recommend or rate, individual securities or companies:

- Reports discussing broad-based indices, such as the Russell 2000 or S&P 500 index.

- Reports commenting on economic, political, or market conditions.

- Reports commenting on or analyzing particular types of debt securities or characteristics of debt securities.

- Technical analysis concerning the demand and supply for a sector, index, or industry based on trading volume and price.

- Reports that recommend increasing or decreasing holdings in particular industries or sectors or types of securities.

The following communications would generally not be research reports even if they recommend or rate individual securities or companies:

- Statistical summaries of multiple companies' financial data (including listings of current ratings) that do not include any analysis of individual companies' data.

- An analysis prepared for a specific person or a limited group of fewer than fifteen persons.

- Periodic reports or other communications prepared for investment company shareholders or discretionary investment account clients discussing past performance or the basis for previously made discretionary investment decisions.



- Internal communications that are not given to customers.

The Commission stated in the adopting release for Regulation AC that “[i]t is not possible to provide a complete list of all types of communications that would or would not fall within the definition of research report. Whether a particular communication constitutes a research report for the purpose of Regulation AC will turn on the individual facts and circumstances surrounding that communication.”

Question: Is there anything else that firms should consider when making changes based on research provisions of the JOBS Act?

Answer: We remind firms contemplating new activities based on the research provisions of the JOBS Act to review and update their policies and procedures, as well as their educational and training efforts, to make corresponding changes to promote compliance with Commission and SRO rules that are designed to minimize conflicts of interest and facilitate the objectivity and reliability of research.



Bank for International Settlements

BIS, Core principles for effective banking supervision September 2012

The Basel Committee on Banking Supervision has completed its review of the October 2006 Core principles for effective banking supervision and the associated Core principles methodology.

The revised Core Principles were endorsed by banking supervisors at the 17th International Conference of Banking Supervisors held in Istanbul, Turkey, on 13-14 September 2012.

Both the existing Core Principles and the associated assessment methodology have served their purpose well in terms of helping countries to assess their supervisory systems and identify areas for improvement.

While conscious efforts were made to maintain continuity and comparability to the extent possible, the revised document combines the Core Principles and the assessment methodology into a single comprehensive document.

The revised set of twenty-nine Core Principles has also been reorganised to foster their implementation through a more logical structure, highlighting the difference between what supervisors do and what they expect banks to do:

Principles 1 to 13 address supervisory powers, responsibilities and functions, focusing on effective risk-based supervision, and the need for early intervention and timely supervisory actions.

Principles 14 to 29 cover supervisory expectations of banks, emphasising the importance of good corporate governance and risk management, as well as compliance with supervisory standards.



Important enhancements have been introduced into the individual Core Principles, particularly in those areas that are necessary to strengthen supervisory practices and risk management.

As a result, certain "additional criteria" have been upgraded to "essential criteria", while new assessment criteria were warranted in other instances.

Close attention was given to addressing many of the significant risk management weaknesses and other vulnerabilities highlighted in the financial crisis.

In addition, the review has taken account of several key trends and developments that emerged during the last few years of market turmoil:

- the need for greater supervisory intensity and adequate resources to deal effectively with systemically important banks;

- the importance of applying a system-wide, macro perspective to the microprudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to address systemic risk; and

- the increasing focus on effective crisis management, recovery and resolution measures in reducing both the probability and impact of a bank failure.

The Committee has sought to give appropriate emphasis to these emerging issues by embedding them into the Core Principles, as appropriate, and including specific references under each relevant Principle.

In addition, sound corporate governance underpins effective risk management and public confidence in individual banks and the banking system.

Given fundamental deficiencies in banks' corporate governance that were exposed during the crisis, a new Core Principle on corporate governance has been added by bringing together existing corporate governance



criteria in the assessment methodology and giving greater emphasis to sound corporate governance practices.

Similarly, the Committee reiterated the key role of robust market discipline in fostering a safe and sound banking system by expanding an existing Core Principle into two new ones dedicated respectively to greater public disclosure and transparency, and enhanced financial reporting and external audit.

As a result of the Committee's review, the number of Core Principles has increased from 25 to 29.

There are a total of 39 new assessment criteria, comprising 34 new essential criteria and 5 new additional criteria.

In addition, 34 additional criteria from the existing assessment methodology have been upgraded to essential criteria that represent minimum baseline requirements for all countries.

A consultative version of the revised Core Principles was issued for public consultation in December 2011.

The Committee appreciates the constructive comments received and thanks those who have taken the time and effort to express their views on the consultative document.



Core Principles for Effective Banking Supervision (The Basel Core Principles) Executive summary 1. The Core Principles for Effective Banking Supervision (Core Principles) are the de facto minimum standard for sound prudential regulation and supervision of banks and banking systems. Originally issued by the Basel Committee on Banking Supervision (the Committee) in 1997, they are used by countries as a benchmark for assessing the quality of their supervisory systems and for identifying future work to achieve a baseline level of sound supervisory practices. The Core Principles are also used by the International Monetary Fund (IMF) and the World Bank, in the context of the Financial Sector Assessment Programme (FSAP), to assess the effectiveness of countries’ banking supervisory systems and practices. 2. The Core Principles were last revised by the Committee in October 2006 in cooperation with supervisors around the world. In its October 2010 Report to the G20 on response to the financial crisis, the Committee announced its plan to review the Core Principles as part of its ongoing work to strengthen supervisory practices worldwide. 3. In March 2011, the Core Principles Group was mandated by the Committee to review and update the Core Principles. The Committee’s mandate was to conduct the review taking into account significant developments in the global financial markets and regulatory landscape since October 2006, including post-crisis lessons for promoting sound supervisory systems. The intent was to ensure the continued relevance of the Core Principles for promoting effective banking supervision in all countries over time and changing environments.



4. In conducting the review, the Committee has sought to achieve the right balance in raising the bar for sound supervision while retaining the Core Principles as a flexible, globally applicable standard.

By reinforcing the proportionality concept, the revised Core Principles and their assessment criteria accommodate a diverse range of banking systems.

The proportionate approach also allows assessments of compliance with the Core Principles that are commensurate with the risk profile and systemic importance of a broad spectrum of banks (from large internationally active banks to small, non-complex deposit-taking institutions).

5. Both the existing Core Principles and the associated Core Principles Methodology (assessment methodology) have served their purpose well in terms of helping countries to assess their supervisory systems and identify areas for improvement. While conscious efforts were made to maintain continuity and comparability as far as possible, the Committee has merged the Core Principles and the assessment methodology into a single comprehensive document. The revised set of twenty-nine Core Principles have also been reorganised to foster their implementation through a more logical structure starting with supervisory powers, responsibilities and functions, and followed by supervisory expectations of banks, emphasising the importance of good corporate governance and risk management, as well as compliance with supervisory standards. 6. Important enhancements have been introduced into the individual Core Principles, particularly in those areas that are necessary to strengthen supervisory practices and risk management. Various additional criteria have been upgraded to essential criteria as a result, while new assessment criteria were warranted in other instances.



Close attention was given to addressing many of the significant risk management weaknesses and other vulnerabilities highlighted in the last crisis. In addition, the review has taken account of several key trends and developments that emerged during the last few years of market turmoil:

- the need for greater intensity and resources to deal effectively with systemically important banks;

- the importance of applying a system-wide, macro perspective to the microprudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to address systemic risk;

- and the increasing focus on effective crisis management, recovery and resolution measures in reducing both the probability and impact of a bank failure.

The Committee has sought to give appropriate emphasis to these emerging issues by embedding them into the Core Principles, as appropriate, and including specific references under each relevant Principle. 7. In addition, sound corporate governance underpins effective risk management and public confidence in individual banks and the banking system. Given fundamental deficiencies in banks’ corporate governance that were exposed in the last crisis, a new Core Principle on corporate governance has been added in this review by bringing together existing corporate governance criteria in the assessment methodology and giving greater emphasis to sound corporate governance practices. Similarly, the Committee reiterated the key role of robust market discipline in fostering a safe and sound banking system by expanding an existing Core Principle into two new ones dedicated respectively to greater public disclosure and transparency, and enhanced financial reporting and external audit.



8. At present, the grading of compliance with the Core Principles is based solely on the essential criteria.

To provide incentives to jurisdictions, particularly those that are important financial centres, to lead the way in the adoption of the highest supervisory standards, the revised Core Principles will allow countries the additional option of voluntarily choosing to be assessed and graded against the essential and additional criteria.

In the same spirit of promoting full and robust implementation, the Committee has retained the existing four-grade scale of assessing compliance with the Core Principles.

This includes the current “materially non-compliant” grading that helps provide a strong signalling effect to relevant authorities on remedial measures needed for addressing supervisory and regulatory shortcomings in their countries.

9. As a result of this review, the number of Core Principles has increased from 25 to 29. There are a total of 39 new assessment criteria, comprising 34 new essential criteria and 5 new additional criteria. In addition, 34 additional criteria from the existing assessment methodology have been upgraded to essential criteria that represent minimum baseline requirements for all countries.

10. The revised Core Principles will continue to provide a comprehensive standard for establishing a sound foundation for the regulation, supervision, governance and risk management of the banking sector.

Given the importance of consistent and effective standards implementation, the Committee stands ready to encourage work at the national level to implement the revised Core Principles in conjunction with other supervisory bodies and interested parties.



I. Foreword to the review 11. The Basel Committee on Banking Supervision (the Committee) has revised the Core Principles for Effective Banking Supervision (Core Principles). In conducting its review, the Committee has sought to balance the objectives of raising the bar for banking supervision (incorporating the lessons learned from the crisis and other significant regulatory developments since the Core Principles were last revised in 2006) against the need to maintain the universal applicability of the Core Principles and the need for continuity and comparability. By raising the bar, the practical application of the Core Principles should improve banking supervision worldwide. 12. The revised Core Principles strengthen the requirements for supervisors, the approaches to supervision and supervisors’ expectations of banks. This is achieved through a greater focus on effective risk-based supervision and the need for early intervention and timely supervisory actions. Supervisors should assess the risk profile of banks, in terms of the risks they run, the efficacy of their risk management and the risks they pose to the banking and financial systems. This risk-based process targets supervisory resources where they can be utilised to the best effect, focusing on outcomes as well as processes, moving beyond passive assessment of compliance with rules. 13. The Core Principles set out the powers that supervisors should have in order to address safety and soundness concerns.



It is equally crucial that supervisors use these powers once weaknesses or deficiencies are identified. Adopting a forward-looking approach to supervision through early intervention can prevent an identified weakness from developing into a threat to safety and soundness. This is particularly true for highly complex and bank-specific issues (eg liquidity risk) where effective supervisory actions must be tailored to a bank’s individual circumstances. 14. In its efforts to strengthen, reinforce and refocus the Core Principles, the Committee has nonetheless remained mindful of their underlying purpose and use. The Committee’s intention is to ensure the continued relevance of the Core Principles in providing a benchmark for supervisory practices that will withstand the test of time and changing environments. For this reason, this revision of the Core Principles builds upon the preceding versions to ensure continuity and comparability as far as possible. 15. In recognition of the universal applicability of the Core Principles, the Committee conducted its review in close cooperation with members of the Basel Consultative Group which comprises representatives from both Committee and non-Committee member countries and regional groups of banking supervisors, as well as the IMF, the World Bank and the Islamic Financial Services Board. The Committee consulted the industry and public before finalising the text.



General approach 16. The first Core Principle sets out the promotion of safety and soundness of banks and the banking system as the primary objective for banking supervision. Jurisdictions may assign other responsibilities to the banking supervisor provided they do not conflict with this primary objective. 6 It should not be an objective of banking supervision to prevent bank failures. However, supervision should aim to reduce the probability and impact of a bank failure, including by working with resolution authorities, so that when failure occurs, it is in an orderly manner. 17. To fulfil their purpose, the Core Principles must be capable of application to a wide range of jurisdictions whose banking sectors will inevitably include a broad spectrum of banks (from large internationally active banks to small, non-complex deposit-taking institutions). Banking systems may also offer a wide range of products or services and the Core Principles are aligned with the general aim of catering to different financial needs. To accommodate this breadth of application, a proportionate approach is adopted, both in terms of the expectations on supervisors for the discharge of their own functions and in terms of the standards that supervisors impose on banks. Consequently, the Core Principles acknowledge that supervisors typically use a risk-based approach in which more time and resources are devoted to larger, more complex or riskier banks. In the context of the standards imposed by supervisors on banks, the proportionality concept is reflected in those Principles focused on



supervisors’ assessment of banks’ risk management, where the Principles prescribe a level of supervisory expectation commensurate with a bank’s risk profile and systemic importance. 18. Successive revisions to existing Committee standards and guidance, and any new standards and guidance will be designed to strengthen the regulatory regime. Supervisors are encouraged to move towards the adoption of updated and new international supervisory standards as they are issued.

Approach toward emerging trends and developments (i) Systemically important banks (SIBs) 19. In the aftermath of the crisis, much attention has been focused on SIBs, and the regulations and supervisory powers needed to deal with them effectively. Consideration was given by the Committee to including a new Core Principle to cover SIBs. However, it was concluded that SIBs, which require greater intensity of supervision and hence resources, represent one end of the supervisory spectrum of banks. Each Core Principle applies to the supervision of all banks. The expectations on, and of, supervisors will need to be of a higher order for SIBs, commensurate with the risk profile and systemic importance of these banks. Therefore, it is unnecessary to include a specific stand-alone Core Principle for SIBs.



(ii) Macroprudential issues and systemic risks 20. The recent crisis highlighted the interface between, and the complementary nature of, the macroprudential and microprudential elements of effective supervision. In their application of a risk-based supervisory approach, supervisors and other authorities need to assess risk in a broader context than that of the balance sheet of individual banks. For example, the prevailing macroeconomic environment, business trends, and the build-up and concentration of risk across the banking sector and, indeed, outside of it, inevitably impact the risk exposure of individual banks. Bank-specific supervision should therefore consider this macro perspective. Individual bank data, where appropriate, data at sector level and aggregate trend data collected by supervisors should be incorporated into the deliberations of authorities relevant for financial stability purposes (whether part of, or separate from, the supervisor) to assist in identification and analysis of systemic risk. The relevant authorities should have the ability to take pre-emptive action to address systemic risks. Supervisors should have access to relevant financial stability analyses or assessments conducted by other authorities that affect the banking system. 21. This broad financial system perspective is integral to many of the Core Principles. For this reason, the Committee has not included a specific stand-alone Core Principle on macroprudential issues.



