Sarbanes Oxley News October 2012

7/28/2019 Sarbanes Oxley News October 2012

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Sarbanes Oxley Compliance ProfessionalsAssociation (SOXCPA)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USATel: 202-449-9750 Web: www.sarbanes-oxley-association.com

Dear Member,Today we will start from the PublicCompany Accounting Oversight BoardInvestor Protection through Audit

OversightLewis H. Ferguson, Board MemberCalifornia State University 11th Annual SEC Financial ReportingConference, Irvine, CAThank you for inviting me to speak today. Iam delighted to be here in sunny SouthernCalifornia to share some thoughts with you

about developments in auditor oversight, thepart of the financial reporting universe inwhich I now spend my time.Before I begin, I must tell you that the views I express today are my ownand do not necessarily reflect the views of the Public CompanyAccounting Oversight Board, any other Board member, or the staff of thePCAOB.Anyone involved in the financial reporting process deals daily with thehard realities of complexity and rapid change -- whether you are apreparer of financial statements, a board or audit committee member, aninvestor, an independent or internal auditor, a counselor, or a regulator.

Sarbanes Oxley Compliance Professionals Association (SOXCPA)www.sarbanes-oxley-association.com
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Commercial activity is increasingly global.Some financial instruments and transactions are bafflingly complex withvalues that can only be estimated.Standard setters in the United States and abroad are moving away fromhistorical cost accounting toward fair value accounting, requiringdifficult estimates.There is a plethora of new rules and requirements growing out of theDodd-Frank and JOBS actsin the United States, and all of this ishappening in what since 2008 has been the most difficult globaleconomic environment since the Great Depression of the 1930s.Much as we struggle with these rapid changes and their complexity,

regulatorsalso struggle to see around the curve, to be prepared for whatis coming tomorrow, and to have tools in their toolbox that will beappropriate for those challenges.In the next session of todays conference, I will discuss a number ofspecific initiatives the PCAOB is undertaking to deal with some of thesechallenges, but in this address I want to focus on one specific area, thechallenge of globalization and cross-border financial reporting, auditingand audit oversight.A bit of background may be useful here.The PCAOB was created by the U.S. Congress in 2002, in response to acrisis stemming from the failures of enterprises like Enron, WorldCom,Adelphia and others.These cases all involved systemic and undetected financial andaccounting fraud.Congress concluded that these cases demonstrated that the longestablished system of auditor quality oversight by the auditingprofession itself, known as peer review, was irretrievably broken.

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Accordingly, Congress created the PCAOB as an independent, not-for-profit body, whose five members are appointed by the United StatesSecurities and Exchange Commission, to oversee the audit of publiccompanies that are subject to the securities laws.The Boardsmission is protect the interest of investors and further thepublic interest in the preparation of informative, accurate, andindependent audit reports for U.S. public companies.From its establishment in 2002, the PCAOB has grown to be anorganization with a projected 800 employees by the end of this yearlocated in 16 offices throughout the United States, including in I rvineand Los Angeles.To prevent capture by the accounting profession, Congress provided that

while two of the five PCAOB board members had to be CPAs, no morethan two could be.That leaves two of my fellow board members and me, including thePCAOBs chairman, who are lawyers by training and profession.The PCAOB was assigned four principal functionsby the statute:1. The first is tooversee and maintain the registration of all auditingfirmswhether they are located here or abroad that file audit reports withthe SEC or participate substantially in the audit of companies that filesuch reports.In 2010, the Dodd-Frank Act also gave the PCAOB jurisdiction overauditorsof registered brokers and dealers and required all such firms tobe registered.Today, 2,380 auditing firms are registered with the PCAOB including570 firms that audit brokers and dealers.Of the total, 1,465 firms are located in the United States and 915 firmsoutside the United States in 85 jurisdictions.



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The largest number of foreign registered firms are in China with 100firms, including 52 in Hong Kong and 48 in the Peoples Republic ofChina, 66 in India, 64 in the U.K., 48 in Canada and 41 in Australia.2.The second principal function of the PCAOB is periodically to inspect

registered firmsthat file or participate in the preparation of audit reportsof public companies and securities brokers and dealers.Any audit firm with more than 100 issuer audit clients must be inspectedannually and at least triennially if they regularly provide audit reports for100 or fewer issuers.In 2012, there are currently 9 annually inspected auditing firms.Our inspections are not randomly selected but are selected on the basis of

audit risk, focusing on issues, industries, or firms where we believe thegreatest risk of audit failure may lie.Since its inception, the PCAOB has conducted more than 1,950inspections and examined portions of over 8,200 individual audits.In 2011, for example, for the 10 firms subject to annual inspection in thatyear, the PCAOB inspectors looked at portions of approximately 340audits.For the 203 firms inspected on a three-year cycle in 2011, portions ofapproximately 485 audits were examined, including 42 non-U.S. auditfirms located in 15 jurisdictions.We are scheduled to inspect approximately 80 non-U.S. firms in 2012.As part of an interim program for the inspection of brokers and dealers, in2011 and early 2012, we inspected 10 audit firms, examining portions of 23separate audits and issued a public interim report on those inspections inAugust of this year.3. Our third function is toset auditing and other professional standards.



