Basel 3 News November 2012

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Basel iii Compliance Professionals Association (BiiiCPA)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.com
Dear Member, Today we will start from the assessment methodology for global systemically important banks (G-SIBs) from the Basel Committee on Banking Supervision.
BIS, A framework for dealing with domestic systemically important banks I. Introduction
1. The Basel Committee on Banking Supervision (the Committee) issued the rules text on the assessment methodology for global systemically important banks (G-SIBs) and their additional loss absorbency requirements in November 2011. The G-SIB rules text was 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 modalities to extend expeditiously the G-SIFI framework to domestic systemically important banks (D-SIBs). 2. The rationale for adopting additional policy measures for G-SIBs was based on the negative externalities (ie adverse side effects) created by
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systemically important banks which current regulatory policies do not fully address. In maximising their private benefits, individual financial institutions may rationally choose outcomes that, from a system-wide level, are sub-optimal because they do not take into account these externalities. These negative externalities include the impact of the failure or impairment of large, interconnected global financial institutions that can send shocks through the financial system which, in turn, can harm the real economy. Moreover, the moral hazard costs associated with direct support and implicit government guarantees may amplify risk-taking, reduce market discipline, create competitive distortions, and further increase the probability of distress in the future. As a result, the costs associated with moral hazard add to any direct costs of support that may be borne by taxpayers. 3. The additional requirement applied to G-SIBs, which applies over and above the Basel III requirements that are being introduced for all internationally-active banks, is intended to limit these 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. There are many banks that are not significant from an international perspective, but nevertheless could have an important impact on their domestic financial system and economy compared to non-systemic institutions. Some of these banks may have cross-border externalities, even if the effects are not global in nature. Similar to the case of G-SIBs, it was
considered appropriate to review ways to address the externalities posed by D-SIBs. 4. A D-SIB framework is best understood as taking the complementary perspective to the G-SIB regime by focusing on the impact that the distress or failure of banks (including by international banks) will have on the domestic economy. As such, it is based on the assessment conducted by the local authorities, who are best placed to evaluate the impact of failure on the local financial system and the local economy. 5. This point has two implications. The first is that in order to accommodate the structural characteristics of individual jurisdictions, the assessment and application of policy tools should allow for an appropriate degree of national discretion. This contrasts with the prescriptive approach in the G-SIB framework. The second implication is that because a D-SIB framework is still relevant for reducing cross-border externalities due to spillovers at regional or bilateral level, the effectiveness of local authorities in addressing risks posed by individual banks is of interest to a wider group of countries. A framework, therefore, should establish a minimum set of principles, which ensures that it is complementary with the G-SIB framework, addresses adequately cross-border externalities and promotes a level-playing field. 6. The principles developed by the Committee for D-SIBs would allow for appropriate national discretion to accommodate structural characteristics of the domestic financial system, including the possibility for countries to go beyond the minimum D-SIB framework and impose additional
requirements based on the specific features of the country and its domestic banking sector. 7. The principles set out in the document focus on the higher loss absorbency (HLA) requirement for D-SIBs. The Committee would like to emphasise that other policy tools, particularly more intensive supervision, can also play an important role in dealing with D-SIBs. 8. The principles were developed to be applied to consolidated groups and subsidiaries. However, national authorities may apply them to branches in their jurisdictions in accordance with their legal and regulatory frameworks. 9. The implementation of the principles will be combined with a strong peer review process introduced by the Committee. The Committee intends to add the D-SIB framework to the scope of the Basel III regulatory consistency assessment programme. This will help ensure that appropriate and effective frameworks for D-SIBs are in place across different jurisdictions. 10. Given that the D-SIB framework complements the G-SIB framework, the Committee considers that it would be appropriate if banks identified as D-SIBs by their national authorities are required by those authorities to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.
II. The principles

11. The Committee has developed a set of principles that constitutes the D-SIB framework. The 12 principles can be broadly categorised into two groups:
The first group (Principles 1 to 7) focuses mainly on the assessment methodology for D-SIBs while the second group (Principles 8 to 12) focuses on HLA for D-SIBs. 12. The 12 principles are set out below:
Assessment methodology
Principle 1:
National authorities should establish a methodology for assessing the degree to which banks are systemically important in a domestic context.
Principle 2:
The assessment methodology for a D-SIB should reflect the potential impact of, or externality imposed by, a banks failure.
Principle 3:
The reference system for assessing the impact of failure of a D-SIB should be the domestic economy.
Principle 4:
Home authorities should assess banks for their degree of systemic importance at the consolidated group level, while host authorities should assess subsidiaries in their jurisdictions, consolidated to include any of their own downstream subsidiaries, for their degree of systemic importance.
Principle 5:
The impact of a D-SIBs failure on the domestic economy should, in principle, be assessed having regard to bank-specific factors: (a) Size
(b) Interconnectedness (c) Substitutability/financial institution infrastructure (including considerations related to the concentrated nature of the banking sector) (d) Complexity (including the additional complexities from cross-border activity). In addition, national authorities can consider other measures/data that would inform these bank-specific indicators within each of the above factors, such as size of the domestic economy.
Principle 6:
National authorities should undertake regular assessments of the systemic importance of the banks in their jurisdictions to ensure that their assessment reflects the current state of the relevant financial systems and that the interval between D-SIB assessments not be significantly longer than the G-SIB assessment frequency.
Principle 7:
National authorities should publicly disclose information that provides an outline of the methodology employed to assess the systemic importance of banks in their domestic economy.
Higher loss absorbency

Principle 8:
National authorities should document the methodologies and considerations used to calibrate the level of HLA that the framework would require for D-SIBs in their jurisdiction. The level of HLA calibrated for D-SIBs should be informed by quantitative methodologies (where available) and country-specific factors without prejudice to the use of supervisory judgement.
Principle 9:
The HLA requirement imposed on a bank should be commensurate with the degree of systemic importance, as identified under Principle 5.
Principle 10:
National authorities should ensure that the application of the G-SIB and D-SIB frameworks is compatible within their jurisdictions. Home authorities should impose HLA requirements that they calibrate at the parent and/or consolidated level, and host authorities should impose HLA requirements that they calibrate at the sub-consolidated/subsidiary level. The home authority should test that the parent bank is adequately capitalised on a stand-alone basis, including cases in which a D-SIB HLA requirement is applied at the subsidiary level. Home authorities should impose the higher of either the D-SIB or G-SIB HLA requirements in the case where the banking group has been identified as a D-SIB in the home jurisdiction as well as a G-SIB.
Principle 11:
In cases where the subsidiary of a bank is considered to be a D-SIB by a host authority, home and host authorities should make arrangements to coordinate and cooperate on the appropriate HLA requirement, within the constraints imposed by relevant laws in the host jurisdiction.
Principle 12:
The HLA requirement should be met fully by Common Equity Tier 1 (CET1). In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB.
Assessment methodology
Principle 1: National authorities should establish a methodology for assessing the degree to which banks are systemically important in a domestic context. Principle 2: The assessment methodology for a D-SIB should reflect the potential impact of, or externality imposed by, a banks failure.
13. A starting point for the development of principles for the assessment of D-SIBs is a requirement that all national authorities should undertake an assessment of the degree to which banks are systemically important in a domestic context. The rationale for focusing on the domestic context is outlined in paragraph 17 below. 14. Paragraph 14 of the G-SIB rules text states that global systemic importance should be measured in terms of the impact that a failure of a bank can have on the global financial system and wider economy rather than the risk that a failure can occur. This can be thought of as a global, system-wide, loss-given-default (LGD) concept rather than a probability of default (PD) concept. Consistent with the G-SIB methodology, the Committee is of the view that D-SIBs should also be assessed in terms of the potential impact of their failure on the relevant reference system. One implication of this is that to the extent that D-SIB indicators are included in any methodology, they should primarily relate to impact of failure measures and not risk of failure measures.
Principle 3: The reference system for assessing the impact of failure of a D-SIB should be the domestic economy.
Principle 4: Home authorities should assess banks for their degree of systemic importance at the consolidated group level, while host authorities should assess subsidiaries in their jurisdictions, consolidated to include any of their own downstream subsidiaries, for their degree of systemic importance.
15. Two key aspects that shape the D-SIB framework and define its relationship to the G-SIB framework relate to how it deals with two conceptual issues with important practical implications: What is the reference system for the assessment of systemic impact What is the appropriate unit of analysis (ie the entity which is being assessed)? 16. For the G-SIB framework, the appropriate reference system is the global economy, given the focus on cross-border spillovers and the negative global externalities that arise from the failure of a globally active bank. As such this allowed for an assessment of the banks that are systemically important in a global context. The unit of analysis was naturally set at the globally consolidated level of a banking group (paragraph 89 of the G-SIB rules text states that (t)he assessment of the systemic importance of G-SIBs is made using data that relate to the consolidated group). 17. Correspondingly, a process for assessing systemic importance in a domestic context should focus on addressing the externalities that a banks failure generates at a domestic level. Thus, the Committee is of the view that the appropriate reference system should be the domestic economy, ie that banks would be assessed by the national authorities for their systemic importance to that specific jurisdiction.
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The outcome would be an assessment of banks active in the domestic economy in terms of their systemic importance. 18. In terms of the unit of analysis, the Committee is of the view that home authorities should consider banks from a (globally) consolidated perspective. This is because the activities of a bank outside the home jurisdiction can, when the bank fails, have potential significant spillovers to the domestic (home) economy. Jurisdictions that are home to banking groups that engage in cross-border activity could be impacted by the failure of the whole banking group and not just the part of the group that undertakes domestic activity in the home economy. This is particularly important given the possibility that the home government may have to fund/resolve the foreign operations in the absence of relevant cross-border agreements. This is in line with the concept of the G-SIB framework. 19. When it comes to the host authorities, the Committee is of the view that they should assess foreign subsidiaries in their jurisdictions, also consolidated to include any of their own downstream subsidiaries, some of which may be in other jurisdictions. For example, for a cross-border financial group headquartered in country X, the authorities in country Y would only consider subsidiaries of the group in country Y plus the downstream subsidiaries, some of which may be in country Z, and their impact on the economy Y. Thus, subsidiaries of foreign banking groups would be considered from a local or sub-consolidated basis from the level starting in country Y.
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The scope should be based on regulatory consolidation as in the case of the G-SIB framework. Therefore, for the purposes of assessing D-SIBs, insurance or other non-banking activities should only be included insofar as they are included in the regulatory consolidation. 20. The assessment of foreign subsidiaries at the local consolidated level also acknowledges the fact that the failure of global banking groups could impose outsized externalities at the local (host) level when these subsidiaries are significant elements in the local (host) banking system. This is important since there exist several jurisdictions that are dominated by foreign subsidiaries of internationally active banking groups.
Principle 5: The impact of a D-SIBs failure on the domestic economy should, in principle, be assessed having regard to bank-specific factors: (a) Size; (b) Interconnectedness; (c) Substitutability/financial institution infrastructure (including considerations related to the concentrated nature of the banking sector); and (d) Complexity (including the additional complexities from cross-border activity). In addition, national authorities can consider other measures/data that would inform these bank-specific indicators within each of the above factors, such as size of the domestic economy.
21. The G-SIB methodology identifies five broad categories of factors that influence global systemic importance: size, cross-jurisdictional activity, interconnectedness, substitutability/financial institution infrastructure and complexity.
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The indicator-based approach and weighting system in the G-SIB methodology was developed to ensure a consistent international ranking of G-SIBs. The Committee is of the view that this degree of detail is not warranted for D-SIBs, given the focus is on the domestic impact of failure of a bank and the wide ranging differences in each jurisdictions financial structure hinder such international comparisons being made. This is one of the reasons why the D-SIB framework has been developed as a principles-based approach. 22. Consistent with this view, it is appropriate to list, at a high level, the broad category of factors (eg size) that jurisdictions should have regard to in assessing the impact of a D-SIBs failure. Among the five categories in the G-SIB framework, size, interconnectedness, substitutability/financial institution infrastructure and complexity are all relevant for D-SIBs as well. Cross-jurisdictional activity, the remaining category, may not be as directly relevant, since it measures the degree of global (cross-jurisdictional) activity of a bank which is not the focus of the D-SIB framework. 23. In addition, national authorities may choose to also include some country-specific factors. A good example is the size of a bank relative to domestic GDP. If the size of a bank is relatively large compared to the domestic GDP, it would make sense for the national authority of the jurisdiction to identify it as a D-SIB whereas a same-sized bank in another jurisdiction, which is smaller relative to the GDP of that jurisdiction, may not be identified as a D-SIB.
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24. National authorities should have national discretion as to the appropriate relative weights they place on these factors depending on national circumstances.
Principle 6: National authorities should undertake regular assessments of the systemic importance of the banks in their jurisdictions to ensure that their assessment reflects the current state of the relevant financial systems and that the interval between D-SIB assessments not be significantly longer than the G-SIB assessment frequency.
25. The list of G-SIBs (including their scores) is assessed annually, based on updated data submitted by each participating bank, but measured against a global sample that is largely unchanged for three years. It is expected that the names and buckets of G-SIBs and the data used to produce the scores will be disclosed. 26. The Committee believes it is good practice for national authorities to undertake a regular assessment as to the systemic importance of the banks in their financial systems. The assessment should also be conducted if there are important structural changes to the banking system such as, for example, a merger of major banks. A national authoritys assessment process and methodology will be reviewed by the Committees implementation monitoring process. 27. It is also desirable that the interval of the assessments not be significantly longer than that for G-SIBs (ie one year). For example, a SIB could be identified as a G-SIB but also a D-SIB in the same jurisdiction or in other host jurisdictions. Alternatively, a G-SIB could drop from the G-SIB list and become/continue to be a D-SIB.
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In order to keep a consistent approach in these cases, it would be sensible to have a similar frequency of assessments for the two frameworks.
Principle 7: National authorities should publicly disclose information that provides an outline of the methodology employed to assess the systemic importance of banks in their domestic economy.
28. The assessment process used needs to be clearly articulated and made public so as to set up the appropriate incentives for banks to seek to reduce the systemic risk they pose to the reference system. This was the key aspect of the G-SIB framework where the assessment methodology and the disclosure requirements of the Committee and the banks were set out in the G-SIB rules text. By taking these measures, the Committee sought to ensure that banks, regulators and market participants would be able to understand how the actions of banks could affect their systemic importance score and thereby the required magnitude of additional loss absorbency. The Committee believes that transparency of the assessment process for the D-SIB framework is also important, even if it is likely to vary across jurisdictions given differences in frameworks and policy tools used to address the systemic importance of banks.
Higher loss absorbency