22. In supervising an individual bank which is part of a corporate group, it is essential that supervisors consider the bank and its risk profile from a number of perspectives: on a solo basis (but with both a micro and macro focus as discussed above); on a consolidated basis (in the sense of supervising the bank as a unit together with the other entities within the “banking group”) and on a group-wide basis (taking into account the potential risks to the bank posed by other group entities outside of the banking group). Group entities (whether within or outside the banking group) may be a source of strength but they may also be a source of weakness capable of adversely affecting the financial condition, reputation and overall safety and soundness of the bank. The Core Principles include a specific Core Principle on the consolidated supervision of banking groups, but they also note the importance of parent companies and other non-banking group entities in any assessment of the risks run by a bank or banking group. This supervisory “risk perimeter” extends beyond accounting consolidation concepts. In the discharge of their functions, supervisors must observe a broad canvas of risk, whether arising from within an individual bank, from its associated entities or from the prevailing macro financial environment. 23. Supervisors should also remain alert to the movement, or build-up, of financial activities outside the regulated banking sector (the development of “shadow banking” structures) and the potential risks this may create. Data or information on this should also be shared with any other authorities relevant for financial stability purposes.



(iii) Crisis management, recovery and resolution 24. Although it is not a supervisor’s role to prevent bank failures, supervisory oversight is designed to reduce both the probability and impact of such failures. Banks will, from time to time, run into difficulties, and to minimise the adverse impact both on the troubled bank and on the banking and financial sectors as a whole, effective crisis preparation and management, and orderly resolution frameworks and measures are required. 25. Such measures may be viewed from two perspectives: (i) The measures to be adopted by supervisory and other authorities (including developing resolution plans and in terms of information sharing and cooperation with other authorities, both domestic and cross-border, to coordinate an orderly restructuring or resolution of a troubled bank); and (ii) Those to be adopted by banks (including contingency funding plans and recovery plans) which should be subject to critical assessment by supervisors as part of their ongoing supervision. 26. To reflect, and to emphasise, the importance of crisis management, recovery and resolution measures, certain Core Principles include specific reference to the maintenance and assessment of contingency arrangements. The existing Core Principle on home-host relationships has also been strengthened to require cooperation and coordination between home and host supervisors on crisis management and resolution for cross-border banks.



(iv) Corporate governance, disclosure and transparency 27. Corporate governance shortcomings in banks, examples of which were observed during the crisis, can have potentially serious consequences both for the bank concerned and, in some cases, for the financial system as a whole. A new Core Principle, focused on effective corporate governance as an essential element in the safe and sound functioning of banks, has therefore been included in this revision. The new Principle brings together existing corporate governance criteria in the assessment methodology and gives greater emphasis to sound corporate governance practices. 28. Similarly, the crisis served to underline the importance of disclosure and transparency in maintaining confidence in banks by allowing market participants to understand better a bank’s risk profile and thereby reduce market uncertainties about the bank’s financial strength. In recognition of this, a new Core Principle has been added to provide more direction on supervisory practices in this area.

Structure and assessment of Core Principles Structure 29. The preceding versions of the Core Principles were accompanied by a separate assessment methodology that set out the criteria to be used to gauge compliance with the Core Principles. In this revision, the assessment methodology has been merged into a single document with the Core Principles reflecting the essential interdependence of Core Principles and Assessment Criteria and their common usage.



The Core Principles have also been reorganised: Principles 1-13 address supervisory powers, responsibilities and functions, and Principles 14-29 cover supervisory expectations of banks, emphasising the importance of good corporate governance and risk management, as well as compliance with supervisory standards. This re-ordering highlights the difference between what supervisors do themselves and what they expect banks to do. For comparability with the preceding version, a mapping table is provided in Annex 1.

Assessment 30. The Core Principles establish a level of sound supervisory practice that can be used as a benchmark by supervisors to assess the quality of their supervisory systems. They are also used by the IMF and the World Bank, in the context of the Financial Sector Assessment Programme (FSAP), to assess the effectiveness of countries’ banking supervisory systems and practices. 31. This revision of the Core Principles retains the previous practice of including both essential criteria and additional criteria as part of the assessment methodology. Essential criteria set out minimum baseline requirements for sound supervisory practices and are of universal applicability to all countries. An assessment of a country against the essential criteria must, however, recognise that its supervisory practices should be commensurate with the risk profile and systemic importance of the banks being supervised. In other words, the assessment must consider the context in which the supervisory practices are applied. The concept of proportionality underpins all assessment criteria even if it is not always directly referenced.



32. Effective banking supervisory practices are not static. They evolve over time as lessons are learned and banking business continues to develop and expand. Supervisors are often swift to encourage banks to adopt “best practice” and supervisors should demonstrably “practice what they preach” in terms of seeking to move continually towards the highest supervisory standards. To reinforce this aspiration, the additional criteria in the Core Principles set out supervisory practices that exceed current baseline expectations but which will contribute to the robustness of individual supervisory frameworks. As supervisory practices evolve, it is expected that upon each revision of the Core Principles, a number of additional criteria will migrate to become essential criteria as expectations on baseline standards change. The use of essential criteria and additional criteria will, in this sense, contribute to the continuing relevance of the Core Principles over time. 33. In the past, countries were graded only against the essential criteria, although they could volunteer to be assessed against the additional criteria too and benefit from assessors’ commentary on how supervisory practices could be enhanced. In future, countries undergoing assessments by the IMF and/or the World Bank can elect to be graded against the essential and additional criteria. It is anticipated that this will provide incentives to jurisdictions, particularly those that are important financial centres, to lead the way in the adoption of the highest supervisory standards. As with the essential criteria, any assessment against additional criteria should recognise the concept of proportionality as discussed above.



34. Moreover, it is important to bear in mind that some tasks, such as a correct assessment of the macroeconomic environment and the detection of the build-up of dangerous trends, do not lend themselves to a rigid compliant/non-compliant structure. Although these tasks may be difficult to assess, supervisors should make assessments that are as accurate as possible given the information available at the time and take reasonable actions to address and mitigate such risks. 35. While the publication of the assessments of jurisdictions affords transparency, an assessment of one jurisdiction will not be directly comparable to that of another. First, assessments will have to reflect proportionality. Thus, a jurisdiction that is home to many SIBs will naturally have a higher hurdle to obtain a “Compliant” grading10 versus a jurisdiction which only has small, non-complex deposit-taking institutions. Second, with this version of the Core Principles, jurisdictions can elect to be graded against essential criteria only or against both essential criteria and additional criteria. Third, assessments will inevitably be country-specific and time - dependent to varying degrees. Therefore, the description provided for each Core Principle and the qualitative commentary accompanying the grading for each Core Principle should be reviewed in order to gain an understanding of a jurisdiction’s approach to the specific aspect under consideration and the need for any improvements. Seeking to compare countries by a simple reference to the number of “Compliant” versus “Non-Compliant” grades they receive is unlikely to be informative.



36. From a broader perspective, effective banking supervision is dependent on a number of external elements, or preconditions, which may not be within the direct jurisdiction of supervisors. Thus, in respect of grading, the assessment of preconditions will remain qualitative and distinct from the assessment (and grading) of compliance with the Core Principles. 37. Core Principle 29 dealing with the Abuse of Financial Services includes, among other things, supervision of banks’ anti-money laundering/combating the financing of terrorism (AML/CFT) controls. The Committee recognises that assessments against this Core Principle will inevitably, for some countries, involve a degree of duplication with the mutual evaluation process of the Financial Action Task Force (FATF). To address this, where an evaluation has recently been conducted by the FATF on a given country, FSAP assessors may rely on that evaluation and focus their own review on the actions taken by supervisors to address any shortcomings identified by the FATF. In the absence of any recent FATF evaluation, FSAP assessors will continue to assess countries’ supervision of banks’ AML/CFT controls.

Consistency and implementation 38. The banking sector is only a part, albeit an important part, of a financial system and in conducting this review of its Core Principles, the Committee has sought to maintain consistency, where possible, with the corresponding standards for securities and insurance (which have themselves been the subject of recent reviews), as well as those for anti-money laundering and transparency. Differences will, however, inevitably remain as key risk areas and supervisory priorities differ from sector to sector. In implementing the



Core Principles, supervisors should take into account the role of the banking sector in supporting and facilitating productive activities for the real economy.

II. The Core Principles 39. The Core Principles are a framework of minimum standards for sound supervisory practices and are considered universally applicable. The Committee issued the Core Principles as its contribution to strengthening the global financial system. Weaknesses in the banking system of a country, whether developing or developed, can threaten financial stability both within that country and internationally. The Committee believes that implementation of the Core Principles by all countries would be a significant step towards improving financial stability domestically and internationally, and provide a good basis for further development of effective supervisory systems. The vast majority of countries have endorsed the Core Principles and have implemented them. 40. The revised Core Principles define 29 principles that are needed for a supervisory system to be effective. Those principles are broadly categorised into two groups: the first group (Principles 1 to 13) focus on powers, responsibilities and functions of supervisors, while the second group (Principles 14 to 29) focus on prudential regulations and requirements for banks. The original Principle 1 has been divided into three separate Principles, while new Principles related to corporate governance, and disclosure and transparency, have been added. This accounts for the increase from 25 to 29 Principles.



41. The 29 Core Principles are:

Supervisory powers, responsibilities and functions • Principle 1 – Responsibilities, objectives and powers: An effective system of banking supervision has clear responsibilities and objectives for each authority involved in the supervision of banks and banking groups. A suitable legal framework for banking supervision is in place to provide each responsible authority with the necessary legal powers to authorise banks, conduct ongoing supervision, address compliance with laws and undertake timely corrective actions to address safety and soundness concerns.

• Principle 2 – Independence, accountability, resourcing and legal protection for supervisors: The supervisor possesses operational independence, transparent processes, sound governance, budgetary processes that do not undermine autonomy and adequate resources, and is accountable for the discharge of its duties and use of its resources. The legal framework for banking supervision includes legal protection for the supervisor.

• Principle 3 – Cooperation and collaboration: Laws, regulations or other arrangements provide a framework for cooperation and collaboration with relevant domestic authorities and foreign supervisors.

These arrangements reflect the need to protect confidential information.

• Principle 4 – Permissible activities:



The permissible activities of institutions that are licensed and subject to supervision as banks are clearly defined and the use of the word “bank” in names is controlled.

• Principle 5 – Licensing criteria: The licensing authority has the power to set criteria and reject applications for establishments that do not meet the criteria.

At a minimum, the licensing process consists of an assessment of the ownership structure and governance (including the fitness and propriety of Board members and senior management) of the bank and its wider group, and its strategic and operating plan, internal controls, risk management and projected financial condition (including capital base).

Where the proposed owner or parent organisation is a foreign bank, the prior consent of its home supervisor is obtained.

• Principle 6 – Transfer of significant ownership: The supervisor has the power to review, reject and impose prudential conditions on any proposals to transfer significant ownership or controlling interests held directly or indirectly in existing banks to other parties.

• Principle 7 – Major acquisitions: The supervisor has the power to approve or reject (or recommend to the responsible authority the approval or rejection of), and impose prudential conditions on, major acquisitions or investments by a bank, against prescribed criteria, including the establishment of cross-border operations, and to determine that corporate affiliations or structures do not expose the bank to undue risks or hinder effective supervision.



• Principle 8 – Supervisory approach: An effective system of banking supervision requires the supervisor to develop and maintain a forward-looking assessment of the risk profile of individual banks and banking groups, proportionate to their systemic importance; identify, assess and address risks emanating from banks and the banking system as a whole; have a framework in place for early intervention; and have plans in place, in partnership with other relevant authorities, to take action to resolve banks in an orderly manner if they become non-viable.

• Principle 9 – Supervisory techniques and tools: The supervisor uses an appropriate range of techniques and tools to implement the supervisory approach and deploys supervisory resources on a proportionate basis, taking into account the risk profile and systemic importance of banks.

• Principle 10 – Supervisory reporting: The supervisor collects, reviews and analyses prudential reports and statistical returns from banks on both a solo and a consolidated basis, and independently verifies these reports through either on-site examinations or use of external experts.

• Principle 11 – Corrective and sanctioning powers of supervisors: The supervisor acts at an early stage to address unsafe and unsound practices or activities that could pose risks to banks or to the banking system.

The supervisor has at its disposal an adequate range of supervisory tools to bring about timely corrective actions.



This includes the ability to revoke the banking licence or to recommend its revocation.

• Principle 12 – Consolidated supervision: An essential element of banking supervision is that the supervisor supervises the banking group on a consolidated basis, adequately monitoring and, as appropriate, applying prudential standards to all aspects of the business conducted by the banking group worldwide.

• Principle 13 – Home-host relationships: Home and host supervisors of cross-border banking groups share information and cooperate for effective supervision of the group and group entities, and effective handling of crisis situations. Supervisors require the local operations of foreign banks to be conducted to the same standards as those required of domestic banks.

Prudential regulations and requirements • Principle 14 – Corporate governance: The supervisor determines that banks and banking groups have robust corporate governance policies and processes covering, for example, strategic direction, group and organisational structure, control environment, responsibilities of the banks’ Boards and senior management, and compensation.

These policies and processes are commensurate with the risk profile and systemic importance of the bank.

• Principle 15 – Risk management process:



The supervisor determines that banks have a comprehensive risk management process (including effective Board and senior management oversight) to identify, measure, evaluate, monitor, report and control or mitigate all material risks on a timely basis and to assess the adequacy of their capital and liquidity in relation to their risk profile and market and macroeconomic conditions.

This extends to development and review of contingency arrangements (incuding robust and credible recovery plans where warranted) that take into account the specific circumstances of the bank.

The risk management process is commensurate with the risk profile and systemic importance of the bank.

• Principle 16 – Capital adequacy: The supervisor sets prudent and appropriate capital adequacy requirements for banks that reflect the risks undertaken by, and presented by, a bank in the context of the markets and macroeconomic conditions in which it operates.

The supervisor defines the components of capital, bearing in mind their ability to absorb losses.

At least for internationally active banks, capital requirements are not less than the applicable Basel standards.

• Principle 17 – Credit risk: The supervisor determines that banks have an adequate credit risk management process that takes into account their risk appetite, risk profile and market and macroeconomic conditions.



This includes prudent policies and processes to identify, measure, evaluate, monitor, report and control or mitigate credit risk (including counterparty credit risk) on a timely basis.

The full credit lifecycle is covered including credit underwriting, credit evaluation, and the ongoing management of the bank’s loan and investment portfolios.

• Principle 18 – Problem assets, provisions and reserves: The supervisor determines that banks have adequate policies and processes for the early identification and management of problem assets, and the maintenance of adequate provisions and reserves.

• Principle 19 – Concentration risk and large exposure limits: The supervisor determines that banks have adequate policies and processes to identify, measure, evaluate, monitor, report and control or mitigate concentrations of risk on a timely basis.

Supervisors set prudential limits to restrict bank exposures to single counterparties or groups of connected counterparties.