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We have an ambitious standard-setting agenda that tackles old and newissues in auditing, particularly issues that surfaced after the recentfinancial crisis from improving communications with audit committeesto reforming the auditors reporting model.In the next session of this conference, I will discuss in more detail thePCAOBs standard-setting projects.4. Our fourth and last principal function is to conduct investigations andenforcement proceedings.The Board has the authority to impose disciplinary sanctions, includingbarring auditors from public company auditing and imposing substantialmonetary penalties.Since 2003, the PCAOB has taken 55 disciplinary actions against 42registered accounting firms and 56 persons associated with registeredfirms.As part of these enforcement actions, the Board has revoked theregistration of 27 firms, barred 43 individuals, and suspended theregistration of five individuals and one firm.These are ourfour core functions: registration, inspections, standardsetting, and investigation and enforcement.Everything the Board does is in support of these functions.Other offices, particularly the Office of Research and Analysis, providesvaluable input.ORAs staff of more than 30 economists and analysts study economictrends and the large bodies of confidential data we collect as part of ourinspection process.The broad reach of our activities gives us a unique perspective on thestate of audit practice in the United States and abroad, and on theoperations of major auditing firms.



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When the PCAOB was created in 2002, the United States was essentiallyalone in the world in having comprehensive regulation of the auditors ofpublic companies that was independent of the profession itself.Initially, Sarbanes-Oxley was seen by many, particularly outside the

United States, as an effort to address something that was strictly anAmerican problem.But shortly after the failures of Enron and WorldCom, a series of majoraccounting failures were uncovered at non-U.S. companies, such asParmalat, Vivendi, Hollinger, Ahold, Royal Dutch Shell, China Aviationand others.As a result, many other countries began to adopt independent auditsupervisory regimes.Today, just 10 years after the creation of the PCAOB, almost alladvanced or emerging market countries have an independent auditregulator.These regimes differ. Some like the PCAOB are independent agencies;others are housed in the local securities regulator.But they share certain common attributes: they are either governmentagencies or bodies that are independent of the audit profession; theyconduct regular inspections of audit firms; and they possess disciplinaryand sometimes licensing and standard-setting powers.

We are grateful that the example of the PCAOB has encouraged thecreation of similar, independent audit oversight in other countriesoversight that can only benefit the investors in our national and globalmarkets.



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International Cooperation

IFIARIt is not surprising that these new regulators soon decided that theyshould form an organization for sharing views and helping each otherimprove their work.In September 2006, a group of18 independent audit regulatorsformed theInternational Forum of Independent Audit Regulators, to provide a forumfor regulators to share knowledge of the audit market environment andthe practical experience gained from their independent audit regulatoryactivity.Only regulators that are truly independent of the auditing profession areeligible for membership which has grown steadily to 43 members todaywith another 13 candidate members in various stages of the applicationprocess.In addition to the United States, Canada and one South Americanregulator, most European regulators are members as well as severalregulators in the Middle East, and a number of Asian regulators,including those in Japan, Korea, Taiwan, Thailand, Malaysia, Singapore,Sri Lanka, and Australia.The United States has come to play a leadership role in IFIAR and I washonored recently to be elected Vice-Chair of the organization.IFIAR holds annual plenary meetings at which regulators from aroundthe world meet to exchange information on a variety of topics includinggeneral inspection and enforcement findings, standard-setting initiativesand cross-border cooperation.The next such meeting will be in London at the beginning of October.



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In addition, there are five working groups that meet more frequently andfocus on specific issues like standard setting, international cooperation,investor concerns, inspection training and public policy.One of the most important is the last, the Global Public Policy

Committee Working Group, that meets three times each year with theleadership of the six global network audit firms to discuss issues ofconcern to the regulators and the firms.IFIAR also conducts an annual inspection training workshop for auditinspectors from around the world.For the first time this year, I FIAR has surveyed its members about theiraudit inspection findings.Thirty-seven of the 43 IFIAR members responded to the survey andwhile the results are presently confidential, I can tell you that a strikingresult of the survey is that other regulators around the world seem to befinding the same types of defects in their inspections that the PCAOB isfinding, particularly deficiencies in auditing fair value measurements,testing internal controls, revenue recognition and engagement qualitycontrol reviews.The Global Environment

You might ask why an organization like IFIAR is important.The short answer is that it enables individual regulators to get a betterwindow on the global landscape of audit practice and financialreporting.This is important because the worlds largest enterprises -- those thatrepresent the largest share of global economic activity and shareholderwealth -- operate globally.



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Not only do they sell products globally, but increasingly they purchaseraw and component materials, manufacture, distribute, and do researchand development globally.One only needs to look at some of the latest signature industrial

products, like new automobiles, computer and smartphone products, orthe Boeing 787 airliner to realize that these products are produced fromdesigns and components sourced and manufactured in many differentcountries.A global company, perhaps operating in more than 100 countries, alsohas financial reporting activities in many, if not all, of those countries.Any regulator, confined to a view within its own borders, can only see aportion, and often a small portion, of the activities and risks of such anenterprise.Cross-border regulatory cooperation, working together and sharinginformation, is vital to our common mission to improve the protection ofinvestors who rely on auditors to assure that the financial reports ofpublicly traded companies are transparent, complete and fairly stated.Just as the largest corporations in the world have become increasinglyglobal in their operations, their auditors must be able to conduct audits

on a global basis.