Principle 8: National authorities should document the methodologies and considerations used to calibrate the level of HLA that the framework would require for D-SIBs in their jurisdiction. The level of HLA calibrated for D-SIBs should be informed by quantitative methodologies (where available) and country-specific factors without prejudice to the use of supervisory judgement.
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29. The purpose of an HLA requirement for D-SIBs is to reduce further the probability of failure compared to non-systemic institutions, reflecting the greater impact a D-SIB failure is expected to have on the domestic financial system and economy. 30. The Committee intends to assess the implementation of the framework by the home and host authorities for its degree of cross-jurisdictional consistency, having regard to the differences in national circumstances. In order to increase the consistency in the implementation of the D-SIB framework and to avoid situations where banks similar in terms of the level of domestic systemic importance they pose in the same or different jurisdictions have substantially different D-SIB frameworks applied to them, it is important that there is sufficient documentation provided by home and host authorities for the Committee to conduct an effective implementation review assessment. It is important for the application of a D-SIB HLA, at both the parent and subsidiary level, to be based on a transparent and well articulated assessment framework to ensure the implications of the requirements are well understood by both the home and the host authorities. 31. The level of HLA for D-SIBs should be subject to policy judgement by national authorities. That said, there needs to be some form of analytical framework that would inform policy judgements. This was the case for the policy judgement made by the Committee on the level of the additional loss absorbency requirement for G-SIBs. 32. The policy judgement on the level of HLA requirements should also be guided by country-specific factors which could include the degree of concentration in the banking sector or the size of the banking sector relative to GDP.
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Specifically, countries that have a larger banking sector relative to GDP are more likely to suffer larger direct economic impacts of the failure of a D-SIB than those with smaller banking sectors. While size-to-GDP is easy to calculate, the concentration of the banking sector could also be considered (as a failure in a medium-sized highly concentrated banking sector would likely create more of an impact on the domestic economy than if it were to occur in a larger, more widely dispersed banking sector). 33. The use of these factors in calibrating the HLA requirement would provide justification for different intensities of policy responses across countries for banks that are otherwise similar across the four key bank-specific factors outlined in Principle 5.
Principle 9: The HLA requirement imposed on a bank should be commensurate with the degree of systemic importance, as identified under Principle 5.
34. In the G-SIB framework, G-SIBs are grouped into different categories of systemic importance based on the score produced by the indicator-based measurement approach. Different additional loss absorbency requirements are applied to the different buckets (G-SIB rules text paragraphs 52 and 73). 35. Although the D-SIB framework does not produce scores based on a prescribed methodology as in the case of the G-SIB framework, the Committee is of the view that the HLA requirements for D-SIBs should also be decided based on the degree of domestic systemic importance. This is to provide the appropriate incentives to banks which are subject to the HLA requirements to reduce (or at least not increase) their systemic importance over time. In the case where there are multiple D-SIB buckets in a jurisdiction, this could imply differentiated levels of HLA between D-SIB buckets.
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Principle 10: National authorities should ensure that the application of the G-SIB and D-SIB frameworks is compatible within their jurisdictions. Home authorities should impose HLA requirements that they calibrate at the parent and/or consolidated level, and host authorities should impose HLA requirements that they calibrate at the sub-consolidated/subsidiary level. The home authority should test that the parent bank is adequately capitalised on a stand-alone basis, including cases in which a D-SIB HLA requirement is applied at the subsidiary level. Home authorities should impose the higher of either the D-SIB or G-SIB HLA requirements in the case where the banking group has been identified as a D-SIB in the home jurisdiction as well as a G-SIB.
36. National authorities, including host authorities, currently have the capacity to set and impose capital requirements they consider appropriate to banks within their jurisdictions. The G-SIB rules text states that host authorities of G-SIB subsidiaries may apply an additional loss absorbency requirement at the individual legal entity or consolidated level within their jurisdiction. The Committee has no intention to change this aspect of the status quo when introducing the D-SIB framework. An imposition of a D-SIB HLA by a host authority is no different (except for additional transparency) from their current capacity to impose a Pillar 1 or 2 capital charge. Therefore, the ability of the host authorities to implement a D-SIB HLA on local subsidiaries does not raise any new home-host issues. 37. National authorities should ensure that banks with the same degree of systemic importance in their jurisdiction, regardless of whether they are domestic banks, subsidiaries of foreign banking groups, or subsidiaries of
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G-SIBs, are subject to the same HLA requirements, ceteris paribus. Banks in a jurisdiction should be subject to a consistent, coherent and non-discriminatory treatment regardless of the ownership. The objective of the host authorities power to impose HLA on subsidiaries is to bolster capital to mitigate the potential heightened impact of the subsidiaries failure on the domestic economy due to their systemic nature. This should be maintained in cases where a bank might not be (or might be less) systemic at home, but its subsidiary is (more) systemic in the host jurisdiction. 38. An action by the host authorities to impose a D-SIB HLA requirement leads to increases in capital at the subsidiary level which can be viewed as a shift in capital from the parent bank to the subsidiary, unless it already holds an adequate capital buffer in the host jurisdiction or the additional capital raised by the subsidiary is from outside investors. This could, in the case of substantial or large subsidiaries, materially decrease the level of capital protecting the parent bank. Under such cases, it is important that the home authority continues to ensure there are sufficient financial resources at the parent level, for example through a solo capital requirement. Indeed, paragraph 23 of the Basel II rules text states (f)urther, as one of the principal objectives of supervision is the protection of depositors, it is essential to ensure that capital recognised in capital adequacy measures is readily available for those depositors. Accordingly, supervisors should test that individual banks are adequately capitalised on a stand-alone basis.
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39. Within a jurisdiction, applying the D-SIB framework to both G-SIBs and non-G-SIBs will help ensure a level playing field within the national context. For example, in a jurisdiction with two banks that are roughly identical in terms of their assessed systemic nature at the domestic level, but where one is a G-SIB and the other is not, national authorities would have the capacity to apply the same D-SIB HLA requirement to both. In such cases, the home authorities could face a situation where the HLA requirement on the consolidated group will be the higher of those prescribed by the G-SIB and D-SIB frameworks (ie the higher of either the D-SIB or G-SIB requirement). 40. This approach is also consistent with the Committees standards, which are minima rather than maxima. It is also consistent with the G-SIB rules text that is explicit in stating that home authorities can impose higher requirements than the G-SIB additional loss absorbency requirement (G-SIB rules text paragraph 74). 41. The Committee is of the view that any form of double-counting should be avoided and that the HLA requirements derived from the G-SIB and D-SIB frameworks should not be additive. This will ensure the overall consistency between the two frameworks and allows the D-SIB framework to take the complementary perspective to the G-SIB framework.
Principle 11: In cases where the subsidiary of a bank is considered to be a D-SIB by a host authority, home and host authorities should make arrangements to coordinate and cooperate on the appropriate HLA requirement, within the constraints imposed by relevant laws in the host jurisdiction.
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42. The Committee recognises that there could be some concern that host authorities tend not to have a group-wide perspective when applying HLA requirements to subsidiaries of foreign banking groups in their jurisdiction. The home authorities, on the other hand, clearly need to know D-SIB HLA requirements on significant subsidiaries since there could be implications for the allocation of financial resources within the banking group. 43. In these circumstances, it is important that arrangements to coordinate and cooperate on the appropriate HLA requirement between home and host authorities are established and maintained, within the constraints imposed by relevant laws in the host jurisdiction, when formulating HLA requirements. This is particularly important to make it possible for the home authority to test the capital position of a parent on a stand-alone basis as mentioned in paragraph 38 and to prevent a situation where the home authorities are surprised by the action of the host authorities. Home and host authorities should coordinate and cooperate with each other on any plan to impose an HLA requirement on a subsidiary bank, and the amount of the requirement, before taking any action. The host authority should provide a rationale for their decision, and an indication of the steps the bank would need to take to avoid/reduce such a requirement. The home and host authorities should also discuss (i) The resolution regimes (including recovery and resolution plans) in both jurisdictions, (ii) Available resolution strategies and any specific resolution plan in place for the firm, and
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(iii) The extent to which such arrangements should influence HLA requirements.
Principle 12: The HLA requirement should be met fully by Common Equity Tier 1 (CET1). In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB.
44. The additional loss absorbency requirement for G-SIBs is to be met by CET1, as stated in the G-SIBs rules text (paragraph 87). The Committee considered the use of CET1 to be the simplest and most effective way to increase the going concern loss-absorbing capacity of a bank. HLA requirements for D-SIBs should also be fully met with CET1 to ensure a maximum degree of consistency in terms of effective loss absorbing capacity. This has the benefit of facilitating direct and transparent comparability of the application of requirements across jurisdictions, an element that is considered desirable given the fact that most of these banks will have cross-border operations being in direct competition with each other. In addition, national authorities should put in place any additional requirements and other policy measures they consider to be appropriate to address the risks posed by a D-SIB. 45. National authorities should implement the HLA requirement through an extension of the capital conservation buffer, maintaining the division of the buffer into four bands of equal size (as described in paragraph 147 of the Basel III rules text). This is in line with the treatment of the additional loss absorbency requirement for G-SIBs.
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The HLA requirement for D-SIBs is essentially a requirement that sits on top of the capital buffers and minimum capital requirement, with a pre-determined set of consequences for banks that do not meet this requirement. 46. In some jurisdictions, it is possible that Pillar 2 may need to adapt to accommodate the existence of the HLA requirements for D-SIBs. Specifically, it would make sense for authorities to ensure that a banks Pillar 2 requirements do not require capital to be held twice for issues that relate to the externalities associated with distress or failure of D-SIBs if they are captured by the HLA requirement. However, Pillar 2 will normally capture other risks that are not directly related to these externalities of D-SIBs (eg interest rate and concentration risks) and so capital meeting the HLA requirement should not be permitted to be simultaneously used to meet Pillar 2 requirement that relate to these other risks.
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Mario Draghi: Opening statement at Deutscher Bundestag
Speech by Mr Mario Draghi, President of the European Central Bank, at the discussion on ECB policies with Members of Parliament, Berlin *** Dear President Lammert, Honourable Committee Chairs, Honourable Members of the Bundestag, I am deeply honoured to be here today. As President of the European Central Bank (ECB), it is a privilege for me to come to the heart of German democracy to present our policy responses to the challenges facing the euro area economy. I know that central bank actions are often a topic of debate among politicians, the media and the general public in Germany. So I would like to thank President Lammert and all Committee Chairs most warmly for this kind invitation and the opportunity it gives me to participate in that discussion. It is rare for the ECB President to speak in a national parliament. The ECB is accountable to the European Parliament, where we have scheduled hearings every three months and occasional hearings on topical matters.
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We take these duties of accountability to the citizens of Europe and their elected representatives very seriously. But I am here today not only to explain the ECBs policies. I am also here to listen. I am here to listen to your views on the ECB, on the euro area economy and on the longer-term vision for Europe. To lay the ground for our discussion, I would like to explain our view of the current situation and the rationale for our recent monetary policy decisions. I will focus in particular on the Outright Monetary Transactions (OMTs) that we formally announced in September.
Financial markets and the disruptions of monetary policy transmission