• Principle 20 – Transactions with related parties: In order to prevent abuses arising in transactions with related parties and to address the risk of conflict of interest, the supervisor requires banks to enter into any transactions with related parties on an arm’s length basis; to monitor these transactions; to take appropriate steps to control or mitigate the risks; and to write off exposures to related parties in accordance with standard policies and processes.

• Principle 21 – Country and transfer risks:



The supervisor determines that banks have adequate policies and processes to identify, measure, evaluate, monitor, report and control or mitigate country risk and transfer risk in their international lending and investment activities on a timely basis.

• Principle 22 – Market risks: The supervisor determines that banks have an adequate market risk management process that takes into account their risk appetite, risk profile, and market and macroeconomic conditions and the risk of a significant deterioration in market liquidity.

This includes prudent policies and processes to identify, measure, evaluate, monitor, report and control or mitigate market risks on a timely basis.

• Principle 23 – Interest rate risk in the banking book: The supervisor determines that banks have adequate systems to identify, measure, evaluate, monitor, report and control or mitigate interest rate risk in the banking book on a timely basis.

These systems take into account the bank’s risk appetite, risk profile and market and macroeconomic conditions.

• Principle 24 – Liquidity risk: The supervisor sets prudent and appropriate liquidity requirements (which can include either quantitative or qualitative requirements or both) for banks that reflect the liquidity needs of the bank.

The supervisor determines that banks have a strategy that enables prudent management of liquidity risk and compliance with liquidity requirements.



The strategy takes into account the bank’s risk profile as well as market and macroeconomic conditions and includes prudent policies and processes, consistent with the bank’s risk appetite, to identify, measure, evaluate, monitor, report and control or mitigate liquidity risk over an appropriate set of time horizons.

At least for internationally active banks, liquidity requirements are not lower than the applicable Basel standards.

• Principle 25 – Operational risk: The supervisor determines that banks have an adequate operational risk management framework that takes into account their risk appetite, risk profile and market and macroeconomic conditions.

This includes prudent policies and processes to identify, assess, evaluate, monitor, report and control or mitigate operational risk on a timely basis.

• Principle 26 – Internal control and audit: The supervisor determines that banks have adequate internal control frameworks to establish and maintain a properly controlled operating environment for the conduct of their business taking into account their risk profile.

These include clear arrangements for delegating authority and responsibility; separation of the functions that involve committing the bank, paying away its funds, and accounting for its assets and liabilities; reconciliation of these processes; safeguarding the bank’s assets; and appropriate independent internal audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.

• Principle 27: Financial reporting and external audit:



The supervisor determines that banks and banking groups maintain adequate and reliable records, prepare financial statements in accordance with accounting policies and practices that are widely accepted internationally and annually publish information that fairly reflects their financial condition and performance and bears an independent external auditor’s opinion.

The supervisor also determines that banks and parent companies of banking groups have adequate governance and oversight of the external audit function.

• Principle 28 – Disclosure and transparency: The supervisor determines that banks and banking groups regularly publish information on a consolidated and, where appropriate, solo basis that is easily accessible and fairly reflects their financial condition, performance, risk exposures, risk management strategies and corporate governance policies and processes.

• Principle 29 – Abuse of financial services: The supervisor determines that banks have adequate policies and processes, including strict customer due diligence rules to promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities.

42. The Core Principles are neutral with regard to different approaches to supervision, so long as the overriding goals are achieved.

They are not designed to cover all the needs and circumstances of every banking system. Instead, specific country circumstances should be more appropriately considered in the context of the assessments and in the dialogue between assessors and country authorities.



43. National authorities should apply the Core Principles in the supervision of all banking organisations within their jurisdictions.

Individual countries, in particular those with advanced markets and banks, may expand upon the Core Principles in order to achieve best supervisory practice.

44. A high degree of compliance with the Core Principles should foster overall financial system stability; however, this will not guarantee it, nor will it prevent the failure of banks. Banking supervision cannot, and should not, provide an assurance that banks will not fail. In a market economy, failures are part of risk-taking.

45. The Committee stands ready to encourage work at the national level to implement the Core Principles in conjunction with other supervisory bodies and interested parties.

The Committee invites the international financial institutions and donor agencies to use the Core Principles in assisting individual countries to strengthen their supervisory arrangements.

The Committee will continue to collaborate closely with the IMF and the World Bank in their monitoring of the implementation of the Committee’s prudential standards.

The Committee also remains committed to further enhancing its interaction with supervisors from non-member countries.



Is part of your job to predict the future? Do you live in the new forward looking perspective in risk management? In 1964, Arthur C. Clarke, science fiction writer, inventor and futurist observed: “Trying to predict the future is a discouraging and hazardous occupation, because the prophet invariably falls between two chairs. If his predictions sound at all reasonable, you can be quite sure that in 20, or at most 50 years, the progress of science and technology has made him seem ridiculously conservative. On the other hand, if by some miracle, a prophet could describe the future exactly as it was going to take place, his predictions would sound so absurd, so far-fetched, that everybody would laugh him to scorn.”

Statement by Dr. Kaigham J. Gabriel Deputy Director, Defense Advanced Research Projects Agency Submitted to the Subcommittee on Emerging Threats and Capabilities United States House of Representatives Interesting parts

At DARPA, we are often asked to predict the future. After all, since it was created in 1958, DARPA’s singular mission has been to create and prevent strategic surprise. Simple. Clear. Direct. It may appear that the best way to create strategic surprise is to predict what’s next.



Predict with great accuracy and as far as out as possible. We hunger to know what’s next. To predict the future. But our hunger to predict is not matched by our ability to do so. In 1964, Arthur C. Clarke, science fiction writer, inventor and futurist observed: “Trying to predict the future is a discouraging and hazardous occupation, because the prophet invariably falls between two chairs. If his predictions sound at all reasonable, you can be quite sure that in 20, or at most 50 years, the progress of science and technology has made him seem ridiculously conservative. On the other hand, if by some miracle, a prophet could describe the future exactly as it was going to take place, his predictions would sound so absurd, so far-fetched, that everybody would laugh him to scorn.” At DARPA, we believe it is not about predicting the future... it is about building it. Indeed, the technical visionaries at DARPA are not oracles—they are builders. Chairman Thornberry, Ranking Member Langevin, Members of the Subcommittee, my name is Ken Gabriel. I am the Deputy Director of the Defense Advanced Research Projects Agency. I would like to highlight some of the accomplishments of the Agency over the last 12 months and, outline the challenges we see and our intentions for the coming year. The impact from some of our work will be felt years from now. Other work is contributing sooner and is in the fight today.



Regardless of where in that spectrum we are, DARPA’s work is underscored by a focus on building. Building capabilities and demonstrations at convincing scale that drive the advance of the underlying technologies and science. We innovate by building. We achieve our best, by building.

Building the future Some of the Agency’s greatest contributions— things we now take for granted and as having been inevitable were, at their inception, often considered impossible. The Internet, stealth, UAVs for example, when first proposed were described by some as impractical, far-fetched, and risky. But these seemingly impossible things were turned to the improbable and then to the inevitable by people with vision and determination to make their vision real. A determination to build. DARPA program managers have a hunger to succeed, a sense of urgency, and a commitment to the Nation’s Security. For more than 50 years, the Agency has sought the Nation’s best, given them the resources they need, and cleared the obstacles in their way. The lifeblood of DARPA is the cadre of program managers and leadership executives that represent some of the best technical minds in the country. Professionals who put their careers in suspended animation in service to country. Accountable to the Agency, to the Department, and to our Warfighters, DARPA’s program managers are drawn from academia, industry, non-profits, the Services, and laboratories and serve for a tour of 3 to 5 years.



Program managers, office directors, the Director, and the Deputy Director; all change on a regular cadence. This practice results in roughly 25 percent annual starts and exits and ensures the Agency is current with existing and emerging technological trends, encourages a continual challenging of conventional approaches, and imparts an ethic of urgency. One key continuing challenge for the Agency and, by extension, for the well-being of the Department of Defense is recruiting this talent to service. DARPA’s ability to do so demands rapid, agile and efficient hiring. In the last 2.5 years the Agency has recruited more than 75 new program managers – this has been essential to many of our efforts including DARPA’s significantly expanded cyber program and our big data efforts in support of operations in Afghanistan, among others. DARPA has demonstrated successful and responsible use of its hiring authorities. Indeed, the Agency has been at essentially present-day personnel levels since 1992 and has never exceeded the allocated top-line number of authorized full-time equivalents. Timelines for hiring within the Agency are short and match the cadence and tempo of tours reflected above. Simply put, we cannot undertake a 6-month or even a year-long hiring activity, as is common in government, for a technical subject matter expert critically needed to undertake efforts in response to a technological shift and with other competing career opportunities. Rather, we need to sustain an efficient and expedient engagement that is naturally always within the construct of fiscal, ethical, and legal responsibilities.



This is not something we can afford to risk. Together we must protect it vigorously.

Our business practices are a vital part of building. Execution is what allows the people at DARPA to build. To turn ideas into reality, the Agency must operate effectively with agility, speed, and technical and administrative integrity. DARPA executes a budget of nearly $3 billion as appropriated by Congress. It does so with approximately 120 program managers and a roughly equal number of Government support staff. Financial resources and lean business practices allow the Agency to pursue ideas that most dare not touch. And to do so quickly. There are no entitlements to programs or people, no captive laboratories, no immutable tenets. The Agency applies a “thoughtful ruthlessness” in its dogged pursuit of the best people, ideas, and output. The breadth, urgency, and technical demands of DARPA programs are real. The innovative ideas the Agency pursues are fragile and fleeting, and the organization’s business practices must be aligned with the speed and flexibility required to pursue those ideas. The authenticity of Defense applications demands an organization dedicated to excellence in execution through all levels of management, policies, and personnel.



Indeed, in the face of such pressures, creativity requires heroic intellectual leaps not just from the technical side of the organization, but equally from the support side of the organization. DARPA has support offices dedicated to essential functions that enable the mission through innovative practices that mirror the technical innovations of the Agency. In past years, Congressional oversight committees expressed concern that DARPA’s financial execution was inadequate; specifically, that DARPA was not obligating a significant fraction of the money it had requested. These concerns resulted in budget cuts and rescissions, but, as well, obligation delays meant fewer resources at work for the Department. In our 2010 written testimony, we reported on the steps the Agency had taken to improve business process and the resulting, significant improvements in financial execution. In 2011, we maintained our emphasis on responsible and efficient financial execution. At the end of September 2011, the Agency’s obligation rate was 21 points higher (85 percent) than the 5-year average (64 percent) despite the delayed 2011 Appropriations signing. At the end of fiscal year 2011, the improved execution translated into more than $600 million in the performer community, working for the Department and Nation. Speed is part of the vibrancy of innovation and building. Better business practices are just better Government. It affects not only the performers, but the Agency too.



People come to DARPA not for careers in Government, but to serve. Over the decades, this cadre has consistently delivered. The list of historical achievements is well known, long, and includes stealth, the Internet, and UAVs. Today we are working on the production of vaccines from tobacco plants measured in days rather than months; prosthetics controlled directly by thoughts; and clean-slate, convergent approaches to defensive and offensive cyber security capabilities among many other innovations.

Discouraging the fear of failure Doing things that have never been done before, building the future, comes with risk. Risk of failure. As a Department, as a Nation, we must not forget that great accomplishments often had failure along the path. We cannot fear it. The history of the Corona program and imaging satellites tells us that it took 13 launches over several years before the first images were collected. Thirteen. Each of the other 12 launches failed to collect a single image. No doubt, some at the time called them failures. But each of those 12 launches informed the next build and successively created the capability of imaging satellites from what seemed impossible, to just improbable and, eventually, inevitable.



The first successful flight in 1960 covered 1.65 million square miles of Soviet territory—more than all earlier U-2 missions combined. A more recent example is HTV-2, a DARPA program that is part of the Department’s prompt global strike activities. HTV-2 seeks to travel at Mach 20 in an unmanned, boost-glide, maneuvering vehicle. The fastest high lift-to-drag ratio aircraft ever built. Mach 20. Twenty times the speed of sound. That means anywhere in the world in 60 minutes or less. Or New York to Los Angeles in 11 minutes and 20 seconds, with the surface of the vehicle at blast furnace temperatures: 3500 degrees F—the temperature of molten steel. We are essentially burning the airfoil as we fly it. It might seem impossible. It’s not. It’s just hard. There have been two test flights to date. The first revealed an underestimation and simulation of aerodynamic effects in one of four variables needed for controlled hypersonic flight. The second flight demonstrated that we had fixed the aerodynamic control from the first flight, but precisely because we reached a different stage of the flight, we had 3 minutes of fully aerodynamically controlled flight at Mach 20. Although neither of the flights completed all elements of the tests, the two flights combined fielded the largest collection of flight-test assets assembled and yielded more aerodynamic and test measurement data at



these hypersonic regimes than what has been collected in ground tests over the last 40 years. There’s no way to learn to fly at Mach 20 unless you build… and fly. From hypersonic flight to detecting overpressure during blasts, building remains important. A persistent, acute DoD need has been for a reliable, accurate and affordable method to detect and characterize traumatic brain injury or (TBI). We undertook basic and fundamental work in neuroscience and the effect of blasts on the fine structure that revealed the role of over pressure in TBI. Overpressure waves distinguish blast exposure from other types of causes of TBI (for example, sports injuries where acceleration and kinetic impact, but no overpressures are contributors). Informed by this neuroscience work, DARPA launched a program to build, demonstrate, and evaluate a blast gauge that incorporated a pressure sensor, acceleration sensor, and recording electronics. Four versions of the gauge were built over the course of a year and for a total development cost of approximately $1 million. Each version building in the learnings—learnings from both the use and manufacturing of the earlier versions. In partnership with the Army, the final version was fielded to an entire brigade of 841 warfighters, the 2nd Brigade, 4th Infantry Division in RC South over the course of six months— from August 2011 to February 2012. The initial units used to outfit the first brigade cost $85 per unit, 3 per warfighter per month of deployment for a total cost of $1.6M.



But over time, informed by the building and shipping of over 16,000 units and incorporating improved manufacturing processes, the cost is now approximately $45 per unit, and the next brigade will be outfitted for $540,000. At DARPA we plan for success, not failure. We don’t seek, embrace, or celebrate failure. We learn from our failure, and we build future capabilities through persistence, focus, and informed trial. We don’t encourage failure; we discourage the fear of failure.