The largest audit firms have grown globally along with their clients.But unlike their corporate clients, which usually operate globally througha centrally controlled structure of parent and subsidiary entities, the globalaudit firms operate as an affiliation of individual audit firms.They are organized and operating under the laws of different political andregulatory jurisdictions joined together in networks where they shareclients, training, audit methodologies, and quality assurance practices. T



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hey operate under a common name such as Deloitte Touche Tohmatsu,Ernst & Young, PricewaterhouseCoopers, KPMG, Grant Thornton andothers.There are a number of reasons for such structures: local licensing and

ownership requirements; different traditions of training and practice;and not least, concern about cross border liability exposure.The global organization of these networks provides common auditmethodologies, conducts quality assurance examinations and providesother services.But in the final analysis, the only real power the global leadership hasover its individual members is the power to remove a member from thenetwork.This is a very different power from that of the chief executive officer of aglobal corporation over his or her far flung subsidiaries.In the audit of a major global corporation, a number of different auditingfirms, operating under a single trade name, will cooperate to perform theaudit of the corporationsglobal operations.Today, the auditors report on such a corporation is signed by only onefirm in the network and does not reveal whether other affiliated firmsparticipated in the audit or the extent of their participation.The reality of todays global business environment means that regulatorsaround the world must do the same thing. We must cooperate effectivelywith each other if we are to ensure that audit quality remains high andthat investors are protected.Details of the PCAOBsCooperative Arrangements with OtherRegulatorsThe PCAOB cooperates closely with audit regulators outside the UnitedStates, and the scope of that cooperation is extensive.



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Since 2005, we have conducted 338 inspections of PCAOB registeredfirms in 38 different countries.We have cooperative agreements with 14 foreign regulators in Australia,Canada, Dubai, the U.K., Germany, Israel, Japan, the Netherlands,

Norway, Korea, Singapore, Spain, Switzerland, and Taiwan as a result ofwhich we either conduct joint inspections or share inspection findingswith regulators in those jurisdictions.We are also actively negotiating such agreements with regulators in anumber of other European countries.We have conducted international inspections, both alone and jointly,with the local regulator.We have found that joint inspections are particularly useful and haveconducted them with regulators in Canada, Switzerland, the UnitedKingdom, Germany, Norway and the Netherlands.We will shortly conduct joint inspections with the Spanish and Koreanaudit regulators.In these inspections, we have faced and resolved difficult data protectionissues that are of great concern to regulators in the European Union.We have also resolved confidentiality concerns that Swiss regulators haveraised.The joint inspections have demonstrated that with a cooperativeapproach many obstacles can be overcome.In joint inspections each regulator learns from the other and we areconvinced that these inspections have improved regulatory oversightboth by the PCAOB and by our foreign counterparts.



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Limits on PCAOB Inspections and their Effects on InvestorsI want to talk now about some of the limits to the PCAOBs ability toinspect non-U.S. audit firms registered with us and the potential risksthis poses to U.S. investors.The PCAOB currently is prevented from inspecting the U.S.-companyrelated audit work and practices of PCAOB-registered firms in certainEuropean countries, China, and to the extent their audit clients haveoperations in China Hong Kong.In Europe, the obstacles to inspection center around the requirement tosatisfy the individual countrysdata protection requirements underEuropean Union law.After some delay, we are now making progress and have cooperativeagreements with several European Union regulators.We continue to negotiate with others.Where the PCAOB is not able to conduct inspections, investors in U.S.-traded companies who rely on the audit reports of firms' in thosecountries are deprived of the potential benefits of PCAOB inspections ofthose firms.To better inform investors about our inspections, the PCAOB publisheson its website a list of more than 400 companies whose auditors arelocated in jurisdictions where obstacles to PCAOB inspections exist.The list is derived from annual reports filed with the PCAOB byregistered public accounting firms.ChinaNow, let me turn to China. As you are probably aware, in the past year orso, alleged serious financial frauds and attendant accounting problemshave been disclosed involving a number of China-based companies



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whose securities are registered outside of China, particularly in theUnited States, Singapore and, to a lesser extent, Europe.Not more than a decade ago, Chinese firms began to access foreigncapital markets.Two types of Chinese companies sought access to U.S. capital markets,smaller enterprises that had difficulty accessing the very restrictedChinese domestic capital markets and some of the largest state-ownedenterprises in industries such as petroleum and telecommunications.At the same time some of the largest global companies, including U.Scompanies, began to engage in extensive operations in China.The smaller companies most commonly sought access to U.S. marketsby merging with existing, registered U.S. shell companies in reversemergers.The larger companies filed initial public offerings.A PCAOB Research Note showed that, in the United States alone,between January 1, 2007 and March 31, 2010, 159 Chinese companiesentered the U.S. securities markets using reverse mergers and generatedmarket capitalization of $12.8 billion.These transactions represented the largest share of the reverse mergermarket during that period.In the same period, 56 Chinese companies, including a number of verylarge state-owned enterprises completed U.S. IPOs and had anaggregate market capitalization of $27.2 billion.Seventy-four percent of these reverse merger companies were audited byU.S.-based audit firms and China-based audit firms audited the balance,but all of these firms were registered with the PCAOB.As major U.S. companies like General Motors, IBM, Microsoft, AppleComputer, Proctor & Gamble, General Electric and Walmart began to