Let me begin with the challenges facing the euro area. We expect the economy to remain weak in the near term, also reflecting the adjustment that many countries are undergoing in order to lay the foundations for sustainable future prosperity. For next year, we expect a very gradual recovery. Euro area unemployment remains deplorably high. In this environment, the ECB has responded by lowering its key interest rates. In normal times, such reductions would be passed on relatively evenly to firms and households across the euro area.
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But this is not what we have seen. In some countries, the reductions were fully passed on. In others, the rates charged on bank loans to the real economy declined only a little, if at all. And in a few countries, some lending rates have actually risen. Why did this divergence happen? Let me explain this in detail because it is so important for understanding our policies. A fundamental concept in central banking is what is known as monetary policy transmission. This is the way that changes in a central banks main interest rate are passed via the financial system to the real economy. In a well-functioning financial system, there is a stable relationship between changes to central bank rates and the cost of bank loans to firms and households. This allows central banks to influence overall economic conditions and maintain price stability. But the euro area financial system has become increasingly disturbed. There has been a severe fragmentation in the single financial market. Bank funding costs have diverged significantly across countries. The euro area interbank market has been effectively closed to a large number of banks and some countries entire banking systems.
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Interest rates on government bonds in some countries have risen steeply, hurting the funding costs of domestic banks and limiting their access to funding markets. This has been a key factor why banks have passed on interest rates very differently to firms and households across the euro area. Interest rates do not have to be identical across the euro area, but it is unacceptable if major differences arise from broken capital markets or the perception of a euro area break-up. The fragmentation of the single financial market has led to a fragmentation of the single monetary policy. And in an economy like the euro area where about three quarters of firms financing comes from banks, this has very severe consequences for the real economy, investment and employment. It meant that countries in economic difficulties could not benefit from our low interest rates and return to health. Instead, they were experiencing a vicious circle. Economic growth was falling. Public finances were deteriorating. Banks and governments were being forced to pay even higher interest rates. And credit and economic growth were falling further, leading to rising unemployment and reduced consumption and investment. A number of economies could have seen risks of deflation. All of this meant that the outlook for the euro area economy as a whole was increasingly fragile.
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There were potentially negative consequences for Europes single market, as access to finance was increasingly influenced by location rather than creditworthiness and the quality of the project. The disruption of the monetary policy transmission is something deeply profound. It threatens the single monetary policy and the ECBs ability to ensure price stability. This was why the ECB decided that action was essential.
Restoring the proper transmission of monetary policy

So let me now turn directly to our recent policy announcements. To decide what type of action was appropriate, we had to make two key assessments. First, we had to diagnose precisely why the transmission was disrupted. And second, we had to identify the most effective policy tool to repair those disruptions, while remaining within our mandate to preserve price stability. In our analysis, a main cause of disruptions in the transmission was unfounded fears about the future of the euro area. Some investors had become excessively influenced by imagined scenarios of disaster. They were therefore charging interest rates to countries they perceived to be most vulnerable that went beyond levels warranted by economic fundamentals and justifiable risk premia. Clearly, it was not by chance that some countries found themselves in a more difficult situation than others.
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It was mainly those countries that had implemented inappropriate economic policies in the past. This is also why the first responsibility in this situation is for countries to make determined reforms and convince markets that they are credible. But many were already doing this, only for interest rates to rise even higher. There was an element of fear in markets assessments that governments, acting alone, could not remove. Markets were not prepared to wait for the positive effects of reforms to emerge. In our view, to restore the proper transmission of monetary policy, those unfounded fears about the future of the euro area had to be removed. And the only way to do so was to establish a fully credible backstop against disaster scenarios. We designed the OMTs exactly to fulfil this role and restore monetary policy transmission in two key ways. First, it provides for ex ante unlimited interventions in government bond markets, focusing on bonds with a remaining maturity of up to three years. A lot of comments have been made about this commitment. But we have to understand how markets work. Interventions are designed to send a clear signal to investors that their fears about the euro area are baseless.
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Second, as a pre-requisite for OMTs, countries must have negotiated with the other euro area governments a European Stability Mechanism (ESM) programme with strict and effective conditionality. This ensures that governments continue to correct economic weaknesses while the ECB is active. The involvement of the IMF, with its unparalleled track record in monitoring adjustment programmes would be an additional safeguard.
The consequences of the ECBs actions

So what are the likely consequences of the ECBs actions? Before announcing the OMT programme, we considered very carefully the possible risks and we designed our operations to minimise them. But I am aware that some observers in this country remain concerned about the potential impact of this policy. I would therefore like to use this opportunity to go through those concerns one by one and explain our views. First, OMTs will not lead to disguised financing of governments. We have specifically designed our interventions to avoid this. They will take place solely on secondary markets, where bonds that have already been issued are traded. If interventions take place, they will involve buying government debt from investors, not from governments. All this is fully consistent with the Treatys prohibition on monetary financing.
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Moreover, they will focus on shorter maturities and leave room for market discipline. Second, OMTs will not compromise the independence of the ECB. The ECB will continue to take all decisions related to OMTs in full independence. It will decide whether to intervene based on its own assessment of monetary policy transmission and with the aim of safeguarding price stability. The fact that governments have to comply with conditionality will actually protect our independence. The ECB will not be forced to step in for a lack of policy implementation. Third, OMTs will not create excessive risks for euro area taxpayers. Such risks would only materialise if a country were to run unsound policies. This is explicitly prevented by the ESM programme. And we have been very clear that each time a programme starts being reviewed, we will routinely suspend operations and resume them only if the review has been concluded positively. This will ensure that the ECB intervenes only in countries where the economy and public finances are on a sustainable path. Fourth, OMTs will not lead to inflation. We have designed our operations so that their effect on monetary conditions will be neutral.
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For every euro we inject, we will withdraw a euro. In our assessment, the greater risk to price stability is currently falling prices in some euro area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it. Moreover, we see no signs that our announcement has affected inflation expectations. They continue to be firmly anchored. This is testament to our track record on price stability over the last decade and our credible commitment to maintaining price stability. The citizens of the euro area can be confident that we will remain permanently alert to risks to price stability. We have all the necessary tools at our disposal to maintain it and to withdraw any excess liquidity in case of upward risks to price stability.
Conclusion
Let me conclude these opening remarks. Three elements are essential for understanding the policies of the ECB: immutable focus on price stability; acting within our mandate; and being fully independent. The ECBs new measures help to ensure price stability across the euro area. They also contribute to improving the economic environment.
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But completing that task of economic renewal demands continuing action by the governments of the euro area. It is governments that must set right their public finances. It is governments that must reform their economies. And it is governments that must work together effectively to establish an institutional architecture for the euro area that best serves its citizens. We are already moving in the right direction. Across the euro area, deficits are being cut. Competitiveness is being improved. Imbalances are closing. And governments are working seriously to complete economic and monetary union. It is important that Europes leaders stay on course. In doing so, they will be able to unlock fully the enormous potential of the euro to improve living standards and carry forward the project of European integration. Thank you for your attention and I look forward to our discussion.
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Andreas Dombret: As goes Ireland, so goes Europe?

Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Institute of International and European Affairs, Dublin
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1. Introduction
Ladies and Gentlemen, Many thanks for inviting me to speak to you. I am delighted to have the opportunity to be with you here in Dublin today. One of the issues which the Institute of International and European Affairs features on its website is The Future of Europe. And, indeed, the future of Europe is at the centre of the current public debate. After nearly ten very successful years, the European Monetary Union has encountered a serious crisis. Over the past few months, we have seen some progress in this regard: a fiscal compact has been agreed, the ESM has come to life, there is preliminary agreement on a European Single Supervisory Mechanism, and most importantly more member states of the euro area have embarked on broader economic reforms. But the crisis is still not over, and progress is still too often painfully slow. When talking about the euro, the successes, the setbacks and the way forward, Ireland plays an important role. As an open and flexible economy with a highly skilled work force, Ireland
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has seized the opportunities presented by global and especially by European economic integration. When Ireland joined the EU in 1973, it was one of the poorer member states. Since then, your real per capita income has increased more than twofold and is today among the highest in the euro area. Ireland has benefited from several factors: low barriers in terms of language and culture vis vis the US and the UK have certainly helped, but Ireland also has done a lot to raise its growth potential by improving the skills of its labour force, lowering corporate taxes and maintaining flexible labour and product markets. As a result, you attracted a lot of Foreign Direct Investment and became a remarkably open economy. As we all know, this remarkable success story has suffered a number of setbacks. In the light of the crisis, some economic developments have proved unsustainable. The Irish real estate boom as so many others provided a temporary boost at the time, but raised private debt to worrying levels to 215 % of GDP in 2007 and diverted capital away from potentially more productive uses. Exploding unit labour costs have eroded the competitiveness of the Irish economy, undermining the very core of its growth model so far. But even though the last few years have been challenging, many signs point to a silver lining.
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There has been significant progress in reforms with the results to show for it: on-track deficit reduction, falling unit labour costs, a positive current account and last but not least a return to positive growth. To sum it up: I am very much confident with regard to the Irish case. And I am more and more convinced that we are witnessing a resurgence that is instructive for the euro area as a whole. The problems experienced by Ireland are by no means confined to the Green Island, but are typical of what went wrong in the run-up to the crisis. Thus, the reforms undertaken in Ireland hold valuable lessons for the wider monetary union. But what exactly did go wrong at the onset of EMU?
2. The origins of the crisis

For many euro-area member states, the introduction of the euro ushered in a new era of abundant capital. In the case of Ireland, for instance, capital inflows amounted to about two trillion euro between 1999 and 2008. In principle, this is exactly what standard economic reasoning predicts: capital was flowing from capital-rich to capital-poor economies, where returns should be higher. Such flows complemented limited domestic saving in capital-poor countries and reduced their cost of capital, boosting investment and growth. As we all know, it did not always work that way.
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Overblown financial sectors channeled the capital flows into unproductive investments. Ireland is certainly a case in point as light-touch regulation and tax incentives encouraged the financial sector to balloon. Overinvestment in real estate as well as in public and private consumption failed to boost productivity. Unit labour costs soared, competitiveness declined, and rigid labour and product markets meant that this process gained additional momentum. When the financial crisis broke out in 2007, the vulnerabilities became apparent in Ireland. Growth imploded, deficits which were often already too high before the crisis exploded, and cracks in the Irish banking system started to show. As an aside, you may recall that these cracks extended right into Germany, where Irish subsidiaries or special investment vehicles got their German parent companies into trouble. Not surprisingly, investor sentiment began to shift, and also interest rates in your country started to rise sharply, triggering a major crisis that is still far from being resolved. How could it all go so wrong? Key to understanding the crisis is the euro areas unique institutional set-up, a set-up that easily leads to simple, but faulty analogies with other economies. As you are well aware the euro area pairs a common monetary policy with 17 national fiscal policies.
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Firstly, this combination gives rise to a deficit bias, as it allows costs to be shifted partially on to others. If a worsening fiscal position in one country has repercussions for our monetary union as a whole, others may step in and bail out. And, secondly, central banks balance sheets can serve as a conduit for shifting risks among national taxpayers, even if there are no explicit fiscal transfers. The founding fathers of the euro foresaw this risk. Precautions were taken in the form of the prohibition of monetary financing of government deficits, price stability as the primary objective, the no-bail-out clause and the Stability and Growth Pact that was to give teeth to the rules on sound public finances enshrined in the Maastricht Treaty. However, the fiscal rules were breached numerous times, not least by Germany and France. In addition, investors made hardly any distinction between the bonds of individual member states I leave it to you to decide whether this was because they neglected the growing differences in the economic fundamentals or because they never really believed that the no-bail-out clause would hold once the going got tough. While the provisions against unstable fiscal positions proved to be insufficient, the institutional framework took no account of other macroeconomic imbalances. Risks stemming from divergences in competitiveness or exaggerations in national real estate sectors were not considered in the design of the European Monetary Union.
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Hence, even countries that had impressive fiscal data before the crisis ran into deep trouble once the enormous implicit liabilities in their banking sectors became apparent. Ireland, unfortunately, was one of those countries. Assessing the Irish economy in 2007 the IMF which I quote for convenience, not to blame it wrote: Fiscal policy has been prudent, with a medium-term fiscal objective of close to balance or surplus, in line with Fund advice. In the past couple [of] years, windfall property-related revenues were saved and the fiscal stance was not procyclical, in line with Fund advice. However, once the risks in the financial sector materialised and the government had to step in, Irelands fiscal position deteriorated very quickly.
3. The way forward

To overcome the current crisis, and to prevent future crises, we have to address these problems I have just described. And this has to happen both nationally and at the European level. So far, a number of steps have been taken. At the beginning of my speech I mentioned the ESM, to which I might add the fiscal compact and the new excessive imbalance procedure that has been established to prevent macroeconomic developments from diverging too much in the future. Nevertheless, the painful task of correcting past mistakes lies mainly with the member states.
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In this context I wish to point to Ireland as a good example of what has to be done and what can be achieved. In this regard I view Ireland as a role model of the periphery. I have already mentioned the decline in competitiveness that occurred prior to the crisis. In this respect Ireland certainly had a steep mountain to climb. In 2008, Irish unit labour costs, as an indicator of competitiveness, were more than 40% higher than at the launch of EMU. Still, not least thanks to flexible labour markets, the necessary adjustment has been swifter in Ireland than in other member states. There was a similar experience with the bubble in the Irish real estate market. Your problems became apparent earlier than in other member states, with property prices starting to fall in the last quarter of 2007. Hence, Ireland responded earlier than other countries, and in a determined manner, to a shock which, as of today, has cut property prices in half. As a result, the restructuring of the banking sector is more advanced and costs for bank loans to firms are now lower than in countries such as Italy or Spain. This highlights the fact that it is sometimes better to take a big bath rather than just a shower. And it is better to take it as soon as possible because the water typically gets colder as time passes by.
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But the situation in your country also highlights something else: the dangerous link between banks and sovereigns. Looking to the future, this link has to be broken, or at least to be weakened considerably, to prevent history from repeating itself. Let me first step back and take a look at why the close link between banks and sovereigns has proven to be so problematic and so dangerous in this crisis. If many banks run into trouble at the same time, possibly on account of a large asset bubble bursting, financial stability as a whole is threatened. The government then often has no option but to step in if it wants to prevent a meltdown of the real economy. But such a rescue can place a huge burden on government finances and no country knows that better than Ireland, where support for the financial sector was a major factor why the debt ratio soared from 25% of GDP in 2007 to 108% in 2011. Conversely, weak government finances can destabilise banks directly through their exposure to sovereign bonds, and, indirectly, through worsening macroeconomic conditions. That is what we are also witnessing at this very moment. Thus, breaking the link between banks and sovereigns is vital for making the euro area more stable. A banking union can very well be a major step in that direction but by harnessing the disciplinary forces of the market, not by doing away with them. Core elements of a banking union therefore have to be:
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First, a comprehensive bail-in of bank creditors, and second, an appropriate risk-weighting of sovereign bonds. In order to minimise the risk that bank rescues pose to government finances, creditors have to be the first in line when it comes to bearing banks losses. Implicit guarantees have to be removed as taxpayers money can only be the last resort. By the same token, sovereign bonds need to be risk-weighted appropriately when it comes to the adequacy of capital buffers. Riskier bonds have to become more expensive in terms of the amount of equity that they tie down, as is already the case for non-sovereign bonds. This serves two purposes: On the one hand, surcharges of this kind should translate into lower demand and, hence, into larger spreads, which gives a disciplining signal to the respective sovereign. And, on the other hand, banks would become more resilient in the event of market turmoil. Adequate risk-weighting of sovereign bonds helps to prevent fiscal difficulties from translating directly into financial instability. If fiscal autonomy remains with national member states, which is still the status quo in the EU Treaties, this is crucial. Banks have to internalise the fiscal position of sovereigns in a similar manner as they take into account the risk of corporate bonds or loans. Otherwise, the envisaged recapitalisation of banks via European funds could turn out to be a backdoor for mutualising sovereign solvency risks. I therefore believe that these two regulatory reforms a comprehensive bail-in of creditors as well as an adequate risk-weighting of sovereign
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bonds need to complement the envisaged European supervisory mechanism. In principle, this single European supervisor can help prevent future crises by enforcing the same high standards irrespective of the banks country of origin and by taking transnational interdependencies into account. At the moment, it looks as though this task shall be carried out by the European Central Bank. This is, first of all, an expression of confidence in the competence of central banks in general and in the ECB in particular. But conducting monetary policy and financial supervision does not come without risks. If the institution responsible for ensuring the financial soundness of banks simultaneously influences banks financing conditions via its monetary policy, conflicts of interest may arise. Besides, the resolution of banks implies intervening in property rights, which requires democratic accountability. If the ECB is to be tasked with supervising European banks, there will have to be a strict separation of monetary policy and supervision. Such a separation will be difficult from both a legal and an organisational point of view. In this respect, there still are questions that need to be resolved. A banking union will contribute to financial stability, if its design preserves sound incentives for all actors involved.
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This holds true not only for future risks, but also for risks that have already materialised. Economically speaking, a banking union is basically an insurance mechanism. And, as with any insurance, only future losses or damages that are unknown ex ante can be covered. No doubt, the banking union is an important building block for a more stable monetary union. But, as such, it is meant to mitigate future risks and not to cover past sins. In this context, I fully understand that Ireland is closely following the conditions under which euro-area member states will provide financial assistance to Spain for the recapitalisation of its financial institutions. One specific point is the degree of bondholders participation in the Spanish restructuring process. The Eurogroup stated in July with respect to Ireland: Similar cases will be treated equally, taking into account changed circumstances. However, as this issue is currently under discussion I prefer abstaining from public comments. Instead I like to share my view with you on the issue of legacy assets in general. Legacy assets are those risks which evolved under the responsibility of national supervisors. From what I have already said, it follows that these assets have to be dealt with by the respective member states.
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Anything else would amount to a fiscal transfer. It may be that such fiscal transfers are desired or even deemed necessary. But then, they should be conducted via national budgets and subject to approval of national parliaments, rather than under the guise of a banking union, which would then have to start under a heavy burden. And, in the event of such transfers the proper sequencing of events is the key. We should not end up in a world where risks from bank balance sheets are rapidly mutualised, while an effective single supervisory mechanism would be slow in coming. A banking union will therefore not be a quick fix. But it can be an important milestone towards a more stable and prosper monetary union and hence instrumental in regaining confidence in the euro area. Ireland has already come a long way in this regard, as your successful return to the capital markets in July has shown. Trust has been regained because Ireland has walked the talk. And I am sure you agree: Any deviation from this climb when the mountaintop is already in sight would be both short-sighted and costly. More precisely, when listening to the discussion on more leniency for Greece, I can understand that demanding similar adjustments to the Irish programme seem tempting at first glance. But as we have learned the hard way over the last years, trust is as easily lost as it is hard to regain.
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Ireland has made enormous progress in the process of regaining trust and confidence. Important financial market indicators are an expression of this fact. CDS premia for the Irish sovereign have fallen continuously in 2012. In the meantime Irish CDS premia are below those of Spain and even Italy. The same development can be observed for the spread over German bunds. All of these developments are the result of leading by example with structural reforms. Hence, I see no reason for Irish CDS changing the course, and I doubt that this would truly be in Irelands best interest. I suggest not to jeopardise what has been achieved so far.
4. Conclusion
Ladies and gentlemen, When we talk about Europe, Ireland is such an interesting example for a number of reasons. First, it highlights the benefits of a unified Europe which still leaves its member states enough room to establish their own model of success Ireland has certainly seized that opportunity. But the Irish experience at the same time also illustrates some of the things that have gone wrong in Europe over the past decade, and I have mentioned many of them in my speech. Nevertheless, and even more importantly, the Irish experience holds valuable lessons on how to overcome the current crisis.
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Of course, Ireland has not yet overcome all of its problems every country is different and challenges are never exactly the same. But I believe we all can learn a great deal from the Irish way of handling the crisis: As goes Ireland, so goes Europe. Let me conclude my speech with the single most important and most encouraging lesson we can draw from the Irish experience: Yes, it can be done. Thank you for your attention.
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Goldman Sachs Group Interesting numbers before the Basel III deadlines
The Goldman Sachs Group, Inc. (NYSE: GS) reported net revenues of $8.35 billion and net earnings of $1.51 billion for the third quarter ended September 30, 2012. Diluted earnings per common share were $2.85 compared with a diluted loss per common share of $0.84 for the third quarter of 2011 and diluted earnings per common share of $1.78 for the second quarter of 2012. Annualized return on average common shareholders equity (ROE) was 8.6% for the third quarter of 2012 and 8.8% for the first nine months of 2012. The firms global core excess liquidity was $170 billion as of September 30, 2012. In addition, the firms Tier 1 capital ratio under Basel 1 was 15.0% and the firms Tier 1 common ratio under Basel 1 was 13.1% as of September 30, 2012.
Capital
As of September 30, 2012, total capital was $241.57 billion, consisting of $73.69 billion in total shareholders equity (common shareholders equity of $68.34 billion and preferred stock of $5.35 billion) and $167.88 billion in unsecured long-term borrowings. Book value per common share was $140.58 and tangible book value per common share was $129.69, both approximately 3% higher compared with the end of the second quarter of 2012.
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Book value and tangible book value per common share are based on common shares outstanding, including restricted stock units granted to employees with no future service requirements, of 486.1 million at period end. On September 4, 2012, The Goldman Sachs Group, Inc. (Group Inc.) issued 5,000 shares of Perpetual Non-Cumulative Preferred Stock, Series F (Series F Preferred Stock), for aggregate proceeds of $500 million. During the quarter, the firm repurchased 11.8 million shares of its common stock at an average cost per share of $106.17, for a total cost of $1.25 billion. The remaining share authorization under the firms existing repurchase program is 34.2 million shares. Under the regulatory capital guidelines currently applicable to bank holding companies (Basel 1), the firms Tier 1 capital ratio was 15.0% and the firms Tier 1 common ratio was 13.1% as of September 30, 2012, both unchanged compared with June 30, 2012.
Other Balance Sheet and Liquidity Metrics