The price of not building In the best of times, failure is difficult to endure. There is a hunger and need to be efficient. To husband our resources. In times of fiscal pressure that hunger is sharper. The conventional wisdom and response for relief is to roadmap, coordinate and plan to better predict and better prepare. To slow our efforts so as to retire more risks, to build less often and thus lower costs. If we can improve our predictions, we can better plan for and build the systems needed. The argument being, “We can’t afford to fail.” The trouble with this approach is that, out of balance, it fails to weigh the risks of not building. Because it is equally important not to lose sight of the companion worry:



“What’s the price of not building often and along shorter timelines?” At DARPA we examined this fundamental argument through the lens of two parameters: per-system cost and total number of systems to be purchased. Across many different types of representative defense systems— air, land, and sea— over the last 2 to 3 decades, the analysis reveals a consistent and disturbing pattern. Programs of record begin with a target per-system cost and total number of systems to be purchased. Over the course of a program, due to a variety of factors including financial constraints, technical risks and changing priorities, there is a steady increase in the per-system cost and a corresponding decrease in the total number of systems to be purchased. For the systems we analyzed, with associated development and fielding times ranging from 14 to 30 years, the final number of systems purchased were typically one-fourth the original number of systems envisioned at the start of the programs. The judgment of whether fielding one-fourth of the original number of systems is enough is not DARPA’s. This pattern of increasing timelines to initial operational capability, increasing cost per unit delivered, and companion decrease in the number of units, is divergent with an increasingly dynamic threat environment. Our next step was to attempt to reveal what is causing the divergence. Many people are familiar with Norm Augustine’s chart that shows the extrapolated cost of a fighter aircraft intersecting with the Defense



budget, such that sometime in 2054 the entire Defense budget will be required to buy one aircraft. Further, given the pace of global technological development and access, we can no longer afford the time it takes us to build Defense systems. In DARPA’s 2010 and 2011 written testimony, we highlighted and described the Agency’s advanced manufacturing initiative, with the focus on reducing and controlling for time. But it is not simply the argument that time is money. As a Department, we are at a juncture where not only the increasing cost but the increasing time it takes us to develop defense systems is a vulnerability in and of itself. In the past, defense technology could be relied on to be ahead of civil or commercial technology. Defense technology drove commercial technology and the defense industry was often an early adopter and customer of new technologies. And in a few unique areas, defense will remain ahead of commercial capabilities. But the number of these areas is decreasing. In the last 2 decades, this long-standing precedent has begun to reverse, and commercial technology has begun to outstrip defense technology. This is perhaps felt most acutely in cybersecurity and the consumer electronics products and services that have fundamentally changed the way we connect and interact with the world and each other.

Vulnerabilities created by commercial technologies.



Unintentionally, and without malice, commercial consumer electronics has created vulnerabilities by enabling sensors, computing, imaging, and communications capabilities that as recently as 15 years ago, were the exclusive domain of military systems. These capabilities now are in the hands of hundreds of millions of people around the world and in use every day. The effect of these commercial capabilities on Defense and National Security may be seen in the impact of these trends on electronic warfare (EW) systems and anti-access and area denial (A2AD). EW: an area of historic advantage to the US military; and A2AD: an area of increasing concern in several strategic regions of the globe. This is not an abstract vulnerability. We have not enjoyed spectrum dominance since about 1997. Up until then, our EW systems could both detect and respond effectively to EW threats directed at us. In the last 15 or so years, however, that has ceased to be true. In both waveform complexity and carrier frequency, adversaries have moved to operating regimes currently beyond the capabilities of our systems. What we find are three principal reasons why it has been possible to apply commercially available electronic capabilities to produce military-grade EW systems. First, as microelectronic devices continue to shrink in size, they are, perhaps counter intuitively, also improving in performance. For example, smaller microelectronic devices are able to switch faster and, thus, operate at higher frequencies. This means that specialized microelectronic devices produced for DoD are now matched or nearly matched in performance to standard



silicon-based microelectronics commercially available from multiple, global sources. Second, custom signal processing chips that took 2 to 3 years to develop and required chip designers, sophisticated design, and simulation tools along with chip fabrication facilities are increasingly being replaced by programmable chips or field-programmable gate arrays (FPGAs). Unlike custom signal processing chips that have their specific function fixed at the time of fabrication, FPGAs can be programmed, and reprogrammed, like software, after fabrication. This means that developers can cut as much as 18 months off development schedules, from 3 to 4 years to as little as 1.5 years. Finally, the demand created by the global, mobile communications industry has led to a global manufacturing capacity and economic efficiencies that deliver the above capabilities at ever decreasing prices. EW was once the province of a few peer-adversaries. It is now possible to purchase commercial off-the-shelf (COTS) components for more than 90 percent of the electronics needed in an EW system. This has reduced the barriers to developing, producing, and fielding such systems to within the capabilities of many nation states and non-state actors. And because of the improved performance of commercially available, programmable microelectronics, nearly a dozen countries are now producing EW system variants and new versions at a much faster cadence than we have; from a pace of a new system every 5 to 10 years 2 decades ago, to one every 1.5 years today. This means that our conventional approaches no longer afford us a time or capability advantage.



Increasingly, our conventional approaches are divergent with the threat. These insights led us to new investments that leverage COTS technology where it makes sense to, counter COTS where we need to, and transcend COTS where practical. Leveraging COTS. If a commercial computer chip is fast enough to accomplish a task in a US military system, there is no point to designing an alternative; just use what is available. This does not imply equivalent capability at the system level. Namely, we are not doomed to an even playing field just because we are using the same processor chip as an adversary. We can make a network of such chips to overcome the adversary’s system. Better algorithms tightly integrated with the hardware, and improved cooling to wring more performance from each chip, are two examples where technological advances would allow us to prevail even when we are all using the same basic technology. Countering COTS; alternatives to GPS as an example. We use global positioning system (GPS) because it is cheap and easy. It is COTS for us – most of our precision-guided munitions capability, as well as timing for our command and control systems, have become dependent on GPS. The adversary knows this and has aggressively sought means to counter our dependency on GPS. Jammers and commercially driven spectrum compression may threaten our ability to use GPS in areas denied. Attempts to make GPS receivers that can survive that jamming is impractical and not convergent with the threat.



GPS signals are inherently weak. The ease with which GPS signals are jammed or spoofed motivate developments of development of alternative position, navigation, and timing approaches that are not dependent on GPS alone. An example of how we might counter COTS is to recognize that GPS is just one way of providing positioning, navigation, and timing data. But it is not the only way. We might carry our own navigation system. The same trends in COTS advances, used to build alternative navigation guidance systems such as highly integrated, inexpensive, low power accelerometers and gyros, may enable the DoD to accomplish its mission even when GPS is denied. Our analysis revealed that extending the performance of today’s inertial guidance systems by a factor of 20—from roughly 1 minute to 18 minutes, will permit 98 percent of our GPS-dependent weapons to operate at GPS accuracy during their mission duration without a GPS signal. Transcending COTS. COTS electronics is a formidable source of new, high performance technology, but it has inherent limitations. The main one is economics– industry is motivated by the profit incentive, and modern electronics is extremely expensive to design and produce in small volumes. This highly nonlinear effect of high volume manufacturing is why the extremely complex technology inside cell phones appears to be so cheap. This opens a window of opportunity for the US military anywhere that product unit volumes will be low, COTS electronics will be unavailable. Very high power transmit/receive modules for radars and radios, for



example, are simply unnecessary in the COTS space, so the Military must design and produce its own. Although this performance advantage will come with a cost greater than commercial products, this means the United States will enjoy a technical lead over any potential adversary who cannot invest and do likewise.

Operational vice intelligence capabilities in cybersecurity In cybersecurity, we have the area that most highlights the danger of taking too long to build. The shelflife of cybersecurity systems and capabilities is sometimes measured in days. Thus, to a greater degree than in other areas of defense, cybersecurity solutions require that we develop the ability to build quickly, at scale, and over a broad range of capabilities. This is true for both offensive and defensive capabilities. DARPA’s role in the creation of the Internet means we were party to the intense opportunities it created and share in the intense responsibility of protecting it. We should emphasize that national policymakers, not DARPA, will determine how cyber capabilities will be employed to protect and defend National Security interests. But the Agency has a special responsibility to explore the outer boundaries of such capabilities that the United States is well prepared for future challenges. To date, there has been much focus on increasing our defensive capabilities.



To be sure, the list of needed capabilities is long. Our networks may be safer than they were, but systems are often easily penetrated, accounts are routinely hacked, intellectual property and sensitive information are compromised, and the supply chain is not secure. And because computers are embedded in nearly all our systems—cyber attack cannot be regarded as a threat only to our networks and information—but rather to all our physical systems as well. Protecting cyberspace and the Nation requires both significantly enhanced defensive and offensive cyber capabilities; capabilities across the full spectrum of the conflict. Of note, our Intelligence Community has significant cyber capabilities, but the are geared predominantly to intelligence tasks. The tasks required for Defense purposes are sufficiently different that we cannot simply scale our intelligence cyber capabilities and adequately serve the needs of the Department of Defense. Rather we need cyber options that can be executed at the speed, scale, and pace of our military kinetic options with comparable predicted outcomes. Modern warfare demands the effective use of cyber, kinetic, and combined cyber and kinetic means. That will happen only if cyber capabilities are at scales and speeds matched to our kinetic options. Informed by these insights and with a willingness to accept our responsibility to contribute, we assessed that DARPA has a significant role to play.



We recruited an expert cyber team of individuals from diverse experiences including the “white hat” hacker community, academia, labs and nonprofits, major commercial companies, in addition to the Defense and Intelligence Communities. We launched several programs, increased the level of activities in others, and closed some out. Our cyber efforts are designed to create the capabilities needed for military missions. We need more options. We need more speed and scale. We need approaches that match the diversity, dynamic range, and operational tempo of DoD activities. This cannot be achieved by simply doing more of what we’ve been doing or by increasing our intelligence-oriented cyber capabilities. Examples include programs such as Clean-Slate design of Resilient, Adaptive, Secure Hosts or CRASH, which takes its inspiration from the defensive mechanisms of biological systems and seeks to develop cybersecurity technologies by radically rethinking basic hardware and systems designs. And PROgramming Computation on EncryptEd DATA or PROCEED, which is a big reach program motivated by recent breakthroughs in what is called fully homomorphic encryption, which could fundamentally change the nature of assured computations on untrusted hardware. If successful, PROCEED puts cybersecurity into an encryption realm, a realm that requires state-level computational resources. The Cyber Fast Track program recognizes an untapped pool of experts and innovators who could contribute, if we provide a path.



That path matches both their execution and the shelflife of cybersecurity products. In the last 7 months, more than 100 proposals were received by Cyber Fast Track, and 32 awards were made. Just as important, the average time from receipt of proposal to award is 7 days. We note that the process and contracting mechanism rigorously meets DoD regulations for competition and awards; we need not be slow to be fair, ethical, or prudent. Eighty-four percent of these small companies and performers have never done business with the Government before, expanding the number and diversity of talent contributing to the Nation’s cybersecurity. Since 2009, DARPA has steadily increased its cyber research. Our cyber research funding is increasing from $228 million in FY2012 to $246 million in FY2013. And over the next five years, our proposed investment in cyber research will grow steadily from 8 percent to 12 percent of topline. We are also shifting our investments to activities that promise more convergence with the threat that recognize the unique needs of the Department of Defense. To this end, in the coming years, DARPA will focus an increasing portion of our cyber research on the investigation of offensive capabilities to address military-specific needs. We began these efforts on our own. But part of the growth in our resource commitment beginning in 2012 and extending through 2017, is at the hand of senior leaders in the Department, who added $500 million over 5 years for clean-slate, convergent cyber research at DARPA. DARPA’s engagement in cyber is not new.



This expanded effort builds on an existing foundation and continuing contributions to cyber. Indeed, past DARPA-developed technologies are widely prevalent in military, intelligence, and commercial use today. But there is still much to do. DARPA activities are part of a larger whole within National Security at the National Security Agency , the newly formed CYBERCOMMAND, the Services, the private sector, universities, nonprofits and, as appropriate, the Department of Homeland Security. Clearly, the challenges of cyberspace require the concerted efforts of many. Indeed, we all must be protectors of and operate within cyberspace. And these challenges also demand the involvement of technical experts at unprecedented levels. We expect that part of our responsibility will be in advisory roles during the formation of policy and legal frameworks, because new policies and laws—domestic and international—must be executable, enforceable, and sustainable. To be of use, such policies and laws will demand evaluation and adjustment on timescales that correspond to the dynamic nature and compressed evolutionary timescales of advances in cyberspace. We’ll have to move faster than we are accustomed to. We’ll need the tools and guidance to do so.

Discomfort and strategic surprise Some of these observations feel uncomfortable.



Even to us. Our responsibility, however, is to the uncomfortable. It is the Agency’s singular mission to identify divergences and the threats and opportunities they represent. These are the seeds of strategic surprise. We need approaches that are convergent with the challenges and deliver systems and solutions on timescales and with agilities that match operational needs. In this time of fiscal constraint, we are committed to doing our part. But this does not mean that we lose our nerve for building. Thank you.



Basel ii / iii in Russia

The Bank of Russia considers it necessary to create legislative fundamentals in Russia for in-troducing all the standards of banking regulation and banking supervision established by the Basel Committee on Banking Supervision (BCBS). These include legislation empowering the Bank of Russia to set requirements for credit institutions’ corporate governance, risk and capital management systems, to exercise consolidated supervision, to use professional judgment in supervisory practices, and also to define disciplinary action against members of executive bodies and boards of directors (supervisory boards) for faults in the activity of their credit institutions. In order to implement the provisions of Basel II, the Bank of Russia will carry out work in 2012-2014 to draft banking regulation and supervisory rules envisaging approaches to credit risk assessment based on internal ratings. The Bank of Russia will also cooperate with credit institutions in drafting and introducing internal capital adequacy assessment procedures. In order to introduce new international requirements for capital quality and adequacy and maintain the required level of liquidity as stipulated by the BCBS documents adopted in 2010 (Basel III) and supported by the G20 leaders at their summit in Seoul in November 2010, the Bank of Russia intends to take the following measures: – make amendments to the regulations to review the structure of regulatory capital and introduce requirements for the adequacy of capital components;



–set requirements for building capital buffers, introducing the leverage indicator defined as the ratio between capital and the total value of assets and off-balance sheet items that are not weighted by risk; – introduce two liquidity ratios: the short-term liquidity coverage standard defined as the ratio of liquid assets to net cash outflow over the next 30 calendar days in a market stress scenario, and the net stable funding standard determined as the ratio of available reliable sources of funding with a maturity of at least one year to the required amount of stable funding in a stress scenario. In 2013-2014, the Bank of Russia will define approaches for banks to create the counter-cyclical capital buffers as an instrument to limit systemic risks. In order to implement these approaches, additional indicators of risk growth in the Russian financial system are intended to be developed. Measures are planned in 2012-2014 to work out criteria for classifying banks as systemically important, and also define regulatory requirements for their activity, taking into account the proposals developed by the BCBS jointly with the Financial Stability Board (FSB) for global sys-temically important financial institutions. While developing corresponding criteria for Russian banks, the Bank of Russia will take into account the specifics of the domestic market for banking services, and also the work being carried out by the BCBS and the FSB to adapt the proposed approaches to the regulation of national systemically important banks. With regard to international recommendations on compliance with FSB principles and standards relating to compensation (remuneration), the Bank of Russia will implement them taking into account the specific requirements of national legislation. In order to reduce the administrative burden on banks, measures are planned to unify supervisory requirements for the sustainability of credit



institutions and the requirements for their participation in the deposit insurance system by making corresponding amendments to legislation. In order to increase the transparency of Russian credit institutions, they will be required to disclose information to the public on the qualifications and work experience of their top managers. Measures will be required to statutorily establish the duty of shareholders and persons exerting indirectly (through third parties) material influence on decisions taken by the credit institutions’ management bodies, including third parties, to provide information to credit institutions for the disclosure of the ownership structure. These would include cases where the shares of credit institutions are kept by nominal holders. Measures are planned to further develop the legislative framework of credit institutions’ affiliated parties to increase the transparency of the ownership structure of credit institutions. In particular, it will be necessary to stipulate the duty of all affiliated parties of credit institutions to provide information on them and be held responsible for their failure to comply with this requirement. Work will be continued to legislatively improve merger and acquisition processes. Amendments will be made to the legislation to stipulate a possibility for legal entities (including credit institutions) with different forms of incor-poration to participate in the reorganisation of credit institutions, which will give an additional stimulus to raise their capitalisation through re-structuring. The policy towards integration into the world financial market should be conducted taking into account national interests, the real level of development and the competitiveness of the Russian banking sector.