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build extensive operations in China, the China and Hong Kong basedaffiliates of the global network audit firms began to play an increasingrole in the consolidated audits of those companies.Beginning in the latter part of 2010, alleged financial frauds and serious

accounting issues were revealed at a number of the smaller Chinesereverse merger companies.To date, 67 of these China-based issuers have had their auditor resign,and 126 issuers have either been delisted from U.S. securities exchangesorgonedarkmeaning that they are no longer filing current reportswith the SEC.Billions of dollars of market capitalization of such companies have beenlost in U.S. securities markets and it is fair to say that all of these smallerChina-based companies listed on U.S. securities exchanges havesuffered serious losses of both market value and investor confidence as aresult of the problems of other companies.The number of China-based companies that have successfully filed aninitial public offering in the United States in the past year has slowed toa trickle.We understand that smaller Chinese companies have also suffered

similar adverse consequences in other non-U.S. and non-Chinesemarkets.At present, the PCAOB does not have cooperative agreements witheither the China Securities Regulatory Commission or ChinasMinistryof Finance which share jurisdiction over Chinese accountants.The CSRC has jurisdiction over the 53 accounting firms, including theaffiliates of the global network firms that are authorized to file auditreports with respect to companies listing securities on the Chinese

domestic securities markets in Shanghai and Shenzhen.



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The MOF licenses all accountants in China and has jurisdiction overmore than 7,000 accounting firms in China, including some of the firmsregistered with the PCAOB.Under Chinese law, it is illegal to remove audit work papers from China.

At the present time, Chinese authorities will also not permit any non-Chinese regulator to conduct inspections on Chinese soil.As a result, it is impossible for the PCAOB or other regulators to inspectChina-based audit firms or to assess the quality of such firms registeredwith it.This limitation also applies to the affiliates of the global network firmsthat perform audit work on the audits of the Chinese operations of thelarge global companies operating in China.In an attempt to address these problems, the PCAOB has intensified itsdialogue with both the China Securities Regulatory Commission and theMOF over the past year.Both we and the Chinese regulators recognize the importance ofimproving audit quality and investor protection.For the PCAOB, an agreement with China is important not only becauseof the risks investors face, but because of the size and rapid growth of theChinese economy.Almost 5 percent of PCAOB registered firms are based either in China orHong Kong, the largest group of non-U.S. firms.Chinese authorities say that we should rely on their oversight of auditors.They have two principal concerns.The first is that any action by a foreign regulator on Chinese soil, even amere inspection, could violate Chinese sovereignty.



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This concern has deep historical roots, specifically relating to thehumiliations that China suffered at the hands of Western powers in thenineteenth and early twentieth centuries.The second concern grows out of Chinasvery expansive state secrecy

laws.There has been a concern expressed that inspection of audit workpapers, particularly work papers from the audits of state-ownedenterprises, could lead to disclosures of state secrets.The question for both countries is how to conduct inspections in waysthat respect national sovereignty and the legitimate regulatory goals ofboth countries.As mentioned earlier, we have been able successfully to navigate orbalance these seemingly competing interests in a number of countriesaround the globe.As a first step toward further cooperation, we are working toward andhave tentatively agreed on observational visits where PCAOB inspectorswould observe the Chinese authorities conducting their own auditoversight activities and the Chinese could observe the PCAOB at work.This would not be a substitute for a PCAOB inspection but would be atrust building exercise between regulators.Initially, such observations would focus on quality control examinationsof the audit firm being examined rather than a substantive review of aspecific audit.We hope such exercises will build trust and lead to further cooperation.

The ultimate goal for the PCAOB is to achieve a level of cooperationwith the Chinese authorities that will enable us to have enough

information and confidence that we could issue inspection reports on



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those China-based audit firms that prepare or participate substantially inthe preparation of audit reports filed in the United States.There is, however,a second and complicating issue with China andHong Kong.Both the PCAOB and the SEC are in discussion with Chinese authoritiesabout cooperation in connection with investigative activities.Both agencies are seeking the cooperation of the Chinese authorities inobtaining documents in appropriate investigations.Although we remain hopeful that breakthroughs will be achieved, to datedifficulties remain.Despite our hopes, the question arises as to what happens if we are notable to achieve an agreement on regulatory cooperation with theChinese.Any firm that registers with the PCAOB is legally obligated to cooperatewith us and provide documents and potentially testimony if requested inconnection with an inspection or investigation.A refusal to cooperate, either in an inspection or an investigation, couldsubject the firm to PCAOB sanctions even if motivated by compliance

with local laws that restrict such cooperation.One possible sanction could be revocation of a firmsPCAOBregistration.Any company audited by such a firm would either have to get a newaudit opinion signed by a firm registered with the PCAOB or risk beingin violation of SEC and stock exchange rules.The stakes in this matter are very high.But U.S. financial authorities have a primary responsibility to protect theintegrity of our capital markets and the interests of U.S. investors.