The firms global core excess liquidity was $170 billion as of September 30, 2012 and averaged $175 billion for the third quarter of 2012, compared with an average of $174 billion for the second quarter of 2012. Total assets were $949 billion as of September 30, 2012, unchanged compared with June 30, 2012. Level 3 assets were $48 billion as of September 30, 2012, compared with $47 billion as of June 30, 2012 and represented 5.0% of total assets.
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Basel 3
In addition, the U.S. federal bank regulatory agencies issued revised proposals to modify their market risk regulatory capital requirements for banking organizations in the United States that have significant trading activities. The modifications are designed to address the adjustments to the market risk framework that were announced by the Basel Committee in June 2010 (Basel 2.5), as well as the prohibition on the use of credit ratings, as required by the Dodd-Frank Act. We expect the federal banking agencies to propose further modifications to their capital adequacy regulations to address both Basel 3 and other aspects of the Dodd-Frank Act, including requirements for global systemically important banks. Once implemented, it is likely that these changes will result in increased capital requirements, although their full impact will not be known until the U.S. federal bank regulatory agencies publish their final rules. The Dodd-Frank Act also establishes a Bureau of Consumer Financial Protection having broad authority to regulate providers of credit, payment and other consumer financial products and services, and this Bureau has oversight over certain of our products and services.
Managements Discussion and Analysis

We are currently working to implement the requirements set out in the Federal Reserve Boards Risk-Based Capital Standards: Advanced Capital Adequacy Framework Basel 2, as applicable to us as a bank holding company (Basel 2), which are based on the advanced approaches under the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee.
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U.S. banking regulators have incorporated the Basel 2 framework into the existing risk-based capital requirements by requiring that internationally active banking organizations, such as us, adopt Basel 2, once approved to do so by regulators. As required by the Dodd-Frank Act, U.S. banking regulators have adopted a rule that requires large banking organizations, upon adoption of Basel 2, to continue to calculate risk-based capital ratios under both Basel 1 and Basel 2. For each of the Tier 1 and Total capital ratios, the lower of the Basel 1 and Basel 2 ratios calculated will be used to determine whether the bank meets its minimum risk-based capital requirements. The U.S. federal bank regulatory agencies have issued revised proposals to modify their market risk regulatory capital requirements for banking organizations in the United States that have significant trading activities. These modifications are designed to address the adjustments to Basel 2.5, as well as the prohibition on the use of credit ratings, as required by the Dodd-Frank Act. Once implemented, it is likely that these changes will result in increased capital requirements for market risk. Additionally, the guidelines issued by the Basel Committee in December 2010 (Basel 3) revise the definition of Tier 1 capital, introduce Tier 1 common equity as a regulatory metric, set new minimum capital ratios (including a new capital conservation buffer, which must be composed exclusively of Tier 1 common equity and will be in addition to the minimum capital ratios), introduce a Tier 1 leverage ratio within international guidelines for the first time, and make substantial revisions to the computation of RWAs for credit exposures. Implementation of the new requirements is expected to take place over the next several years.
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Although the U.S. federal banking agencies have now issued proposed rules that are intended to implement certain aspects of the Basel 2.5 guidelines, they have not yet addressed all aspects of those guidelines or the Basel 3 changes. The Basel Committee has published its final provisions for assessing the global systemic importance of banking institutions and the range of additional Tier 1 common equity that should be maintained by banking institutions deemed to be globally systemically important. The additional capital for these institutions would initially range from 1%to 2.5% of Tier 1 common equity and could be as much as 3.5% for a bank that increases its systemic footprint (e.g., by increasing total assets). The firm was one of 29 institutions identified by the Financial Stability Board (established at the direction of the leaders of the Group of 20) as globally systemically important under the Basel Committees methodology. Therefore, depending upon the manner and timing of the U.S. banking regulators implementation of the Basel Committees methodology, we expect that the minimum Tier 1 common ratio requirement applicable to us will include this additional capital assessment. The final determination of whether an institution is classified as globally systemically important and the calculation of the required additional capital amount is expected to be disclosed by the Basel Committee no later than November 2014 based on data through the end of 2013. The Dodd-Frank Act will subject us at a firmwide level to the same leverage and risk-based capital requirements that apply to depository institutions and directs banking regulators to impose additional capital requirements as disclosed above. The Federal Reserve Board is expected to adopt the new leverage and risk-based capital regulations in 2012.
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As a consequence of these changes, Tier 1 capital treatment for our junior subordinated debt issued to trusts will be phased out over a three-year period beginning on January 1, 2013. The interaction among the Dodd-Frank Act, the Basel Committees proposed changes and other proposed or announced changes from other governmental entities and regulators adds further uncertainty to our future capital requirements.
Internal Capital Adequacy Assessment Process

We perform an ICAAP with the objective of ensuring that the firm is appropriately capitalized relative to the risks in our business. As part of our ICAAP, we perform an internal risk-based capital assessment. This assessment incorporates market risk, credit risk and operational risk. Market risk is calculated by using Value-at-Risk (VaR) calculations supplemented by risk-based add-ons which include risks related to rare events (tail risks). Credit risk utilizes assumptions about our counterparties probability of default, the size of our losses in the event of a default and the maturity of our counterparties contractual obligations to us. Operational risk is calculated based on scenarios incorporating multiple types of operational failures. Backtesting is used to gauge the effectiveness of models at capturing and measuring relevant risks.
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We evaluate capital adequacy based on the result of our internal risk-based capital assessment, supplemented with the results of stress tests which measure the firms performance under various market conditions. Our goal is to hold sufficient capital, under our internal risk-based capital framework, to ensure we remain adequately capitalized after experiencing a severe stress event. Our assessment of capital adequacy is viewed in tandem with our assessment of liquidity adequacy and integrated into the overall risk management structure, governance and policy framework of the firm. We attribute capital usage to each of our businesses based upon our internal risk-based capital and regulatory frameworks and manage the levels of usage based upon the balance sheet and risk limits established.
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Progress note on the Global LEI Initiative

This is the third of a series of notes on the implementation of the legal entity identifier (LEI) initiative. Following endorsement of the FSB report and recommendations by the G-20, the FSB LEI Implementation Group (IG) has been tasked with taking forward the planning and development work to launch the global LEI system by March 2013. The IG is collaborating closely with private sector experts through a Private Sector Preparatory Group (PSPG) of some 300 members from 25 jurisdictions across the globe.
Charter for the Regulatory Oversight Committee (ROC):

The IG has prepared a draft Charter for the Regulatory Oversight Committee for review and endorsement by the FSB and G20. The draft was supported by the FSB at its recent meeting in Tokyo for submission to the early November G20 Finance Ministers and Central Bank Governors meeting for final endorsement. Approval of the Charter will initiate the process for the ROC to be formed. ROC membership will be open to public authorities from across the globe that assent to the Charter. Authorities will also be able to apply for Observer status. The objective is to launch the ROC as the permanent governance body for the global LEI system in January 2013.
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Location and legal form of the global LEI foundation:

Formation of the ROC is a necessary step for the creation of the global LEI foundation which is the legal form for the Central Operating Unit. The location and exact legal form of the global LEI foundation will have a bearing on the overall governance framework for the Global LEI System. The IG and PSPG have analysed potential locations for the foundation and have now initiated a detailed assessment of a narrow set of potential candidates. The results of the assessment will facilitate the drafting of the necessary legal documentation to establish the foundation and will be presented at the first meeting of the ROC.
Board of Directors of the LEI foundation:

One of the first tasks for the ROC will be the appointment of the initial Board of Directors. PSPG members are working closely with the IG to develop criteria for fitness, experience, regional and sectoral balance, term of office etcetera that will support the process for nomination and selection of the first Board and deliver a governance framework for the global LEI foundation to help sustain the public good nature of the system. The PSPG presented a number of initial recommendations and options related to these criteria for the Board of Directors on 16 October; the proposals are currently being reviewed by the IG and the final version of the recommendations will be presented at the first meeting of the ROC.
Operational Solutions Demonstration Day:

The FSB hosted a Global LEI System Operational Solution Demonstration Day in Basel on 15 October.
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Thirteen presentations from across the globe were made that contained proposals and solutions covering all or part of the proposed global LEI system as set out in the FSB report.
Business Processes and Use Cases:

PSPG members presented an initial set of deliverables containing business processes and use cases for the operational elements of the global LEI system at the joint PSPG and IG meeting on 16 October. PSPG members have already undertaken detailed work in some areas and will expand on a strong base. The next phase of the operational work is to build on these specification documents, focusing on how the system can best address a number of key issues in relation to areas such as data quality, addressing local languages, as well as how to draw most effectively on local infrastructure to deliver a truly global federated LEI system. The PSPG are requested to prepare clear proposals and recommendations by the end of the year, in order to support a successful and speedy launch of the global LEI system.
Number allocation scheme for the global LEI system:

On 12 September, the IG requested an engineering study from PSPG experts to determine which scheme for the management of the issue of identifiers best serves the purposes of the global LEI system. Following receipt of response and discussion with private sector experts at the 16 October PSPG meeting, the IG prepared a recommendation for the technical specification of the LEI code structure which has been endorsed by the FSB Plenary.
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Annex sets out the FSB decision to adopt a structured approach to the number allocation scheme, whereby LOUs are assigned a unique prefix. The FSB decision is provided now to deliver clarity and certainty to the private sector on the approach to be taken by potential pre-LEI systems that will facilitate the integration of such local precursor solutions into the global LEI system.
Ownership and hierarchy data:

Addition of information on ownership and corporate hierarchies is essential to support effective risk aggregation, which is a key objective for the global LEI system. The IG is developing proposals for additional reference data on the direct and ultimate parent(s) of legal entities and on relationship (including ownership) data more generally and will prepare initial recommendations by the end of 2012. The IG is working closely with the PSPG to develop the proposals.
Annex: Number Allocation Scheme for the Global LEI System implications for local pre-LEI Issuers and other early movers
In response to requests for early clarity and guidance on the determination of the number allocation scheme for the management of identifiers for the Global LEI System, the FSB Implementation Group requested an engineering study from the FSB LEI Private Sector Preparatory Group (PSPG) experts to explore the advantages and disadvantages of different schemes. The FSB is very grateful for all of the responses and for the contributions of members of the PSPG. While there are a range of different schemes to manage the issue of identifiers that fit the characteristics of the 20 digit code (including two
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check digits) approach outlined in the ISO 17442 standard, for simplicity those schemes can be categorised into two general groups: - An unstructured numbering system one where an 18 character unique identifier fills the whole numbering spectrum; - A structured numbering system one where subsets of the spectrum of possible codes are partitioned for efficient allocation according to a structural guideline; for instance, an N digit prefix could be assigned to each Local Operating Unit (LOU) for its exclusive use. On the basis of the arguments presented, the FSB has concluded that a structured number offers the best approach for the Global LEI System. The following method is to be used: - Characters 1-4: A four character prefix allocated uniquely to each LOU. - Characters 5-6: Two reserved characters set to zero. - Characters 7-18: Entity-specific part of the code generated and assigned by LOUs according to transparent, sound and robust allocation policies. - Characters 19-20: Two check digits as described in the ISO 17442 standard. Public authorities wishing to sponsor local pre-LEI issuance that would transition to the LEI system should ensure that new numbers are allocated according to the above guideline. Pre-LEI solutions wishing to transition into the Global LEI System upon its launch shall be required to adopt the numbering scheme outlined above no later than 30 November 2012.
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This approach does not affect ISO 17442 compliant numbers issued prior to that date. Once the global LEI system is in place, pre-LEI codes issued according to the ISO 17442 standard (and if issued after November 30, complying with the above guideline and thus embodying an appropriate 4 digit prefix) will be transitioned into LEIs, subject to meeting the agreed global LEI standards, including survival rules adopted by the ROC or the COU in the exceptional cases where entities have multiple ISO 17442 compliant pre-LEI identifiers. The LEI will be portable within the global LEI system, implying that the LEI code may be transferred from one LOU to another. Each LOU should immediately transfer an LEI to a different LOU following the request of the LEI registrant or an LOU acting on its behalf without any financial or operational hindrance. Each LOU must consequently have the capability to take over responsibility for LEIs issued by other LOUs. Given the importance to the system of ensuring high data quality, recommendation 18 of the FSB LEI report highlighted that the LEI system should promote the provision of accurate LEI reference data at the local level from LEI registrants, and that self-registration should be encouraged as a best practice for the global LEI system. To provide force to this recommendation, the FSB has agreed that pre-LEI services should henceforth be based on self-registration. From November 9, all pre-LEI systems will allow self-registration only. Authorities sponsoring pre-LEI issuers are expected to sign the ROC Charter once it is approved by the G20.
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The FSB welcomes the report of the Enhanced Disclosure Task Force
The Financial Stability Board (FSB) welcomes the publication of the Report of the Enhanced Disclosure Task Force (EDTF) and views it as a valuable step to improve the quality of risk disclosures. The EDTFs principles and recommendations for improved bank risk disclosures and leading disclosure practices are designed to provide timely information useful to investors and other users, which together with current regulatory developments and standard setter recommendations can contribute, over time, to improved market confidence in financial institutions. The FSB encourages banks to continue to strive to improve risk disclosures. The EDTF was formed in May at the initiative of the FSB. The task force represents a unique private sector initiative one that brings together on a global basis, senior officials and experts from financial institutions, investors, and audit firms to develop recommendations for enhancing risk disclosure practices by major banks starting with end-year 2012 annual risk disclosures and continuing into 2013 and beyond.
1. Background
It has been five years since the beginning of the financial crisis and the publics trust in financial institutions has yet to be fully restored.
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Investors today are more sensitive to the complexity and opacity of banks business models and credit spreads for financials remain persistently higher than for similarly-rated corporates. Moreover, in some markets, banks still need significant liquidity support from the public sector. Many banks are now trading at market values below their book values, which is in marked contrast to the past. Investors and other public stakeholders are demanding better access to risk information from banks; information that is more transparent, timely and comparable across institutions. In response, international regulators and standard setters have taken a range of steps to improve the quality and content of the financial disclosures of banks, including initiatives by the Financial Stability Board (FSB)1 in 2011 and the Senior Supervisors Group2 in 2008. Banks have also made efforts to improve disclosures, both individually and collectively. This report differs in one crucial respect: it has been developed among private sector stakeholders as a joint initiative representing both users and preparers of financial reports. By bringing together the perspectives of leading global banks, investors, analysts and external auditors, this report seeks to establish a benchmark for high-quality risk disclosures, with specific emphasis on enhancements that can be implemented in the short term, particularly in 2012 and 2013 annual reports. High-quality risk disclosures should be viewed as a collective public good given the systemic importance of banks and the contingent liability they represent for taxpayers.
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Poor quality disclosures can result in higher uncertainty premiums, and this can undermine the extension of credit needed to support employment and productive investments in struggling economies, and affect its price. Disclosures that describe risks and risk management practices transparently help to build confidence in the firms management, which is particularly important in attracting debt and equity investors and may in turn support higher equity valuations. By enhancing investors understanding of banks risk exposures and risk management practices, high-quality risk disclosures may reduce uncertainty premiums and contribute to broader financial stability. For well-managed firms, the benefits of proactively enhancing risk disclosures are clear.
2. Objectives and process

The Enhanced Disclosure Task Force (EDTF) was established by the FSB in May 2012 following an FSB roundtable in December 2011 of eighty-two senior officials and experts from around the world. The roundtable outlined broad goals for improving the quality, comparability and transparency of risk disclosures, while reducing redundant information and streamlining the process for bringing relevant disclosures to the market quickly. With the goal of improving the risk disclosures of banks and other financial institutions, the primary objectives of the EDTF were to: i. Develop fundamental principles for enhanced risk disclosures; ii. Recommend improvements to current risk disclosures, including ways to enhance their comparability; and
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iii. Identify examples of best or leading practice risk disclosures presented by global financial institutions. Membership of the EDTF had wide geographical representation and included senior executives from leading asset management firms, investors and analysts, global banks, credit rating agencies and external auditors. To organise its work and the resulting recommendations, the EDTF established six workstreams reflecting banks primary risk areas, and each task force member was allocated to a workstream so that they comprised both users and preparers of financial reports. The workstreams were as follows: i. risk governance and risk management strategies/business model; ii. capital adequacy and risk-weighted assets; iii. liquidity and funding; iv. market risk; v. credit risk; and vi. other risks. Each workstream analysed current disclosures in its risk area by reviewing a sample of banks recent annual and interim reports, Pillar 3 reports and other publicly available information, such as media releases and presentations to investors. On the basis of that analysis, and following extensive discussion among its members, each workstream developed recommendations for enhancing disclosures in its respective risk area, and presented them to the EDTF plenary for further consideration.
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The task force had plenary meetings in London, New York, Singapore and Frankfurt, and held two additional meetings by telephone. During those meetings, the EDTF thoroughly debated and challenged each recommendation proposed by the workstreams. As a result, the recommendations in this report represent the collective views and expertise of the EDTF membership. Also, at key stages in its work, the Co-chairs of the EDTF engaged in dialogue with securities and banking regulators and supervisors, accounting standard-setters, banking associations and other stakeholder organisations located in Europe, North America, Latin America, the Middle East and Asia. Minutes of these meetings were circulated to EDTF members and, during the plenary meetings, the Co-chairs gave oral accounts of these stakeholder organisations views on risk disclosure issues, including any initiatives underway to address risk disclosure issues. Prior to its finalisation, a draft of the report was circulated by the EDTF to key stakeholder organisations, including the International Banking Federation and the Institute of International Finance, and feedback was solicited on its content. Working within the EDTFs compressed timetable for providing comments, these international organisations expeditiously distributed the document to their respective memberships and provided the EDTF with invaluable feedback. The task force considered the input received from its extensive outreach programme as well as the views of the EDTF membership in the development and finalization of this report.
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3. Scope and other considerations Scope of the recommendations in this report