The ban on opening foreign bank branches will remain as a necessary measure for maintaining the competitiveness of Russian banks in the domestic market for banking services and the Bank of Russia will continue its participation in drafting the corresponding federal law. The Bank of Russia will participate in work to draft laws aimed at providing additional protection for creditors and consumers of financial services, including the improvement of the law on pledge and the development of legislation on consumer credit. At the same time, work will continue to implement measures for improving the financial literacy of the population with respect to banking. Measures to increase the transparency of credit institutions as a result of the use of International Financial Reporting Standards (IFRS) in their activities are an important step towards raising the efficiency of the banking sector and boosting clients’ confidence in banks. With this in mind, these tasks should be resolved through the implementation of Federal Law No. 208-FZ, dated 27 July 2010, ‘On Consolidated Financial Statements’, under which credit institutions are required to draw up, submit and publish consolidated financial statements. For its part, the Bank of Russia considers it necessary to encourage credit institutions to be conservative enough in making fair value measurements under the IFRS standards and, if necessary, will use banking regulation and supervisory powers to adjust the measurements, proceeding from prudential approaches. The Bank of Russia will further study approaches and measures for maintaining the systemic stability of the banking sector. The Bank of Russia will continue to upgrade its macroprudential analysis tools by calculating banking sector financial soundness indicators, among other things, and posting them on the IMF website, and to assess systemic risk by conducting stress tests.



In order to better protect the banking system and credit institutions’ creditors, including bank depositors, and reduce the risks of abuses by credit institutions’ managers and owners, work will continue to improve the mechanisms of liquidation procedures at banks. These measures will include the assignment of criminal responsibility to the heads of credit institutions, and also persons responsible for accounting and other records, for deliberately entering false data into documents regulating civil rights and duties, accounting and other records and reports on the economic activities of a credit institution, and also for making corrections that distort the substance of these documents, if these actions are taken in pursuit of personal gain or in one’s personal interest and inflict damage on citizens, organisations or the state.



The Central Bank of the Russian Federation Banking Legislation

Introduction

The Central Bank of the Russian Federation (Bank of Russia) was founded on July 13, 1990, on the basis of the Russian Republic Bank of the State Bank of the USSR. Accountable to the Supreme Soviet of the RSFSR, it was originally called the State Bank of the RSFSR. On December 2, 1990, the Supreme Soviet of the RSFSR passed the Law on the Central Bank of the RSFSR (Bank of Russia), which declared the Bank of Russia a legal entity and the main bank of the RSFSR, accountable to the Supreme Soviet of the RSFSR. The law specified the functions of the bank in organising money circulation, monetary regulation, foreign economic activity and regulation of the activities of joint-stock and co-operative banks. In June 1991, the Statute of the Central Bank of the RSFSR (Bank of Russia), accountable to the Supreme Soviet of the RSFSR, was approved. In November 1991, when the Commonwealth of Independent States was founded and Union structures dissolved, the Supreme Soviet of the RSFSR declared the Central Bank of the RSFSR to be the only body of state monetary and foreign exchange regulation in the RSFSR.



The functions of the State Bank of the USSR in issuing money and setting the ruble exchange rate were transferred to it. The Central Bank of the RSFSR was instructed to assume before January 1, 1992, full control of the assets, technical facilities and other resources of the State Bank of the USSR and all its institutions, enterprises and organisations. On December 20, 1991, the State Bank of the USSR was disbanded and all its assets, liabilities and property in the RSFSR were transferred to the Central Bank of the RSFSR (Bank of Russia), which several months later was renamed the Central Bank of the Russian Federation (Bank of Russia). In 1991-1992 an extensive network of commercial banks was created in the Russian Federation under Bank of Russia guidance through commercialisation of the specialised banks’ branches. The disbandment of the State Bank of the USSR was followed by changes in the chart of accounts, the establishment of a network of Central Bank cash settlement centres and their provision with computer technology. The Central Bank began to buy and sell foreign exchange in the currency market it established and to set and publish the official exchange rates of foreign currencies against the ruble. In December 1992, as a result of the establishment of a single centralised federal treasury system, the Bank of Russia was no longer required to provide cash services for the federal budget. The Bank of Russia carries out its functions, which were established by the Constitution of the Russian Federation (Article 75) and the Law "On the Central Bank of the Russian Federation (Bank of Russia)" (Article 22), independently from the federal, regional and local government structures. In 1992-1995, to maintain stability of the banking system, the Bank of Russia set up a system of supervision and inspection of commercial



banks and a system of foreign exchange regulation and foreign exchange control. As the agent of the Ministry of Finance, it organised the government securities market, known as the GKO market, and began to participate in its operations. In 1995, the Bank of Russia stopped extending loans to finance the federal budget deficit and centralised loans to individual sectors of the economy. To override the consequences of the 1998 financial crisis, the Bank of Russia took steps towards restructuring the banking system in order to improve the performance of commercial banks and increase their liquidity. Insolvent banks were removed from the banking services market, using the procedures established by the applicable law. Of great importance for the post-crisis recovery of the banking sector was the creation of the Agency for Restructuring Credit Institutions (ARCO) and the Inter-Agency Co-ordinating Committee for Banking Sector Development in Russia (ICC). Thanks to the effective measures implemented by the Bank of Russia, ARCO and ICC, by the middle of 2001 Russia’s banking sector had on the whole overcome the aftermath of the crisis. The Bank of Russia monetary policy was designed to maintain financial stability and create conditions conducive to sustainable economic growth. The Bank of Russia promptly reacted to any change in the real demand for money and took steps to stimulate positive economic dynamics, cut interest rates, damp down inflationary expectations and slow the inflation rate.



As a result, the ruble gained somewhat in real terms and financial market stability increased. Due to the balanced monetary and exchange rate policies pursued by the Bank of Russia, the country’s international reserves have grown and there have been no sharp fluctuations in the exchange rate. The efforts made by the Bank of Russia with regard to the payment system were designed to increase its reliability and efficiency for financial and economic stability. To make the Russian payment system more transparent, the Bank of Russia introduced reports on payments by credit institutions and its own regional branches, which took into account international experience, methodology and practice of surveillance over payment systems. In 2003, the Bank of Russia launched a project designed to improve banking supervision and prudential reporting by introducing international financial reporting standards (IFRS). The project provides for the implementation of a set of measures, including measures to ensure credit institutions’ credible accounting and reporting, raise requirements for the content, amount and periodicity of information to be published, and introduce accounting and reporting standards matching international good practice. In addition, measures are to be taken to disclose information on the real owners of credit institutions, exercise control over their financial position and raise requirements for credit institutions’ executives and their business reputation. There are some problems to which the Bank of Russia pays special attention. One of them is that specific risks connected with the dynamics of the prices of some financial assets and the price situation on the real estate market have begun to play an increasingly important role recently.



The practice of lending to related parties led to high risk concentrations in some banks, compelling the Bank of Russia to upgrade the methods of banking regulation and supervision by making greater emphasis on substantive (risk-oriented) supervision. Fictitious capitalisation of banks is another matter of serious concern for the Bank of Russia. To prevent banks from using all sorts of schemes designed to artificially overvalue or undervalue the required ratios, the Bank of Russia in 2004 issued a number of regulations, including the Regulation "On the Procedure for Creating Loan Loss Reserves by Credit Institutions" and the Instruction "On Banks’ Required Ratios." As the number of credit institutions extending mortgage loans to the public increased, in 2003 the Bank of Russia issued the Ordinance "On Conducting a One-off Survey of Mortgage Lending," which set the procedure for compiling and presenting data on housing mortgage loans extended by credit institutions. With the adoption of the Federal Law "On Mortgage Securities," credit institutions which ensured the observance of the requirements for the protection of investors’ interests received the lawful opportunity to refinance their claims on mortgage loans by issuing mortgage securities. In pursuance of the Federal Law "On the Central Bank of the Russian Federation (Bank of Russia)" and Federal Law "On Mortgage Securities," the Bank of Russia issued the Instruction "On the Required Ratios for Credit Institutions Issuing Mortgage-Backed Bonds," which specified the calculation and established the values of the required ratios and the values and methodology of calculating additional required ratios for credit institutions issuing mortgage-backed bonds. In December 2003, the Federal Law "On Insurance of Personal Bank Deposits in the Russian Federation" was adopted.



The law stipulated the legal, financial and organisational framework for the mandatory personal bank deposits insurance system, and also the powers, procedure for the establishment and operation of an institution implementing mandatory deposit insurance functions and set the procedure for paying deposit compensation. At present, an overwhelming majority of banks participate in the deposit insurance system. They account for almost 100% of total personal deposits placed in Russian banks. In April 2005, the Russian Government and Bank of Russia adopted the Banking Sector Development Strategy for the Period up to 2008, a document which set as the main objective of banking sector development in the medium term (2005-2008) the enhancement of the banking sector’s stability and efficiency. The principal goals of banking sector development are as follows:

- increasing the protection of interests of depositors and other creditors of banks;

- enhancing the effectiveness of the banking sector’s activity in

accumulating household and enterprise sector funds and transforming them into loans and investments;

- making Russian credit institutions more competitive; - preventing the use of credit institutions in dishonest commercial

practices and illegal activities, especially the financing of terrorism and money laundering;

- promoting the development of the competitive environment and

ensuring the transparency of credit institutions; - building up investor, creditor and depositor confidence in the

banking sector.



The banking sector reform will help implement Russia’s medium-term social and economic development programme (2005-2008), especially its objective to end the raw materials bias of the Russian economy by rapidly diversifying it and utilising its competitive advantages.

At the next stage (2009-2015), the Russian Government and Bank of

Russia will attach priority to effectively positioning the Russian banking sector on international financial markets.

Banking Legislation Banking legislation is a branch of law representing a system of statutory acts regulating banking activities. The legal regulation of banking activities is exercised by the Constitution of the Russian Federation, Civil Code of the Russian Federation, Federal Law No. 86-FZ, dated July 10, 2002, ‘On the Central Bank of the Russian Federation (Bank of Russia)’ (hereinafter referred to as the Bank of Russia Law), Federal Law No. 395-1, dated December 2, 1990, ‘On Banks and Banking Activities,’ and other federal laws and Bank of Russia regulations. Point g of Article 71 of the Constitution of the Russian Federation stipulates that the Russian Federation has the jurisdiction over the financial, currency, credit and customs regulation, the issue of money and the fundamentals of the price policy. This provision signifies that the legal regulation of banking activities may only be conducted at the federal level. Part 2 of Article 75 of the Constitution of the Russian Federation lays down the principle of the Bank of Russia being independent from other state bodies when performing its basic function to protect the rouble and ensure its stability.



The Bank of Russia Law spells out the principle of the Bank of Russia independence, stipulating that the Bank of Russia performs the functions and exercises the powers established by the Constitution of the Russian Federation and the Bank of Russia Law independently from other federal bodies of state power, regional authorities and local governments. The Bank of Russia Law establishes the legal status of the Bank of Russia, the size of its authorised capital, the procedure for creating the National Banking Board and management bodies and their principal functions; settles the relations between the Bank of Russia and the bodies of state power and local governments and the relations between the Bank of Russia and credit institutions; spells out the principles of organising non-cash settlements and cash circulation; sets out the principles of implementing the monetary policy and designated its instruments; lists Bank of Russia operations and transactions; establishes the powers in regard of banking regulation and supervision, and formulates the principles of organising the Bank of Russia and its accountability and audit. Article 4 of the Bank of Russia Law lists the functions performed by the Bank of Russia. Article 7 of the Bank of Russia Law stipulates that in regard of the matters related to its competence by this Federal Law and other federal laws the Bank of Russia issues in the form of ordinances, regulations and instructions statutory acts binding upon the federal bodies of state power, regional authorities, local governments and all legal entities and natural persons. With few exceptions, Bank of Russia statutory acts should be registered according to the procedure established for the state registration of statutory legal acts of the federal bodies of executive power. In addition to issuing its own regulations, the Bank of Russia takes an active part in other forms of the legislative process, because under the law the drafts of federal laws and statutory legal acts of the federal bodies of executive power concerning the performance by the Bank of Russia of its



functions should be submitted to the Bank of Russia for consideration and approval. Another basic federal law regulating banking activities is the Federal Law ‘On Banks and Banking Activities’, which defines major terms used in the legal regulation of banking, such as ‘credit institution,’ ‘bank,’ ‘non-bank credit institution,’ ‘banking group,’ etc. This Federal Law determines the components of the Russian banking system, lists banking operations and other transactions, describes the specifics of credit institution operations on the securities market and sets the procedure for registering credit institutions and licensing banking activities and the procedure for opening credit institution branches and representative offices. It formulates the principles of the relationships between credit institutions and their customers and between credit institutions and the state, lists the grounds for the revocation of a banking licence, lays down the principles of ensuring the soundness of credit institutions, establishes the banking secrecy regime and anti-monopoly restrictions for credit institutions and sets out the principles of organising the savings business in the Russian Federation. The passage of Federal Law No. 40-FZ, dated February 25, 1999, ‘On Insolvency (Bankruptcy) of Credit Institutions’ (hereinafter referred to as the Insolvency Law) was a major step forward in building in Russia a civilised credit institution insolvency (bankruptcy) system meeting the generally accepted international standards. The Insolvency Law sets the procedure for carrying out credit institution insolvency (bankruptcy) prevention measures, declaring credit institutions insolvent (bankrupt) and subsequently liquidating them. The relations connected with credit institution insolvency (bankruptcy) prevention that are not regulated by the Insolvency Law are regulated by other federal laws and Bank of Russia statutory acts issued in pursuance of these laws.