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We believe the Chinese authorities are aware of the seriousness of thismatter and we are hopeful that we will be able to work out satisfactoryarrangements.We continue to engage in dialogue with the Chinese authorities, but at

this time it remains uncertain where this dialogue will ultimately lead.Other Steps to Improve Transparency in Audit ReportsAffecting Global EnterprisesThe PCAOB has also proposed another step to increase the transparencyof the audits of global enterprises.Today, the typical audit report for a U.S-listed company is a one-page

document.

It provides general information about how every audit must beconducted and states that the audit complied with applicable standards.It gives the firmsopinion on the companys financial statements,including internal controls over financial reporting where appropriate,and concludes with the signature of the firm that issued it.In this era of global networks firms, that signature does not tell the full

story.

An audit report on a multi-national company may carry the signature ofone audit firm, but gives the reader no hint about the key participants inthe audit, including whether portions of the audit were conducted by anaffiliated firm in the global network or by another auditor.The audit report also gives no information about how the audit work wasallocated among firms.In October 2011, the Board proposed amendments to PCAOB auditingstandards that would require audit reports to disclose the name of theaudit engagement partner as well as the identity of other independent



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audit firms or persons that provided 3 percent or more of the total hoursin the most recent audit.These amendments, if approved by the Board and the SEC, would servetwo purposes.First, they would give investors more information about which firms areactually performing work in the audit which many investors have told usthey want; and second, they would make publicly available the names offirms that have provided more than 3 percent of the total audit hours butare located in jurisdictions where the PCAOB cannot yet conductinspections.Investors can then make a more informed decision about the quality ofthe firms participating in a companys audit.Some Issues in International Registrations and InspectionsFinally, I want to address an issue we have faced in connection with theregistration of certain non-U.S. audit firms as well as certain findings ininternational inspections.As mentioned above, U.S. securities laws require that any company withsecurities traded in U.S. markets be audited by an accounting firmregistered with the PCAOB.Registration subjects each firm to the oversight activities assigned to thePCAOB for the protection of investors including inspections andenforcement.In 2010, the PCAOB began to request additional information fromcertain firms applying for registration.Essentially, we asked the firm to provide assurance -- including written

confirmation from its national regulatory authority -- that the PCAOBwould be able to inspect the firm.



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We have requested such information from applicants from China, H ongKong and certain European countries.To date, one firms registration has been rejected by the Board becauseit could not offer that assurance, and several other firmsapplications

were, at the firmsrequest, essentially put on hold until they are able toprovide this assurance.Some of those applications have since been approved as the Boardreached agreements with the regulators.Since 2005, the PCAOB has inspected portions of more than 825 auditsperformed by 213 registered firms based outside the United States.Seven years of international inspections have revealed that too oftenauditors are missing some basic things and making troubling errors,including errors in the timing and documentation of a companysrevenue recognition; overreliance on managementsestimates of suchthings as contingency and warranty reserves, allowances for doubtfulaccounts in financial institutions, hard to value financial instruments,and obsolete or overvalued inventory.These problems are not confined to inspections of non-U.S. firms and wehave seen similar deficiencies in the audits of U.S.-based auditors.Many of these problems could be solved if auditors approached their

jobs with a higher degree of independence, objectivity and, perhapsmost important, professional skepticism.Auditors are supposed to challenge management, and the PCAOB wouldlike to see more auditors do so.In the same vein, PCAOB inspections continue to find that firms aredeficient in aspects of their internal governance.More specifically, in an international context, our inspectors have founddeficiencies in the quality control mechanisms within the global network



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firms, in the supervision by the principal auditor of work performed byaffiliated firms and in their referral of work to non-affiliated firms orspecialists.We continue to pursue these issues actively directly with individual

firms, with the leadership of the global auditing network firms, andthrough our role as a member of the Global Public Policy CommitteeWorking Group of IFIAR which meets with the leadership of the globalpractice firms three times each year.That Working Group has concentrated on questions around professionalskepticism, engagement quality control review, group audits, revenuerecognition, sovereign debt issues, the role of the audit committee andthe auditors reporting model.ConclusionIn the economic crisis that reached its nadir in 2008 we saw well-knowncompaniesnotably Lehman Brotherswhose bankruptcies eclipsedthe failures of Enron and WorldCom in 2002.What is more sobering is that the economic climate remains uncertain,with weak job growth in the United States, uncertainty inside theEuropean Community and a slowing of business growth in China.Despite these uncertainties globalization of the world economycontinues apace.This is just the time that investors most need protection.We may claim a large company as our own because its headquarters iswithin our national borders, but, more likely than not, the company isdoing business globally and seeking capital in markets in othercountries.As a consequence, it is the duty of all of us involved in the financialreporting process, whether as preparer, manager, audit committee



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member, auditor, counselor or regulator to work to ensure that financialreports are complete, transparent, and fairly stated, wherever theoperations they reflect are located.We owe that to investors who are, after all, our fellow citizens.

Thank you for your attention.



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Five Questions about the Federal Reserve andMonetary PolicyChairman Ben S. Bernanke, at the Economic Club of

Indiana, Indianapolis, Indiana

Good afternoon. I am pleased to be able to join theEconomic Club of Indiana for lunch today.I note that the mission of the club is "to promote an interest in, andenlighten its membership on, important governmental, economic andsocial issues." I hope my remarks today will meet that standard.Before diving in, I 'd like to thank my former colleague at the White

House, Al Hubbard, for helping to make this event possible.