The fundamental principles are applicable to all banks. However, the EDTF has developed the recommendations for enhanced risk disclosures with large international banks in mind, although they should be equally applicable to banks that actively access the major public equity or debt markets. Some of the recommendations, therefore, are likely to be less applicable to smaller banks and subsidiaries of listed banks and the EDTF would expect such entities to adopt only those aspects of the recommendations that are relevant to them. This report was not specifically developed for other types of financial services organisations, such as insurance companies, though the fundamental principles and recommendations contained herein may provide some appropriate guidance. Banks will need to continue to comply with the relevant securities laws and reporting requirements applicable to their activities, and will also need to assess any relevant confidentiality and other jurisdictional legal issues. In addition, all banks, including the large international ones, will need to assess factors specific to their circumstances such as the materiality, costs and benefits of each recommendation in this report. In making these assessments, banks should consider their users needs and expectations and may wish to speak directly to their key stakeholders as they begin to implement changes.
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The EDTF acknowledges that existing jurisdictional differences in accounting and regulatory requirements may affect how banks implement the recommendations, and may make it difficult to achieve full comparability between banks across jurisdictions.
Timing of implementation
The EDTF believes that many of the recommendations can be adopted in 2012 or 2013, for example, those that involve only the re-ordering or aggregation of existing disclosures in banks reports to enable users to find and assimilate information more quickly, or those that are based on information that is already reported to management. However, other recommendations may take longer to develop and implement, particularly where banks need to create new systems and processes to ensure that the information required to support the enhanced disclosure is of high quality, and thus the EDTF envisages enhancements of the risk disclosures of banks continuing after 2013. The EDTF also recognises that banks have other commitments with similar timelines, such as implementing Basel II or Basel III and the Globally Systemically Important Banks (G-SIB) data template. Some of the recommendations are dependent on the finalisation or implementation of particular regulatory rules and, thus, cannot be adopted until then.
Frequency of disclosures
This report has been produced in the context of the existing legal and regulatory requirements for banks public reporting. Banks produce annual reports, which contain audited financial statements and management commentary (including risk commentary), and interim reports.
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Some banks also produce preliminary announcements before their annual or interim reports are available. Interim reports and preliminary announcements are intended to provide users with timely updates on the banks last annual report. The recommendations do not suggest changing the requirements for interim reporting, which vary from market to market. However, the EDTF thinks that several areas in the report should be disclosed more frequently than in annual reports, and thus that more risk disclosures would be included in interim reports than is currently the case. Banks should consider whether their interim reports contain relevant risk information to support the financial information presented and whether such reports provide a sufficient update on top and emerging risks.
Location of disclosures
In making its recommendations, the EDTF generally does not specify where any new disclosure should be made, nor does it suggest that banks change the current location of their reported information when adopting the enhancements. Banks should retain flexibility in what they choose to disclose in their annual reports and other filings, such as their Pillar 3 reports. However, the EDTF expects many of the detailed regulatory capital disclosures will remain in or will be added to the Pillar 3 report. Consistent with the FSBs recommendation in 2011, the task force advocates, as part of the fundamental principles, that annual reports and Pillar 3 reports should be published at the same time, and believes that this would provide users with complete and timely reporting across the key areas of interest.
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It is not the intention of this report to create a checklist of all possible risk disclosures or to reproduce existing disclosure requirements set forth in accounting and regulatory standards. Banks will need to assess the recommendations in this report in the light of how they apply the existing disclosure requirements in their jurisdictions. Indeed, those extensive existing requirements may contribute to both preparers views that financial reporting is a compliance exercise and users difficulties in navigating long annual reports. This can be a particular concern for international banks that must meet varying and sometimes overlapping disclosure requirements in different jurisdictions. As a result, some banks may question whether the benefits of increased transparency justify the additional investment in resources, management attention and the potential risks involved in making forward-looking statements. This report addresses these concerns by recommending ways for banks to communicate important disclosures to users more effectively and efficiently.
4. Fundamental principles for risk disclosure

The EDTF has collectively identified seven principles for enhancing risk disclosures, which both underpin the recommendations set out in this report and provide an enduring framework for future work on risk disclosures. These principles provide a firm foundation from which to achieve transparent, high-quality risk disclosures that enable users to understand in an integrated manner a banks7 business and its risks, and the resultant effects on its performance and financial position.
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The seven fundamental principles for enhanced risk disclosures are: 1. Disclosures should be clear, balanced and understandable. 2. Disclosures should be comprehensive and include all of the banks key activities and risks. 3. Disclosures should present relevant information. 4. Disclosures should reflect how the bank manages its risks. 5. Disclosures should be consistent over time. 6. Disclosures should be comparable among banks. 7. Disclosures should be provided on a timely basis.
Principle 1: Disclosures should be clear, balanced and understandable.

- Disclosures should be written with the objective of communicating information to a range of users (i.e. investors, analysts and other stakeholders) rather than simply complying with minimum requirements. The disclosures should be sufficiently granular to benefit sophisticated users but should also provide summarised information for those who are less specialised, along with clear signposting to enable navigation through the information. Disclosures should be organised so that key information and messages are prioritised and easy to find.
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- There should be an appropriate balance between qualitative and quantitative disclosures, using text, numbers and graphical presentations. Fair and balanced narrative explanations should provide insight into the implications of the quantitative disclosures and any changes or developments that they portray. - Disclosures should provide straightforward explanations for more complex issues. Descriptions and terms should fairly represent the substance of the banks activities. Terms used in the disclosures should be explained or defined.
Principle 2: Disclosures should be comprehensive and include all of the banks key activities and risks.
- Disclosures should provide an overview of the banks activities and its key risks. They should include a description of how the bank identifies, measures, manages and reports each risk, highlighting any significant internal or external changes during the reporting period and the key actions taken by management in response. - Disclosures should include informative explanations of important processes and procedures as well as underlying cultures and behaviours that affect the banks business and its risk generation or risk management. Disclosures of such items should enable users to obtain an understanding of the banks risk management operations and the related governance by the banks board and senior management.
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- When appropriate and meaningful, disclosures should be complemented with information about key underlying assumptions and sensitivity or scenario analysis. Such analysis should demonstrate the effect on selected risk metrics or exposures of changes in the key underlying assumptions, both in qualitative and quantitative terms.
Principle 3: Disclosures should present relevant information.

- The bank should provide disclosures only if they are material and reflect its activities and risks and can be prepared without unreasonable cost. Accordingly, disclosures should be eliminated if they are immaterial or redundant. Disclosing immaterial information or information on situations that do not apply to the bank reduces the relevance of its disclosures and undermines the ability of users to understand them. However, when exposures receiving significant current market attention are either immaterial or nonexistent, the bank should acknowledge this fact to reduce uncertainty among users. Moreover, banks should avoid generic or boilerplate disclosures that do not add value or do not communicate useful information. - Disclosures should be presented in sufficient detail to enable users to understand the nature and extent of the banks risks. Where period-end information may not be representative of the risks, consideration should be given to providing averages and high and low balances during the period.
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The type of information, the way in which it is presented and the accompanying explanatory notes will differ between banks and will change over time, but information should be reported at the level of detail that users need in order to understand the bank, its risk appetite, its exposures and the manner in which it manages its business and risks, including in stress conditions. - The bank should explain its business model to provide context for its business and risk disclosures. In many cases, disclosures will focus on the consolidated group. However, understanding the risks relative to returns embedded in key operating subsidiaries and business divisions and the way that risks are shared or assets, liabilities, income and costs are allocated across the group can be key to users understanding of the risks to which the group is exposed.
Principle 4: Disclosures should reflect how the bank manages its risks.
- Disclosures should be based on the information that is used for internal strategic decision making and risk management by key management, the board and the boards risk committee. Approaches to disclosure should be sufficiently flexible to allow banks to reflect their particular circumstances in both narrative and quantitative terms. - The bank should explain the risk and reward profile of its activities. Disclosures should be representative of risk exposures during the period, as well as at the end of the period. - If disclosure of particularly commercially sensitive or otherwise confidential information would unduly expose the bank to litigation
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or other risks, the level of information provided will need to balance confidentiality and materiality. If material, a bank should assess what information should be provided to ensure users are aware of important issues without disclosing potentially damaging confidential details.
Principle 5: Disclosures should be consistent over time.

- Disclosures should be consistent over time to enable users to understand the evolution of the banks business, risk profile and management practices. Core disclosures should not change dramatically but should evolve over time, allowing for inter-period comparisons. - Changes in disclosures and related approaches or formats (e.g. due to changes in risk practices, emerging risks, measurement methodologies or accounting or regulatory requirements) should be clearly highlighted and explained. Presenting comparative information is helpful; however, in some situations it may be preferable to include a new disclosure even if comparative information cannot be prepared or restated.
Principle 6: Disclosures should be comparable among banks.

- Disclosures should be sufficiently detailed to enable users to perform meaningful comparisons of businesses and risks between different banks, including across various national regulatory regimes. Disclosures that facilitate users understanding of the banks exposures compared with its competitors are of particular importance in building users understanding and confidence as well as reducing the risk of inappropriate comparisons.
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Principle 7: Disclosures should be provided on a timely basis.

- Information should be delivered to users in a timely manner using appropriate media (e.g. annual and interim reports, websites, news releases, or regulatory reports). The bank should seek to release to the market all relevant and important risk-based information at the same time (e.g. the annual report and Pillar 3 disclosures). Equally important are regular updates of financial information; users need more frequent updates than just the annual report. This can be accomplished through various means and media; thus banks should endeavour to provide frequent updates to their users to ensure financial information remains up to date. The EDTF acknowledges that in some cases there will be tension between two or more fundamental principles. For example, under Principles 4 and 5, disclosures are most useful if they provide information that reflects how the bank manages its risks and are consistent over time while, under Principle 6, disclosures should enable users to perform meaningful comparisons between banks. Similarly, there can be tension within a single principle. For example, Principle 1 states that disclosures should be clear, balanced and understandable, but users have differing views on the level of detail that is needed to achieve that objective. Even sophisticated users find that some granular disclosures, which may be provided to comply with particular regulatory or accounting requirements, are difficult to use or understand unless they are accompanied by summarised information.
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Tension may also arise if investors seek information that is too commercially sensitive for banks to disclose. The EDTF believes that these tensions do not reflect a fault or weakness in the fundamental principles but are inevitable given the varying, and sometimes competing, needs of users, preparers and regulators. Banks should endeavour, both individually and collectively, to find an appropriate balance among the principles, and indeed within particular principles, without creating excessive disclosures that will overwhelm users. Users should provide ongoing feedback to banks about whether they are achieving an appropriate balance. It is acknowledged that the applications of the principles will differ between risk areas and may change over time. The aim of the fundamental principles, and the recommendations that follow from them, is to address investors concerns about the quality and transparency of banks disclosures. However, users already have considerable knowledge of topics such as general business risks, finance and current economic conditions, and a banks disclosures are not the sole source of information available to them. This report builds on that existing knowledge and information, and seeks to avoid developing disclosures that would duplicate information that should already be known, apparent or readily accessible from other sources.
5. Recommendations for enhancing risk disclosures

The EDTF has identified the following recommendations for enhancing risk disclosures.
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Additionally, there are eight examples in the appendix to this section that illustrate how particular recommendations could be adopted to produce clear and understandable disclosures. Section 6 provides additional commentary that expands on these recommendations.
General
1: Present all related risk information together in any particular report. Where this is not practicable, provide an index or an aid to navigation to help users locate risk disclosures within the banks reports. 2: Define the banks risk terminology and risk measures and present key parameter values used. 3: Describe and discuss top and emerging risks, incorporating relevant information in the banks external reports on a timely basis. This should include quantitative disclosures, if possible, and a discussion of any changes in those risk exposures during the reporting period. 4: Once the applicable rules are finalised, outline plans to meet each new key regulatory ratio, e.g. the net stable funding ratio, liquidity coverage ratio and leverage ratio and, once the applicable rules are in force, provide such key ratios.
Risk governance and risk management strategies/business model

5: Summarise prominently the banks risk management organisation, processes and key functions.
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6: Provide a description of the banks risk culture, and how procedures and strategies are applied to support the culture. 7: Describe the key risks that arise from the banks business models and activities, the banks risk appetite in the context of its business models and how the bank manages such risks. This is to enable users to understand how business activities are reflected in the banks risk measures and how those risk measures relate to line items in the balance sheet and income statement. 8: Describe the use of stress testing within the banks risk governance and capital frameworks. Stress testing disclosures should provide a narrative overview of the banks internal stress testing process and governance.
Capital adequacy and risk-weighted assets