The relations connected with credit institution insolvency (bankruptcy) that are not regulated by the Insolvency Law are regulated by Federal Law No. 127-FZ, dated October 26, 2002, ‘On Insolvency (Bankruptcy),’ and Bank of Russia regulations in cases stipulated by the Insolvency Law. Under the Insolvency Law, a credit institution is considered incapable of meeting creditors’ pecuniary claims and (or) making compulsory payments if it has failed to exercise these duties for 14 days after they are due and (or) the value of the credit institution’s property (assets) is not enough to allow it to meet its obligations to creditors and (or) make compulsory payments. The Insolvency Law pays special attention to the bankruptcy prevention measures conducted before the revocation of a banking licence. These measures are as follows:

— the financial rehabilitation of the credit institution; — the appointment of the provisional administration to the credit

institution; — the reorganisation of the credit institution. The legal regulation of the system of measures aimed at anti-money

laundering and counter-terrorism financing is implemented pursuant to Federal Law No. 115-FZ, dated August 7, 2001, ‘On Countering the Legalisation (Laundering) of Criminally Obtained Incomes and Terrorist Financing’ (hereinafter referred to as the Anti-money Laundering Law). The Anti-money Laundering Law contains criteria for the volume of operations subject to mandatory control, lists these operations and determines the organisations conducting operations with money or other property that should inform an authorised agency about these operations, which include credit institutions, among other. Taking into consideration that capital may be laundered in many different ways, these organisations are required to conduct internal



control for detecting operations subject to mandatory control and other operations with money or other property, in regard of which these organisations have the suspicion that these operations are conducted with the objective of money laundering or financing terrorism. The Anti-money Laundering Law also stipulates that the provision to the authorised agency of information and documents by organisations conducting operations with money or other property according to the procedure established by this Federal Law does not constitute a breach of official, banking, tax or commercial secrets. The Anti-money Laundering Law was passed in compliance with the Convention on Laundering, Search, Seizure and Confiscation of the Proceeds from Crime, signed in Strasbourg, France, and ratified by Federal Law No. 62-FZ, dated May 28, 2001. To boost public trust in the banking system, stimulate growth in organised savings and reduce the risks taken by banks when building a long-term resource base, Russia passed Federal Law No. 177-FZ, dated December 23, 2003, ‘On Insurance of Household Deposits with Russian Banks’. This Federal Law lays down the legal, financial and organisational principles of operating the compulsory household bank deposit insurance system (hereinafter referred to as the deposit insurance system), establishes the competence of and the procedure for creating an organisation performing compulsory deposit insurance functions (hereinafter referred to as the Deposit Insurance Agency), sets the procedure for paying deposit compensation and regulates relations among banks, the Deposit Insurance Agency, the Bank of Russia and the federal executive power bodies within the deposit insurance system. This Federal Law specifies the following basic principles of building and operating the deposit insurance system:

— the participation in the deposit insurance system is compulsory for banks;



— the deposit insurance system serves to mitigate the risk of adverse

consequences for depositors in the event of the banks’ failure to meet their obligations;

— the deposit insurance system is transparent; — the deposit insurance fund accumulates regular insurance

contributions made by the banks participating in the deposit insurance system.

There are two insured events when an individual is entitled to deposit

compensation from the Deposit Insurance Agency: — the revocation (cancellation) of the Bank of Russia banking licence

from a bank in compliance with the Federal Law on Banks and Banking Activities;

— the imposition by the Bank of Russia, pursuant to applicable

federal legislation, of a ban on the satisfaction of bank creditors’ claims. Federal Law No. 96-FZ, dated July 29, 2004, ‘On Bank of Russia

Payments on Household Deposits with Bankrupt Banks Uncovered by the Compulsory Deposit Insurance System’, was a logical addition to the deposit insurance system built in Russia.

As the establishment of the deposit insurance system created the risk

of financial instability for the banks that have not joined this system as a result of the loss of customer and investor confidence and the eventual outflow of deposits to the participating banks, this Federal Law extended to the depositors of the non-member banks guarantees similar to those enjoyed by the depositors of the member banks. Under the law, compensation to depositors of the non-member banks is paid from Bank of Russia funds.

Thus, the passing of this Federal Law became a major step forward in

boosting confidence in the banking system as a whole.



To ensure the implementation of the single state foreign exchange policy and stability of the Russian currency and domestic foreign exchange market, which are the factors of the country’s economic progress and successful international economic cooperation, Russia passed Federal Law No. 173-FZ, dated December 10, 2003, ‘On Foreign Exchange Regulation and Control’ (hereinafter referred to as the Foreign Exchange Regulation Law). The Foreign Exchange Regulation Law defines foreign exchange operations. In addition, it separates the powers of the federal government and the Bank of Russia relating to the regulation of foreign exchange operations. On January 1, 2007, the restrictions on foreign exchange operations between residents and non-residents (the requirements that such operations are routed through special accounts and that a certain amount of money is deposited when foreign exchange operations are conducted, the prohibition to buy domestic securities for foreign currency, the preliminary registration of a resident account (deposit) opened with a bank outside Russia and the compulsory sale of a part of foreign currency earnings) were lifted. Residents and non-residents may now make settlements on operations with domestic and foreign securities in rubles or foreign currency. At the same time, the Foreign Exchange Regulation Law (Article 11) retains the requirement that foreign exchange and cheques, including traveller’s cheques, denominated in foreign currency are bought through authorised banks only. To boost the domestic foreign exchange market and prevent capital flight from Russia, the Foreign Exchange Regulation Law retains the requirement for residents to repatriate foreign and domestic currency (Article 19). Federal Law No. 218-FZ, dated December 30, 2004, ‘On Credit Histories’, has an important role to play in arranging credit relations and building a modern economy.



The purpose of this Federal Law is to create and legalise conditions for the compiling, processing, storage and disclosure by credit bureaus of information about how borrowers meet their obligations under loan (credit) agreements, give creditors and borrowers more protection by reducing overall credit risk and enhance the efficiency of credit institutions. The Federal Law on Credit Histories is designed to allow banks to cut costs when assessing their borrowers’ creditworthiness and, consequently, reduce the price of loans they extend. A major role in implementing this Federal Law is played by the Bank of Russia, whose division, the Central Catalogue of Credit Histories, performs the function of a single information centre informing users free of charge in what credit bureau they can find information about an individual credit history maker. In addition to the borrowers, creditors and the Central Catalogue of Credit Histories, the credit bureaus participate in the exchange of information about how borrowers meet their obligations to creditors. The principal objective of the credit bureaus is to accumulate information characterising the borrower’s payment discipline in regard of the fulfilment of the loan (credit) agreements and eventually this information forms the credit histories of legal entities and natural persons, which may be subsequently passed to the persons who have received permission to get a credit report for the conclusion of a loan (credit) agreement.

Measures to be implemented by the Bank of Russia to upgrade the banking system and banking supervision in 2012 and in 2013 and 2014

In order to upgrade the banking system and banking supervision in 2012-2014, the Bank of Russia will focus on implementing measures stipulated by the Strategy of Russian Banking Sector Development until



2015 that are intended to increase the quality of banks’ activity and maintaining the stability of the Russian banking sector. The banking sector will face increased competition (both intrasectoral and intersectoral) in the most lucrative segments of the banking services market. This will lead credit institutions to raise their capitalisation. The consolidation of the banking sector is also expected to intensify, and new, larger banking structures will emerge. At the same time, the diversification of the banking business and banking income will develop further, including as a result of the introduction of new technologies and the improvement of bank risk management and banking regulation. Measures will be taken to reduce risk concentration, including risk concentration per borrower (or group of related borrowers), investment, area of activity, and industry. Banks are expected to develop banking products that generate an income from fee in order to keep their incomes stable. Credit institutions will pay close attention to the development of their long-term resource base, in which household deposits will play an increasingly important role. These trends are expected to improve the accessibility of banking services both for individuals and organisations. Tougher competition and measures to develop banking regulation and banking supervision will increase transparency and market discipline in the banking sector. As a result, credit institutions will increasingly focus on their long-term performance, make more rational decisions and build effective management systems, including risk management systems.



As part of its efforts to improve banking regulation and banking supervision, the Bank of Russia will continue in 2012-2014 its work to raise the quality of bank capital and assets, limit the level of risks, including the level of their concentration, and increase the reliability of credit institutions’ accounting and reporting. The development of substantive risk-based approaches that take the domestic and international experience into account will be a key instrument in the sphere of banking regulation and banking supervision. Measures to improve banking supervision and increase its quality envisage:

- identifying bank risks, taking into account the prospects of the economy and the financial sector, and developing an early response system;

- using differentiated approaches to supervision, taking into account the systemic importance, profile and level of risks, and also the level of credit institutions’ transparency;

- carrying out supervisory measures to reduce risk concentration, including exposure to affiliated parties;

- developing supervision on a consolidated basis; - developing cooperation with government regulatory and

control agencies, including foreign supervisors, in order to exchange information.

Measures are envisaged to develop a system of control to be exercised by the Bank of Russia’s head office over the situation in the banking sector, especially at systemically important credit institutions.

The Bank of Russia considers it necessary to create legislative fundamentals in Russia for introducing all the standards of banking regulation and banking supervision established by the Basel Committee on Banking Supervision (BCBS).

These include legislation empowering the Bank of Russia to set requirements for credit institutions’ corporate governance, risk and



capital management systems, to exercise consolidated supervision, to use professional judgment in supervisory practices, and also to define disciplinary action against members of executive bodies and boards of directors (supervisory boards) for faults in the activity of their credit institutions.

In order to implement the provisions of Basel II, the Bank of Russia will carry out work in 2012-2014 to draft banking regulation and supervisory rules envisaging approaches to credit risk assessment based on internal ratings. The Bank of Russia will also cooperate with credit institutions in drafting and introducing internal capital adequacy assessment procedures. In order to introduce new international requirements for capital quality and adequacy and maintain the required level of liquidity as stipulated by the BCBS documents adopted in 2010 (Basel III) and supported by the G20 leaders at their summit in Seoul in November 2010, the Bank of Russia intends to take the following measures:

- make amendments to the regulations to review the structure of regulatory capital and introduce requirements for the adequacy of capital components;

- set requirements for building capital buffers, introducing the leverage indicator defined as the ratio between capital and the total value of assets and off-balance sheet items that are not weighted by risk;

- introduce two liquidity ratios: the short-term liquidity coverage

standard defined as the ratio of liquid assets to net cash outflow over the next 30 calendar days in a market stress scenario, and the net stable funding standard determined as the ratio of available reliable sources of funding with a maturity of at least one year to the required amount of stable funding in a stress scenario.

In 2013-2014, the Bank of Russia will define approaches for banks to create the counter-cyclical capital buffers as an instrument to limit systemic risks.



In order to implement these approaches, additional indicators of risk growth in the Russian financial system are intended to be developed. Measures are planned in 2012-2014 to work out criteria for classifying banks as systemically important, and also define regulatory requirements for their activity, taking into account the proposals developed by the BCBS jointly with the Financial Stability Board (FSB) for global sys-temically important financial institutions. While developing corresponding criteria for Russian banks, the Bank of Russia will take into account the specifics of the domestic market for banking services, and also the work being carried out by the BCBS and the FSB to adapt the proposed approaches to the regulation of national systemically important banks. With regard to international recommendations on compliance with FSB principles and standards relating to compensation (remuneration), the Bank of Russia will implement them taking into account the specific requirements of national legislation. In order to reduce the administrative burden on banks, measures are planned to unify supervisory requirements for the sustainability of credit institutions and the requirements for their participation in the deposit insurance system by making corresponding amendments to legislation. In order to increase the transparency of Russian credit institutions, they will be required to disclose information to the public on the qualifications and work experience of their top managers. Measures will be required to statutorily establish the duty of shareholders and persons exerting indirectly (through third parties) material influence on decisions taken by the credit institutions’ management bodies, including third parties, to provide information to credit institutions for the disclosure of the ownership structure. These would include cases where the shares of credit institutions are kept by nominal holders.



Measures are planned to further develop the legislative framework of credit institutions’ affiliated parties to increase the transparency of the ownership structure of credit institutions. In particular, it will be necessary to stipulate the duty of all affiliated parties of credit institutions to provide information on them and be held responsible for their failure to comply with this requirement. Work will be continued to legislatively improve merger and acquisition processes. Amendments will be made to the legislation to stipulate a possibility for legal entities (including credit institutions) with different forms of incor-poration to participate in the reorganisation of credit institutions, which will give an additional stimulus to raise their capitalisation through re-structuring. The policy towards integration into the world financial market should be conducted taking into account national interests, the real level of development and the competitiveness of the Russian banking sector. The ban on opening foreign bank branches will remain as a necessary measure for maintaining the competitiveness of Russian banks in the domestic market for banking services and the Bank of Russia will continue its participation in drafting the corresponding federal law. The Bank of Russia will participate in work to draft laws aimed at providing additional protection for creditors and consumers of financial services, including the improvement of the law on pledge and the development of legislation on consumer credit. At the same time, work will continue to implement measures for improving the financial literacy of the population with respect to banking. Measures to increase the transparency of credit institutions as a result of the use of International Financial Reporting Standards (IFRS) in their



activities are an important step towards raising the efficiency of the banking sector and boosting clients’ confidence in banks. With this in mind, these tasks should be resolved through the implementation of Federal Law No. 208-FZ, dated 27 July 2010, ‘On Consolidated Financial Statements’, under which credit institutions are required to draw up, submit and publish consolidated financial statements. For its part, the Bank of Russia considers it necessary to encourage credit institutions to be conservative enough in making fair value measurements under the IFRS standards and, if necessary, will use banking regulation and supervisory powers to adjust the measurements, proceeding from prudential approaches. The Bank of Russia will further study approaches and measures for maintaining the systemic stability of the banking sector. The Bank of Russia will continue to upgrade its macroprudential analysis tools by calculating banking sector financial soundness indicators, among other things, and posting them on the IMF website, and to assess systemic risk by conducting stress tests. In order to better protect the banking system and credit institutions’ creditors, including bank depositors, and reduce the risks of abuses by credit institutions’ managers and owners, work will continue to improve the mechanisms of liquidation procedures at banks. These measures will include the assignment of criminal responsibility to the heads of credit institutions, and also persons responsible for accounting and other records, for deliberately entering false data into documents regulating civil rights and duties, accounting and other records and reports on the economic activities of a credit institution, and also for making corrections that distort the substance of these documents, if these actions are taken in pursuit of personal gain or in one’s personal interest and inflict damage on citizens, organisations or the state.