As the head of the N ational Economic Council under President Bush, Alhad the difficult task of making sure that diverse perspectives oneconomic policy issues were given a fair hearing beforerecommendations went to the President.Al had to be a combination of economist, political guru, diplomat, andtraffic cop, and he handled it with great skill.My topic today is "Five Questions about the Federal Reserve andMonetary Policy."I have used a question-and-answer format in talks before, and I knowfrom much experience that people are eager to know more about theFederal Reserve, what we do, and why we do it.And that interest is even broader than one might think.I'm a baseball fan, and I was excited to be invited to a recent batting

practice of the playoff-bound Washington Nationals.



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We monitor the financial system as a whole for possible risks to itsstability.We encourage financial and economic literacy, promote equal access tocredit, and advance local economic development by working with

communities, nonprofit organizations, and others around the country.We also provide some basic services to the financial sector--for example,by processing payments and distributing currency and coin to banks.But today I want to focus on a role that is particularly identified with theFederal Reserve--the making of monetary policy.The goals ofmonetary policy--maximum employment and pricestability--are given to us by the Congress.These goals mean, basically, that we would like to see as manyAmericans as possible who want jobs to have jobs, and that we aim tokeep the rate of increase in consumer prices low and stable.In normal circumstances, the Federal Reserve implements monetarypolicy through its influence on short-term interest rates, which in turnaffect other interest rates and asset prices.Generally, if economic weakness is the primary concern, the Fed acts toreduce interest rates, which supports the economy by inducingbusinesses to invest more in new capital goods and by leadinghouseholds to spend more on houses, autos, and other goods andservices.Likewise, if the economy is overheating, the Fed can raise interest ratesto help cool total demand and constrain inflationary pressures.Following this standard approach, the Fed cut short-term interest rates

rapidly during the financial crisis, reducing them to nearly zero by theend of 2008--a time when the economy was contracting sharply.



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At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy toolfor dealing with economic weakness was no longer available.

Yet, with unemployment soaring, the economy and job market clearly

needed more support.Central banks around the world found themselves in a similarpredicament.We asked ourselves, "What do we do now?"To answer this question, we could draw on the experience of Japan,where short-term interest rates have been near zero for many years, aswell as a good deal of academic work.Unable to reduce short-term interest rates further, we looked instead forways to influence longer-term interest rates, which remained well abovezero.We reasoned that, as with traditional monetary policy, bringing downlonger-term rates should support economic growth and employment bylowering the cost of borrowing to buy homes and cars or to financecapital investments.Since 2008, we've used two types of less-traditional monetary policy toolsto bring down longer-term rates.The first of these less-traditional tools involves the Fed purchasinglonger-term securities on the open market--principally Treasurysecurities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac.The Fed's purchases reduce the amount of longer-term securities held

by investors and put downward pressure on the interest rates on thosesecurities.



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That downward pressure transmits to a wide range of interest rates thatindividuals and businesses pay.For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a

little above 6 percent; today they average about 3-1/ 2 percent.Lower mortgage rates are one reason for the improvement we have beenseeing in the housing market, which in turn is benefiting the economymore broadly.Other important interest rates, such as corporate bond rates and rates onauto loans, have also come down.Lower interest rates also put upward pressure on the prices of assets,such as stocks and homes, providing further impetus to household andbusiness spending.The second monetary policy tool we have been using involvescommunicating our expectations for how long the short-term interestrate will remain exceptionally low.Because the yield on, say, a five-year security embeds marketexpectations for the course of short-term rates over the next five years,convincing investors that we will keep the short-term rate low for alonger time can help to pull down market-determined longer-term rates.In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--isthe same as it has always been.The difference is that, with the short-term interest rate nearly at zero, wehave shifted to tools aimed at reducing longer-term interest rates moredirectly.



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Last month, my colleagues and I used both tools--securities purchasesand communications about our future actions--in a coordinated way tofurther support the recovery and the job market.Why did we act? Though the economy has been growing since mid-2009

and we expect it to continue to expand, it simply has not been growingfast enough recently to make significant progress in bringing downunemployment.At 8.1 percent, the unemployment rate is nearly unchanged since thebeginning of the year and is well above normal levels.While unemployment has been stubbornly high, our economy hasenjoyed broad price stability for some time, and we expect inflation toremain low for the foreseeable future.So the case seemed clear to most of my colleagues that we could domore to assist economic growth and the job market withoutcompromising our goal of price stability.Specifically, what did we do? On securities purchases, we announcedthat we would buy mortgage-backed securities guaranteed by thegovernment-sponsored enterprises at a rate of $40 billion per month.Those purchases, along with the continuation of a previous programinvolving Treasury securities, mean we are buying $85 billion of longer-term securities per month through the end of the year.We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates.To underline the Federal Reserve's commitment to fostering asustainable economic recovery, we said that we would continuesecurities purchases and employ other policy tools until the outlook for

the job market improves substantially in a context of price stability.



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In the category of communications policy, we also extended our estimateof how long we expect to keep the short-term interest rate at exceptionallylow levels to at least mid-2015.That doesn't mean that we expect the economy to be weak through 2015.