In the course of inspections, which the Bank of Russia will conduct in 2012-2014, special at tention will be paid to the inspection of credit in-stitutions of systemic importance to the banking sector of the Russian Federation and its regions, along with the inspection of credit institutions that conduct highly risky operations and credit institutions that are not transparent enough. The inspections will focus on assessing bank risks (credit and market risks, liquidity and concentration risks, including risk concentration on the owners’ business), the systems of their management, and the identification of doubtful transactions. In order to achieve the best results in the inspection of credit institutions (their branches), the Bank of Russia will continue the on-going monitoring of the process of arranging and holding inspections and the coordination of work for conducting these inspections. Special attention will be paid to formulating risk-based assignments for the inspections of credit institutions. The improvement of the inspection organisation’s structure, which envisages measures to centralise the Bank of Russia’s inspecting activity by 2014, will help make inspections more effective. Regulatory support for inspections will be improved, taking into account internationally-accepted approaches, and the Bank of Russia’s measures to implement the Strategy of Russian Banking Sector Development until 2015. The Bank of Russia is legislatively empowered to set requirements for credit institutions to develop internal control procedures to prevent the legalisation (laundering) of criminally obtained incomes and the financing of terrorism. In light of this, special attention will be paid to risk-based approaches used by credit institutions to identify customers, their representatives, beneficiaries, and also to monitor operations for the provision of services to customers.



–participate in carrying out a plan to create an international financial

centre in Moscow; –participate, jointly with the Federal Financial Markets Service, in

improving approaches towards regulating the activity of clearing or-ganisations and central counterparties;

– participate in upgrading the legislation regulating depository

activities, and recognise the concept of a foreign nominal holder; – participate in upgrading the legislation regulating the organisation

of exchange trade; – make arrangements for the inclusion of the Russian rouble in

settlement currencies of the Continuous Linked Settlement (CLS) system; – participate, jointly with the Ministry of Finance, in efforts to further

liberalise the government securities market by making amendments to Bank of Russia’s regulations and other instructions allowing the placement and circulation of government securities on stock exchanges in accordance with their rules;

– participate in upgrading the legislation to define the status of the

precious metal account; – participate in upgrading the legislation regulating the terms and

conditions of the issue and circulation of the certificates of deposit and savings certificates.

– improve the legislative and contractual base regulating repo

transactions in the Russian market.



Measures to be implemented by the Bank of Russia to improve the Russian payment system in 2012 and in 2013 and 2014

In 2012-2014, the Bank of Russia will carry out measures to develop and upgrade the Russian payment system for the purpose of ensuring the stable functioning of Russia’s financial system. The Bank of Russia will take measures to implement Federal Law No. 161-FZ, dated 27 June 2011, ‘On the National Payment System’. In particular, work will be carried out to draft a Strategy for the Development of the National Payment System stipulating measures to ensure the stable functioning of the national payment system, increase its effectiveness and competitiveness, improve the Bank of Russia payment system, develop infrastructural and intersystem interaction between participants in the national payment system, and also enhance accessibility and the security of payment services, including with the use of innovative payment instruments. In order to follow up with this federal law, the Bank of Russia will develop regulations in 2012 to cover the following areas:

–the regulation of the Bank of Russia payment system; – the regulation of payment systems, as well as supervision and

oversight in the national payment system; –measures to ensure the smooth operation of payment systems and

information protection (security) in money remittances. In order to ensure the development of the national payment system, the Bank of Russia will participate in the work of the Technical Committee on Financial Operations Standards to continue creating a national standard of cashless settlements based on the ISO 20022 methodology and introducing it into the national payment system.



Basic measures to develop the Bank of Russia payment system will focus on improving the Bank of Russia system of real-time gross settlements (BESP). It will especially focus on expanding settlement services provided to credit institutions, as well as financial market participants, the Federal Treasury and Bank of Russia divisions, including a broader format of the BESP system operation. It will also increase the operational efficiency and automation of intraday liquidity management procedures. The implementation of these measures will create conditions for lowering the risks and costs incurred by payment system participants.



The Importance of Strong Risk Management: Insights From The Examination World

By Jason C. Schemmel, Community and Regional supervisory examiner with the Federal Reserve Bank of Richmond

Introduction

In 1995, the Board of Governors of the Federal Reserve System issued SR 95-51, which instructed examiners to begin assigning a formal supervisory rating to the adequacy of an institution’s risk management processes.

Examiners had always emphasized the importance of sound risk management processes, but this guidance heralded an era of heightened awareness in light of new technologies, product innovation and rapidly changing banking markets.

Examiners continue to assess and consider factors such as profitability, asset quality and capital adequacy when assigning supervisory ratings, but these indicators, to a large degree, tell a story about the past.

At the heart of risk management is the concept of looking toward the future, as being able to identify, measure, monitor and control risks before they spread is critical to the conduct of safe and sound banking, regardless of the size and complexity of the institution.

Analysis of banking performance during the recession of 2007–2009 indicates that banks with strong forward-looking risk mitigation strategies weathered the recession more successfully than other banks, even those taking identical risks (see “Weathering the Storm: A Case Study of Healthy Fifth District State Member Banks Over the Recent Downturn” in the summer 2012 edition of S&R Perspectives).

These successful institutions all possessed the key elements of a risk management framework, including:

- An active board of directors and senior management team



- Policies, procedures and risk limits governing all activities that are clearly communicated throughout the organization

- Timely and accurate management information systems (MIS)

- Strong internal controls

To understand the risk management challenges currently facing our state member banks, we asked key members of the Federal Reserve Bank of Richmond’s Community and Regional (C&R) management team to identify areas that are

(1) Consistently cited in reports of examination as risk management weaknesses or

(2) Expected to receive heightened attention in the near future. This article reinforces existing supervisory guidance and expectations and discusses the most commonly cited examination issues related to the management of credit, liquidity, market, operational, and legal and reputational risks.

Properly addressing these matters will improve the prospects of early risk detection and help to prevent losses.

Credit Risk

C&R relationship managers and subject matter experts alike expressed concern over three areas: new product lines, home equity lines of credit (HELOC) and appraisal review.

New Product Lines

Interviews with bankers during examinations over the previous 12–24 months revealed that many management teams and boards of directors intend to reduce future reliance on real estate lending by expanding into commercial lending.

The number of bankers that stated this intention is striking and indicates the potential for fierce competition for commercial business. In fact,



several banks have reported recent solicitations from third parties attempting to negotiate participation in syndicated commercial loans.

Prior to expanding into commercial lending, or any new product line, it will be critical for banks to properly research the product and ensure it aligns with the bank’s strategic plan and the risk appetite of the board of directors.

Banks that venture into commercial lending are expected to have the appropriate expertise on staff to underwrite and monitor the credits.

Moreover, the lending staff must be guided by robust policies, procedures and risk limits.

As was the case in the late 1990s, intense competition for commercial loan customers often leads to significant easing of both loan terms and front-end financial analysis.

Discipline was — and will be — a key success factor.

Existing supervisory guidance stresses:

- The importance of using formal forward-looking analysis in the loan approval process

- The value of assessing alternative or “downside” scenarios

- The dangers of unduly weighting the short-term benefit of attracting or retaining customers through price concessions while giving insufficient consideration to potential longer-term consequences1

Additionally, exceptions to approved underwriting and pricing policies should be rare, properly approved, aggregated and actively monitored by senior management.

HELOCs

There is considerable concern among C&R credit risk specialists that, unlike many other real estate loans, the losses in HELOC portfolios have yet to fully materialize.



Many of the loans originated from 2003 to 2007 are approaching the end of their draw periods and will soon convert from interest-only to amortizing loans or have principal due as a balloon payment.

Observations from recent examinations indicate that banks with significant concentrations of HELOCs have not fully identified and measured the potential impact of these events.

Institutions with significant exposure to HELOCs should ensure that they are adhering to effective account management practices.

These include:

- Periodically refreshing credit scores on customers

- Periodically assessing utilization rates

- Periodically assessing payment patterns, including borrowers who make only minimum payments or those who rely on the line to keep payments current

- Using reasonably available tools to determine the payment status of senior liens associated with junior liens

- Obtaining updated information on the collateral’s value when market factors indicate a deterioration in value since origination or when the borrower’s payment performance deteriorates

Measurement of this data will allow bankers to identify customers who may default when loan terms change and facilitate the creation of effective workout solutions.

Data procured from this analysis should also be incorporated into the institution’s allowance for loan and lease losses (ALLL) methodology.

Appraisal Review

Examiners continue to observe appraisal review practices that are inconsistent with supervisory guidance.



Too often, appraisal reviews only consist of checklists used by the reviewer to determine compliance with federal regulations.

While determining compliance with regulations is surely critical, it is merely one aspect of the appraisal review process.

Just as important is an evaluation of whether the methods, assumptions and data sources in the appraisal (or evaluation) are appropriate and well-supported.

An institution’s policies and procedures for reviewing appraisals and evaluations should address, at a minimum, the following:

Staff members who review appraisals and evaluations should be independent of both the property being valued and the loan production staff.

Reviewers should also possess the requisite expertise to perform a review commensurate with the level of risk and complexity in the transaction.

The depth of review should be appropriate for the risk and complexity of the transaction and property, but always be sufficient to ensure the methods, assumptions and conclusions within the appraisal and evaluation are reasonable and well-supported.

Staff within the institution should have clear written guidance on how to resolve deficiencies uncovered during a review.

All reviews should be thoroughly documented and placed within appropriate credit files.

Liquidity Risk

All financial institutions, regardless of size and complexity, should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations.

C&R relationship managers indicated that most banks have instituted some form of CFP; however, many banks continue to struggle with the details.



In general, the CFPs reviewed during examinations do not adequately address a sufficient range of liquidity stress events.

The narrative section of the CFP should contain a thorough description of any liquidity event — or combination of events — that could adversely impact the bank’s liquidity.

The events may be institution-specific or arise from external factors. Examples include, but are not limited to, the inability to fund asset growth; the inability to renew or replace a maturing funding source; unexpected deposit runoff; or financial market dislocations.

Additionally, CFPs frequently are not robust enough with regard to the various stages and levels of stress severity that can occur during a contingent liquidity event.

The narrative section should fully describe the stages of each event, its severity and its expected duration.

Stress events should be modeled with sufficient severity to provide management and the board of directors with enough information to ascertain the durability of the bank’s liquidity position.

Moreover, the duration of the event is a critical factor in accurately measuring potential funding gaps and available funding sources.

Some events may be temporary while others may be longer-term.

In either case, the event should ultimately be modeled through its conclusion.

Designing the CFP in this fashion affords the opportunity to identify early-warning indicators for each stage, assess potential funding needs at various points in a developing crisis and specify action plans.

Market Risk

Proper measurement of market risk requires regularly assessing the reasonableness of assumptions that underlie an institution’s exposure estimates.



C&R subject matter experts have observed repeated weaknesses in three areas related to model assumptions: documentation, sensitivity testing and corporate governance.

Key model assumptions such as asset prepayments, nonmaturity deposit price sensitivity and deposit decay rates are often unsupported and undocumented.

Inputs for these assumptions typically have a material impact on the model’s output; therefore, it is critical to ensure they are accurate.

Assumptions should be specific to the bank and based on an appropriate level of empirical evidence.

The decisions made and the rationale behind them should then be thoroughly documented.

To aid in determining which assumptions exert the greatest impact on measurement results, banks should periodically perform sensitivity testing.

Doing so will provide valuable insight into how to allocate scarce resources, i.e., the most critical assumptions should be given the most attention. When actual experience differs significantly from past assumptions and expectations, institutions should use a range of assumptions to appropriately reflect this uncertainty.

Finally, banks should develop a comprehensive governance system for actively monitoring and regularly updating key underlying assumptions.

This system should include oversight by representatives from any major business line that can directly or indirectly influence the bank’s market risk exposure.

Deliberations from these meetings and the rationale behind changes to key assumptions should be thoroughly documented in meeting minutes.



Operational Risk

C&R operational risk specialists have identified two areas of concern as technology is increasingly integrated into the business of banking: information security and vendor management.

Information Security

One of the most common operational risk deficiencies cited during examinations over the last 18 months relates to information security.

It remains a challenge for all banks, regardless of size, because of the complex interconnectivity between the bank, its customers and its vendors.

The proliferation of mobile devices and electronic payment channels has increased the opportunities for hackers to compromise bank systems and steal critical data.

Therefore, strong internal controls surrounding access management are essential, including a robust risk assessment process; effective procedures for administering, logging and monitoring critical systems; and independent validation of controls through audits or penetration testing.

Vendor Management

Not surprisingly, the increase in technological banking solutions has led to an increase in outsourcing.

The scope of activities outsourced, however, has not been limited to traditional activities such as core processing and now may include interest rate risk modeling, stress testing or loan loss mitigation strategies.

Recent examinations indicate that vendor management practices are often not keeping pace with the growing volume and scope of outsourcing activities, particularly in the areas of due diligence and service provider oversight.



Due diligence prior to engagement should fully consider the provider’s ability to meet the institution’s needs.

Institutions should consider the provider’s technical and industry expertise, operations and controls, and financial condition.

Once a contract has been signed, the institution must implement an oversight program to monitor each service provider’s controls, conditions and performance.

The oversight program should be commensurate with the risk of the outsourced relationship and be thoroughly documented for use in future contract negotiations, termination issues and contingency planning.

Legal and Reputational Risk

Finally, C&R operational risk specialists expressed concern with the proliferation of social networking platforms and their potential effect on banks’ legal and reputational risks.

A social networking service is an online service, platform or site that facilitates the building of social relations among people who share common interests, activities or relationships.

Their use has exploded as companies attempt to reach customers with advertising and to generate business intelligence for future sales or customer service.

Social networks pose several risks to banking organizations, including the potential disclosure of nonpublic personal information (NPI), disinformation or derogatory information, and security threats such as viruses or social engineering.

Any of these or similar events could result in significant lawsuits or damage to the institution’s reputation.

Banks are encouraged to develop sound social connectivity policies that govern the use of social media by employees and to provide adequate training to employees on those policies.



The use of social media should also be considered in the institution’s information technology risk assessment.

Conclusion

The current recession has been longer and deeper than any since the Great Depression, and institutions facing severe earnings pressures may be tempted to reduce resources dedicated to risk management.

But evidence suggests that strong risk management, not historical financial performance, is the common denominator of successful community banks.

Institutions should remain vigilant in order to identify risks that could negatively affect the bank and take appropriate action to measure, monitor and control them.



Regulatory reform: getting it done

Remarks by Mr Stefan Ingves, Governor of Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision, at the 17th International Conference of Banking Supervisors, Istanbul

Introduction

Good morning and welcome to the 17th International Conference of Banking Supervisors.

Let me start by thanking our hosts - the Central Bank of the Republic of Turkey and the Turkish Banking Regulation and Supervision Agency.

I would like to thank in particular Governor Erdem Başçi, Chairman Mukim Öztekin and of course the staff of both organisations for doing such an outstanding job of hosting this ICBS.

We have benefited tremendously from your presence on the Committee since 2009 and we look forward to returning to this historic city for future meetings and conferences.

Finally, let me thank Deputy Prime Minister Ali Babacan for his insightful remarks.

This ICBS will focus on the challenges we are facing to improve supervisory practices, building on what we have learned in the recent past.

The starting point for such improvements and the foundation of all bank supervisory frameworks is the Core Principles for Effective Banking Supervision, which will be the topic of discussion on this first day of the ICBS.

We have also organised several panel and workshop discussions to examine and debate the most recent policy responses to the financial crisis and other supervisory and market developments.



A critical aspect of these policies is their full and timely implementation and we will have the opportunity to discuss the challenges that arise in this regard.

The conference's themes

Let me say a few words about these two main topics.

In conducting its review of the Core Principles, the Committee has sought to raise the bar for banking supervision by incorporating the lessons learned from the crisis and other significant regulatory developments.

At the same time, we have remained mindful of the fact that the Core Principles are applied on a global basis and that we need to maintain continuity and comparability.

Given the worldwide application of the Core Principles, it is of utmost importance that the revisions we have made are well understood and implemented with, at a minimum, the same rigour as the previous set of principles.

The two co-chairs of the Basel Committee group that was responsible for the revisions - Sabine Lautenschläger of the Deutsche Bundesbank and Teo Swee Lian of the Monetary Authority of Singapore - will co-chair a panel discussion on the revised Core Principles.

This is a topic of great relevance for all of us, so I know this discussion will be of great interest to everyone here.

Regarding policy responses to the financial crisis - the second theme of the ICBS - there is always a danger of believing we have learned "all there is to learn" or that "this couldn't happen to me".

On the one hand, the root causes of financial crises are always very similar although they can differ in their manifestation.

For example, in my own country - Sweden - and in many other countries around the globe, I have seen different crises evolve and one common



element has been excessive credit extended by banks that did not fully appreciate the risks.

On the other hand - and I can tell you this from first-hand experience having been through too many financial crises for my liking - overconfidence and supervisory complacency are extremely dangerous and we must continually be alert to guard against these risks.

Tomorrow's workshops and panel discussion on what the crisis has taught us are indeed timely.

While a single day is not sufficient to address all of our challenges, the reflections of an impressive cast of speakers will offer a wide range of different perspectives on topical issues.

These issues include:

1. The implications of non-financial sector leverage for banks and bank supervision;

2. Basel III implementation;

3. Liquidity standards and risk management;

4. Corporate governance, disclosure and transparency; and

5. Systemically important banks.

The common thread here is the universal applicability of the lessons we have drawn.

The relevance of these topics is not limited to only certain jurisdictions or types of banks.

Some will call this "back to basics" and rightly so.

The label we choose to apply is not important; what is important is that we get the regulation right and that we are diligentin implementing our standards.



The Committee's work on implementation

Having learned this lesson, the Committee now devotes considerable resources to monitoring implementation of the rules and standards agreed by its members.

Our work no longer stops once we issue a press release announcing new regulatory standards.

From the Basel Committee's perspective, one of the most enduring lessons we as supervisors have learnt is that full, timely and consistent implementation is not a bonus - it is an imperative.

So what have we done to put this commitment into practice? Almost one year ago, the Committee agreed on a process and framework to review members' implementation of Basel III.

The review framework is intended to provide additional incentives for member jurisdictions to fully implement the standards within the timelines agreed.

Let me briefly review its key elements.

There are three levels of review:

The first level is the timely adoption of Basel III. We have been regularly reporting on member countries' progress in implementing rules in their local jurisdictions in accordance with agreed timetables.

The second level is to ensure consistency of domestic regulations with the international minimum requirements. This is a line-by-line review of local rules with the Committee's standards, conducted by teams of peer supervisors.

The third level of review consists of an analysis of the outcomes of the Basel III implementation.

It extends the first two levels of analyses to supervisory implementation at the bank level.



One cannot overstate what a significant step this is, as we for the first time have teams of global supervisors travelling to individual banks and comparing notes at a very detailed level across borders.

This, more than anything, is symbolic of the big step the Committee is taking to get implementation right.

Perhaps most importantly, the results of this work will be public, so there will be complete transparency for all about how our rules are being applied in practice.

In the past year, the Committee has published two standalone reports detailing its members' progress in adopting the Basel III rules and we have also prepared a report to the G20 Leaders that provided an update on implementation.

In a couple of weeks, we will issue Level 2 assessment reports for the first three jurisdictions under review: the European Union, Japan and the United States.

Our next assessment will soon begin and this will review Singapore's Basel III rules; this will be followed by reviews of Switzerland and China.

We are currently conducting Level 3 assessments on the calculation of risk-weighted assets and expect to publish our findings around the end of 2012.

The revised Core Principles and the Basel III rules were designed to achieve safer and sounder financial systems, whether big or small, complex or not.

After considerable consultation with supervisors, bankers and other interested parties from around the world, the rules and standards have been developed and now need to be put into practice.

Financial stability issues know no borders.

We are keenly aware that the roots of the recent financial crisis are replicable anywhere in the world and we know that risk will flow to wherever it is underpriced.



We know - and I have seen first-hand from my days at the IMF - that the risk of cross-border contagion rises exponentially with an increase in cross-border banking activity and increasingly international financial markets.

Our global banking foundation is therefore much firmer when we act together in implementing sound prudential standards.

In that regard, I would like to spend a few minutes updating you on the Committee's current and future work agenda for developing regulatory standards.

Current and future agenda

I will start with the global liquidity rules, which are a much debated topic.

The Basel III liquidity framework, which was published in December 2010, forms an essential part of the Basel III package and continues to be one of the most important items on the Committee's agenda.

When we published the rules, the Committee said it would carefully assess whether there would be any unintended consequences.

Some banks told us this careful approach has given rise to unnecessary uncertainty and has hindered their efforts to work toward managing to the new standards.

The Committee's governing body of Central Bank Governors and Heads of Supervision therefore directed the Committee to finalise any revisions around the end of this year and we are on track to deliver.

The Basel III liquidity rules represent the first ever global framework to ensure a bank maintains an adequate stock of liquidity and operates with a prudent funding structure.

The Committee is therefore taking a careful and deliberate approach to reviewing the rules.

But let me remind you that our goal is to raise the bar.



It is designed to have an impact on banks and markets: that is not unintended.

The rules are already having the desired effect as we have seen an improvement in risk management and in liquidity at many banks.

In Sweden, for example, the four major banks all had liquidity coverage ratios below 100% when they started reporting their LCR.

They have since improved their liquidity management and positions and currently all four meet the new standards.

OTC derivatives

I would also like to say a few words about another of the Committee's high priorities and this relates to the broader global reform for over-the-counter derivatives markets.

The financial crisis exposed major weaknesses of OTC derivatives markets, namely counterparty credit risk and a lack of transparency and the attendant effects of contagion risk and spillover.

A package of reforms agreed by the G20 Leaders aims to address these deficiencies, for example, by moving OTC trades towards central clearing.

The Basel Committee plays a key role in ensuring that banks adequately capitalise counterparty credit risk exposures, whether those exposures relate to other banks or to central counterparties (CCPs).

For example, in December 2010 we published enhanced capital rules for bank exposures to counterparty credit risk arising from non-centrally cleared derivatives.

More recently, we issued interim capital rules for bank exposures to CCPs.

These rules will both take effect at the start of next year although work will continue over the course of 2013 to ensure that the capitalisation rules for bank exposures to CCPs reflect risks in an appropriate manner and



provide incentives for banks to move derivatives trades towards central clearing.

Another OTC derivatives market reform in which the Committee is involved is the development of global standards on margin requirements which are intended to mitigate contagion and spillover effects.

A consultative paper on this topic was published in July and we hope this work, which is being conducted in collaboration with other standard setters, will lead to updated proposals that we can consider by the end of this year.

Securitisation

Allow me to say a few words about the Committee's ongoing work related to the regulatory treatment of securitisations, on which we will soon publish a consultative proposal.

The performance of securitisation exposures and the central role they played during the recent financial crisis were a key motivation for the Committee to perform a broader review of its securitisation framework for regulatory capital requirements.

Our objectives are to make capital requirements more prudent and risk-sensitive; to mitigate mechanistic reliance on external credit ratings; and to reduce cliff effects.

The Committee is well aware of the trade-off between the risk posed by securitisation and its function as an important tool for bank funding and liquidity.

Now that there are signs of revival of the securitisation markets, it is important to finalise prudent and risk-sensitive solvency rules for securitisations as soon as possible.

Fundamental review of the trading book

The Committee's proposals to revamp the securitisation framework are as sweeping as our fundamental review of the trading book rules.



The Basel 2.5 modifications adopted in 2009 resulted in a substantial increase in capital requirements for certain securitisations and structured credit products.

But these modifications were largely built on the existing regulatory definitions and framework.

At around the same time, the Committee commenced a fundamental review of trading book capital requirements.

That review resulted in the publication of a conceptual paper this past May.

That paper set out a revised market risk framework and proposed a number of specific measures to improve trading book capital requirements.

These proposals reflect the Committee's increased focus on achieving a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions.

The consultation period ended last week.

Once the Committee has reviewed the responses it has received, it intends to release for comment a more detailed set of proposals to amend the Basel III framework.

We also plan on conducting a quantitative impact study based on those proposals.

Global and Domestic Systemically Important Banks

In the time remaining, I would like to say a few words about the Committee's work with respect to global and domestic systemically important banks.

Last year, the Basel Committee issued final rules for global systemically important banks (G-SIBs), which were endorsed by the G20 Leaders at their November 2011 meeting.



The G20 Leaders also asked the Committee and the Financial Stability Board to work on extending the G-SIFI framework to domestic systemically important banks (D-SIBs).

G-SIBs will be subject to an additional loss absorbency requirement over and above the Basel III requirements that are being introduced for all internationally active banks.

This additional requirement is intended to limit the cross-border negative externalities on the global financial system and economy associated with the most globally systemic banking institutions.

But similar externalities can apply at a domestic level: indeed, from a domestic perspective, they can be even larger.

While not all D-SIBs are significant from a global perspective, the failure of such a bank could have a much greater impact on its domestic financial system and economy than that of a non-systemic institution.

Against this backdrop, the Basel Committee has developed a set of principles on the assessment methodology and the higher loss absorbency requirement for D-SIBs.

The proposed framework takes a complementary perspective to the G-SIB framework by focusing on the impact that the distress or failure of banks will have on the domestic economy.

However, the proposed D-SIB framework will take a principles-based approach, in contrast to the prescriptive approach of the G-SIB framework.

This will allow an appropriate degree of national discretion in the assessment and application of policy tools in order to accommodate the structural characteristics of individual jurisdictions.

The D-SIB principles, which will be published in the coming weeks, require countries to adopt a framework for assessing the systemic importance of their banks on a domestic basis by January 2016.



This is consistent with the phase-in arrangements for the G-SIB framework and means that national authorities will establish a D-SIB framework in advance of that deadline.

The Basel Committee will introduce a strong peer review process for the implementation of the principles. This will help ensure that appropriate and effective frameworks for D-SIBs are in place across different jurisdictions.

Simplicity in our rules I will finish my review of the Committee's current work by saying a few words about a topic that pervades our current efforts - and that is simplicity. Basel III, with its straightforward, non-risk-based measure of capital to assets and the framework's rules for a streamlined capital structure are two good examples. This mindset has become ingrained in other efforts, such as the Committee's current review of the securitisation framework and the operational risk framework. More broadly, the Committee is also reviewing the broader Basel framework to determine whether the rules strike the appropriate balance between regulatory complexity and risk sensitivity. The aim of this work is identify areas where we could reduce the level of complexity or where comparability could be improved.

Special acknowledgment

Before concluding, let me make a special acknowledgement of someone who very well may be the most widely known person in the room today, and who is attending the ICBS for the last time.

As many of you know, Jonathan Fiechter will be retiring from the IMF in a month or so, and I would be remiss if I did not acknowledge the



significant contribution he has made to the work of the Basel Committee, its working groups, regional groups of banking supervisors and national supervisors themselves.

Even though he is currently not a supervisor himself, he has been unfailing in his support of effective regulation and strong supervision. So, Jonathan, on behalf of everyone here, we thank you and wish you the very best for the future.

Conclusion Let me bring my remarks to a close as we have a stimulating programme ahead of us and, therefore, I will not keep you waiting. The Basel Committee is leading on two very important efforts: the first is to fine-tune the regulatory framework and develop policy responses that firstly respond to the lessons of the crisis, and then keep pace as markets and institutions evolve. The second is ensure that the agreed-upon policy responses are implemented fully, consistently and globally. That is the reality check. We believe, as do the G20 Leaders, that these reforms are the right ones for making progress towards improved financial stability, growth and sustainable economic development. With this in mind let us make sure that the discussions today and tomorrow are fruitful and will help you and your organisations achieve these important goals.

Notes Stefan Ingves

Stefan Ingves is Chairman of the Executive Board and Governor of the Riksbank. Mr Ingves is a member of the ECB General Council and a



member of the Board of Directors of the Bank for International Settlements (BIS).

He was appointed Chairman of the Basel Committee on Banking Supervision in 2011.

He also chairs the Advisory Technical Committee of the European Systemic Risk Board.

In addition, Mr Ingves is Sweden’s governor in the International Monetary Fund.

Mr Ingves has previously been Director of the Monetary and Financial Systems Department at the International Monetary Fund, Deputy Governor of the Riksbank and General Director of the Swedish Bank Support Authority.

Prior to that he was Under-Secretary and Head of the Financial Markets Department at the Ministry of Finance.

Stefan Ingves holds a PhD in economics.

Stefan Ingves' term of office is six years from 1 January 2006.

The General Council of the Riksbank has appointed Stefan Ingves as Governor of the Riksbank for an additional term of office of six years, from and including 1 January 2012.



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Risk Compliance News September 2012

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Transcript of Risk Compliance News September 2012