Rather, our message was that, so long as price stability is preserved, wewill take care not to raise rates prematurely.Specifically, we expect that a highly accommodative stance of monetarypolicy will remain appropriate for a considerable time after the economystrengthens.We hope that, by clarifying our expectations about future policy, we canprovide individuals, families, businesses, and financial markets greater

confidence about the Federal Reserve's commitment to promoting asustainable recovery and that, as a result, they will become more willingto invest, hire and spend.Now, as I have said many times, monetary policy is no panacea.It can be used to support stronger economic growth in situations inwhich, as today, the economy is not making full use of its resources, andit can foster a healthier economy in the longer term by maintaining lowand stable inflation.However, many other steps could be taken to strengthen our economyover time, such as putting the federal budget on a sustainable path,reforming the tax code, improving our educational system, supportingtechnological innovation, and expanding international trade.Although monetary policy cannot cure the economy's ills, particularly intoday's challenging circumstances, we do think it can providemeaningful help.



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So we at the Federal Reserve are going to do what we can do and trustthat others, in both the public and private sectors, will do what they canas well.What's the Relationship between Monetary Policy and FiscalPolicy?That brings me to the second question: What's the relationship betweenmonetary policy and fiscal policy?To answer this question, it may help to begin with the more basicquestion of how monetary and fiscal policy differ.In short, monetary policy and fiscal policy involve quite different sets of

actors, decisions, and tools.

Fiscal policy involves decisions about how much the government shouldspend, how much it should tax, and how much it should borrow.At the federal level, those decisions are made by the Administration andthe Congress.Fiscal policy determines the size of the federal budget deficit, which isthe difference between federal spending and revenues in a year.Borrowing to finance budget deficits increases the government's totaloutstanding debt.As I have discussed, monetary policy is the responsibility of the FederalReserve--or, more specifically, the Federal Open Market Committee,which includes members of the Federal Reserve's Board of Governorsand presidents of Federal Reserve Banks.Unlike fiscal policy, monetary policy does not involve any taxation,

transfer payments, or purchases of goods and services. Instead, as Imentioned, monetary policy mainly involves the purchase and sale ofsecurities.



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The securities that the Fed purchases in the conduct of monetary policyare held in our portfolio and earn interest.The great bulk of these interest earnings is sent to the Treasury, therebyhelping reduce the government deficit.In the past three years, the Fed remitted $200 billion to the federalgovernment.Ultimately, the securities held by the Fed will mature or will be sold backinto the market. So the odds are high that the purchase programs that theFed has undertaken in support of the recovery will end up reducing, notincreasing, the federal debt, both through the interest earnings we sendthe Treasury and because a stronger economy tends to lead to higher taxrevenues and reduced government spending (on unemployment benefits,for example).Even though our activities are likely to result in a lower national debtover the long term, I sometimes hear the complaint that the FederalReserve is enabling bad fiscal policy by keeping interest rates very lowand thereby making it cheaper for the federal government to borrow.I find this argument unpersuasive.The responsibility for fiscal policy lies squarely with the Administrationand the Congress.At the Federal Reserve, we implement policy to promote maximumemployment and price stability, as the law under which we operaterequires.Using monetary policy to try to influence the political debate on thebudget would be highly inappropriate.For what it's worth, I think the strategy would also likely be ineffective:Suppose, notwithstanding our legal mandate, the Federal Reserve were



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to raise interest rates for the purpose of making it more expensive for thegovernment to borrow.Such an action would substantially increase the deficit, not only becauseof higher interest rates, but also because the weaker recovery that would

result from premature monetary tightening would further widen the gapbetween spending and revenues.Would such a step lead to better fiscal outcomes? I t seems likely that asignificant widening of the deficit--which would make the needed fiscalactions even more difficult and painful--would worsen rather thanimprove the prospects for a comprehensive fiscal solution.I certainly don't underestimate the challenges that fiscal policymakersface.They must find ways to put the federal budget on a sustainable path, butnot so abruptly as to endanger the economic recovery in the near term.In particular, the Congress and the Administration will soon have toaddress the so-called fiscal cliff, a combination of sharply higher taxesand reduced spending that is set to happen at the beginning of the year.According to the Congressional Budget Office and virtually all otherexperts, if that were allowed to occur, it would likely throw the economyback into recession.The Congress and the Administration will also have to raise the debtceiling to prevent the Treasury from defaulting on its obligations, anoutcome that would have extremely negative consequences for thecountry for years to come.Achieving these fiscal goals would be even more difficult if monetarypolicy were not helping support the economic recovery.



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What Is the Risk that the Federal Reserve's Monetary PolicyWill Lead to Inflation?A third question, and an important one, is whether the Federal

Reserve's monetary policy will lead to higher inflation down the road.

In response, I will start by pointing out that the Federal Reserve's pricestability record is excellent, and we are fully committed to maintainingit. I nflation has averaged close to 2 percent per year for several decades,and that's about where it is today.In particular, the low interest rate policies the Fed has been following forabout five years now have not led to increased inflation.Moreover, according to a variety of measures, the public's expectationsof inflation over the long run remain quite stable within the range thatthey have been for many years.With monetary policy being so accommodative now, though, it is notunreasonable to ask whether we are sowing the seeds of future inflation.A related question I sometimes hear--which bears also on therelationship between monetary and fiscal policy, is this: By buyingsecurities, are you "monetizing the debt"--printing money for the

government to use--and will that inevitably lead to higher inflation?No, that's not what is happening, and that will not happen.Monetizing the debt means using money creation as a permanent sourceof financing for government spending.In contrast, we are acquiring Treasury securities on the open market andonly on a temporary basis, with the goal of supporting the economicrecovery through lower interest rates.



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At the appropriate time, the Federal Reserve will gradually sell thesesecurities or let them mature, as needed, to return its balance sheet to amore normal size.Moreover, the way the Fed finances its securities purchases is by

creating reserves in the banking system.Increased bank reserves held at the Fed don't necessarily translate intomore money or cash in circulation, and, indeed, broad measures of thesupply of money have not grown especially quickly, on balance, over thepast few years.For controlling inflation, the key question is whether the Federal Reservehas the policy tools to tighten monetary conditions at the appropriatetime so as to prevent the emergence of inflationary pressures down theroad.I'm confident that we have the necessary tools to withdraw policyaccommodation when needed, and that we can do so in a way thatallows us to shrink our balance sheet in a deliberate and orderly way.For example, the Fed can tighten policy, even if our balance sheetremains large, by increasing the interest rate we pay banks on reservebalances they deposit at the Fed.Because banks will not lend at rates lower than what they can earn at theFed, such an action should serve to raise rates and tighten creditconditions more generally, preventing any tendency toward overheatingin the economy.Of course, having effective tools is one thing; using them in a timelyway, neither too early nor too late, is another.Determining precisely the right time to "take away the punch bowl" isalways a challenge for central bankers, but that is true whether they areusing traditional or nontraditional policy tools.



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I can assure you that my colleagues and I will carefully consider howbest to foster both of our mandated objectives, maximum employmentand price stability, when the time comes to make these decisions.How Does the Fed's Monetary Policy Affect Savers andInvestors?The concern about possible inflation is a concern about the future. Oneconcern in the here and now is about the effect of low interest rates onsavers and investors.My colleagues and I know that people who rely on investments that pay afixed interest rate, such as certificates of deposit, are receiving very lowreturns, a situation that has involved significant hardship for some.However, I would encourage you to remember that the current low levelsof interest rates, while in the first instance a reflection of the FederalReserve's monetary policy, are in a larger sense the result of the recentfinancial crisis, the worst shock to this nation's financial system since the1930s.Interest rates are low throughout the developed world, except incountries experiencing fiscal crises, as central banks and otherpolicymakers try to cope with continuing financial strains and weak

economic conditions.A second observation is that savers often wear many economic hats.

Many savers are also homeowners; indeed, a family's home may be itsmost important financial asset.Many savers are working, or would like to be. Some savers ownbusinesses, and--through pension funds and 401(k) accounts--they oftenown stocks and other assets.



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The crisis and recession have led to very low interest rates, it is true, butthese events have also destroyed jobs, hamstrung economic growth, andled to sharp declines in the values of many homes and businesses.What can be done to address all of these concerns simultaneously?The best and most comprehensive solution is to find ways to a strongereconomy.Only a strong economy can create higher asset values and sustainablygood returns for savers.And only a strong economy will allow people who need jobs to findthem.Without a job, it is difficult to save for retirement or to buy a home or topay for an education, irrespective of the current level of interest rates.The way for the Fed to support a return to a strong economy is bymaintaining monetary accommodation, which requires low interest ratesfor a time.If, in contrast, the Fed were to raise rates now, before the economicrecovery is fully entrenched, house prices might resume declines, thevalues of businesses large and small would drop, and, critically,unemployment would likely start to rise again. Such outcomes wouldultimately not be good for savers or anyone else.How Is the Federal Reserve Held Accountable in a DemocraticSociety?I will turn, finally, to the question of how the Federal Reserve is heldaccountable in a democratic society.



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The Federal Reserve was created by the Congress, now almost a centuryago.In the Federal Reserve Act and subsequent legislation, the Congress laidout the central bank's goals and powers, and the Fed is responsible to the

Congress for meeting its mandated objectives, including fosteringmaximum employment and price stability.At the same time, the Congress wisely designed the Federal Reserve tobe insulated from short-term political pressures.For example, members of the Federal Reserve Board are appointed tostaggered, 14-year terms, with the result that some members may servethrough several Administrations.Research and practical experience have established that freeing thecentral bank from short-term political pressures leads to better monetarypolicy because it allows policymakers to focus on what is best for theeconomy in the longer run, independently of near-term electoral orpartisan concerns.All of the members of the Federal Open Market Committee take thisprinciple very seriously and strive always to make monetary policydecisions based solely on factual evidence and careful analysis.It is important to keep politics out of monetary policy decisions, but it isequally important, in a democracy, for those decisions--and, indeed, all ofthe Federal Reserve's decisions and actions--to be undertaken in a strongframework of accountability and transparency.The American people have a right to know how the Federal Reserve iscarrying out its responsibilities and how we are using taxpayer resources.One of my principal objectives as Chairman has been to make monetary

policy at the Federal Reserve as transparent as possible.We promote policy transparency in many ways.

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Sarbanes Oxley News October 2012

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