9: Provide minimum Pillar 1 capital requirements, including capital surcharges for G-SIBs and the application of counter-cyclical and capital conservation buffers or the minimum internal ratio established by management. 10: Summarise information contained in the composition of capital templates adopted by the Basel Committee to provide an overview of the main components of capital, including capital instruments and regulatory adjustments. A reconciliation of the accounting balance sheet to the regulatory balance sheet should be disclosed. 11: Present a flow statement of movements since the prior reporting date in regulatory capital, including changes in common equity tier 1, tier 1 and tier 2 capital.
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12: Qualitatively and quantitatively discuss capital planning within a more general discussion of managements strategic planning, including a description of managements view of the required or targeted level of capital and how this will be established. 13: Provide granular information to explain how risk-weighted assets (RWAs) relate to business activities and related risks. 14: Present a table showing the capital requirements for each method used for calculating RWAs for credit risk, including counterparty credit risk, for each Basel asset class as well as for major portfolios within those classes. For market risk and operational risk, present a table showing the capital requirements for each method used for calculating them. Disclosures should be accompanied by additional information about significant models used, e.g. data periods, downturn parameter thresholds and methodology for calculating loss given default (LGD). 15: Tabulate credit risk in the banking book showing average probability of default (PD) and LGD as well as exposure at default (EAD), total RWAs and RWA density for Basel asset classes and major portfolios within the Basel asset classes at a suitable level of granularity based on internal ratings grades. For non-retail banking book credit portfolios, internal ratings grades and PD bands should be mapped against external credit ratings and the number of PD bands presented should match the number of notch -specific ratings used by credit rating agencies. 16: Present a flow statement that reconciles movements in RWAs for the period for each RWA risk type.
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17: Provide a narrative putting Basel Pillar 3 back-testing requirements into context, including how the bank has assessed model performance and validated its models against default and loss.
Liquidity
18: Describe how the bank manages its potential liquidity needs and provide a quantitative analysis of the components of the liquidity reserve held to meet these needs, ideally by providing averages as well as period-end balances. The description should be complemented by an explanation of possible limitations on the use of the liquidity reserve maintained in any material subsidiary or currency.
Funding
19: Summarise encumbered and unencumbered assets in a tabular format by balance sheet categories, including collateral received that can be rehypothecated or otherwise redeployed. This is to facilitate an understanding of available and unrestricted assets to support potential funding and collateral needs. 20: Tabulate consolidated total assets, liabilities and off-balance sheet commitments by remaining contractual maturity at the balance sheet date. Present separately (i) Senior unsecured borrowing (ii) Senior secured borrowing (separately for covered bonds and repos) and (iii) Subordinated borrowing.
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Banks should provide a narrative discussion of managements approach to determining the behavioural characteristics of financial assets and liabilities. 21: Discuss the banks funding strategy, including key sources and any funding concentrations, to enable effective insight into available funding sources, reliance on wholesale funding, any geographical or currency risks and changes in those sources over time.
Market risk
22: Provide information that facilitates users understanding of the linkages between line items in the balance sheet and the income statement with positions included in the traded market risk disclosures (using the banks primary risk management measures such as Value at Risk (VaR)) and non-traded market risk disclosures such as risk factor sensitivities, economic value and earnings scenarios and/or sensitivities. 23: Provide further qualitative and quantitative breakdowns of significant trading and nontrading market risk factors that may be relevant to the banks portfolios beyond interest rates, foreign exchange, commodity and equity measures. 24: Provide qualitative and quantitative disclosures that describe significant market risk measurement model limitations, assumptions, validation procedures, use of proxies, changes in risk measures and models through time and descriptions of the reasons for back-testing exceptions, and how these results are used to enhance the parameters of the model. 25: Provide a description of the primary risk management techniques employed by the bank to measure and assess the risk of loss beyond reported risk measures and parameters, such as VaR, earnings or economic value scenario results, through methods such as stress tests, expected shortfall, economic capital, scenario analysis, stressed VaR or other alternative approaches.
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The disclosure should discuss how market liquidity horizons are considered and applied within such measures.
Credit risk
26: Provide information that facilitates users understanding of the banks credit risk profile, including any significant credit risk concentrations. This should include a quantitative summary of aggregate credit risk exposures that reconciles to the balance sheet, including detailed tables for both retail and corporate portfolios that segments them by relevant factors. The disclosure should also incorporate credit risk likely to arise from offbalance sheet commitments by type. 27: Describe the policies for identifying impaired or non-performing loans, including how the bank defines impaired or non-performing, restructured and returned-to-performing (cured) loans as well as explanations of loan forbearance policies. 28: Provide a reconciliation of the opening and closing balances of non-performing or impaired loans in the period and the allowance for loan losses. Disclosures should include an explanation of the effects of loan acquisitions on ratio trends, and qualitative and quantitative information about restructured loans. 29: Provide a quantitative and qualitative analysis of the banks counterparty credit risk that arises from its derivatives transactions. This should quantify notional derivatives exposure, including whether derivatives are over-the-counter (OTC) or traded on recognised exchanges.
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Where the derivatives are OTC, the disclosure should quantify how much is settled by central counterparties and how much is not, as well as provide a description of collateral agreements. 30: Provide qualitative information on credit risk mitigation, including collateral held for all sources of credit risk and quantitative information where meaningful. Collateral disclosures should be sufficiently detailed to allow an assessment of the quality of collateral. Disclosures should also discuss the use of mitigants to manage credit risk arising from market risk exposures (i.e. the management of the impact of market risk on derivatives counterparty risk) and single name concentrations.
Other risks
31: Describe other risk types based on managements classifications and discuss how each one is identified, governed, measured and managed. In addition to risks such as operational risk, reputational risk, fraud risk and legal risk, it may be relevant to include topical risks such as business continuity, regulatory compliance, technology, and outsourcing. 32: Discuss publicly known risk events related to other risks, including operational, regulatory compliance and legal risks, where material or potentially material loss events have occurred. Such disclosures should concentrate on the effect on the business, the lessons learned and the resulting changes to risk processes already implemented or in progress.
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Appendix to Section 5
The following appendix includes eight examples of possible disclosure formats to assist banks in adopting the recommendations in this report. These examples reflect instances where investors have suggested that consistent tabular presentation is particularly important to improving their understanding of the disclosed information and facilitating comparability among banks. All numbers included in the Figures are for illustrative purposes. It is understood that differing business models, reporting regimes and materiality will affect how banks provide such information.
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Core Tier 1 (CET1) Capital

In addition to those items illustrated on the previous page, the line item other, including regulatory adjustments and transitional arrangements may include (as per applicable regime): - common share capital issued by subsidiaries and held by third parties; - other movements in shareholders equity; - reserves arising from property revaluation; - defined benefit pension fund adjustment; - cash flow hedging reserve; - shortfall of provisions to expected losses;
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- securitisation positions; - investments in own CET1; - reciprocal cross-holdings in CET1; - investments in the capital of unconsolidated entities (less than 10%); - significant investments in the capital of unconsolidated entities (amount above 10% threshold); - mortgage servicing rights (amount above 10% threshold); - deferred tax assets arising from temporary differences (amount above 10% threshold); - amounts exceeding 15% threshold; and - regulatory adjustments applied due to insufficient additional tier 1.
Other non-core tier 1 (additional tier 1) capital

The line item other, including regulatory adjustments and transitional arrangements may include (as per applicable regime): - other non-core tier 1 capital (additional tier 1) instruments issued by subsidiaries and held by third parties; - unconsolidated investments deductions; - investments in own additional tier 1 instruments; - reciprocal cross-holdings; - significant investments in the capital of unconsolidated entities;
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- other investments in the capital of unconsolidated entities; - grandfathering adjustments; - regulatory adjustments applied due to insufficient tier 2 capital; and - currency translation differences.
Tier 2 Capital
The line item other, including regulatory adjustments and transitional arrangements may include (as per applicable regime): - tier 2 capital instruments issued by subsidiaries and held by third parties; - unconsolidated investments deductions; - investments in own tier 2 instruments; - reciprocal cross-holdings; - significant investments in the capital of unconsolidated entities; - other investments in the capital of unconsolidated entities; - collective impairment allowances; - grandfathering adjustments; and - currency translation differences.
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6. Additional commentary on areas identified for enhanced risk Disclosures

This section describes the EDTFs views on current risk disclosure practices, recognizing areas of leading practice and those which could be enhanced. The section also reproduces the recommendations and provides additional explanatory guidance designed to place them in context and highlight their importance to users.
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Banks will need to continue to comply with securities laws and reporting requirements relevant to their operations to ensure that they are not breached, and assess appropriate confidentiality and other jurisdictional legal issues, particularly where the disclosure of commercially sensitive information would threaten a banks stability or possess the potential to give rise to systemic risk. They will also wish to consider factors specific to their circumstances such as the materiality, costs and benefits of disclosures. The additional commentary accords with the fundamental principles and expands on the recommendations set out in Section 5 of this report. The enhanced disclosures emphasise relevance, consistency or comparability, depending on the importance of the principle to a particular area. Users need to understand how the bank manages risk and be able to make comparisons over time and between reporting organisations. The EDTF recognises that differences in regulatory and accounting requirements in different jurisdictions may make it difficult to achieve comparability and it will take time to improve this, but it remains an aim of enhanced disclosures. The EDTFs recommendations are organised within the following seven broad risk areas, which are the major categories of risk for banks: 6.1 risk governance and risk management strategies/business model; 6.2 capital adequacy and risk-weighted assets; 6.3 liquidity; 6.4 funding;
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6.5 market risk; 6.6 credit risk; and 6.7 other risks. Many of these risk areas are inter-related. For example, reputational risk may be addressed as part of other risks but may also be a key driver of risk governance.
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Report to G20 Finance Ministers and Central Bank Governors on Basel III implementation Introduction and summary
The G20 Leaders met in Los Cabos in June 2012. At this Summit, they endorsed the work of the Basel Committee on Banking Supervision in monitoring the global implementation of its standards, and urged jurisdictions to meet their commitments. We welcome progress in implementing Basel II, 2.5 and III and urge jurisdictions to fully implement the standards according to the agreed timelines. This report updates the G20 Finance Ministers and Central Bank Governors on the progress made by Basel Committee member jurisdictions in implementing the Basel III standards (including Basel II and Basel 2.5, which now form integral parts of Basel III). It also highlights specific areas that require attention if the goal of achieving timely and consistent implementation is to be achieved. The Basel Committee believes that full, timely and consistent implementation of Basel III by its members is essential for restoring confidence in the regulatory framework for banks and to help ensure a safe and stable global banking system. The transitional phase for implementing the Basel III package commences on 1 January 2013, by when all jurisdictions should have in place the necessary regulations.
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At the time of this report, eight of the 27 member jurisdictions of the Basel Committee have issued their final set of Basel III related regulations, 17 members have published draft regulations, and two members are currently in the process of drafting regulations but have not yet published them. Given their commitment, and the fact that the transitional date is a publically announced one, it is especially important that member jurisdictions that are home to global systemically important banks (G-SIBs) make every effort to issue final regulations as soon as possible in order to meet the transition period deadline. To facilitate proper implementation and follow up, the Basel Committee has begun to assess the consistency of these regulations and progress with implementation against 14 core elements of the Basel framework. As a first step, the Committee conducted detailed assessments of the content and substance of the final regulations implementing the Basel III package in Japan, and the draft regulations in the European Union and the United States. While noting implementation progress in all three jurisdictions, the assessments have identified areas of divergence from the globally agreed Basel standards. In the case of Japan, no material deviations were observed and the jurisdiction is assessed overall as compliant. In the European Union and the United States, 4 there were a few deviations in the draft regulations that were assessed to be of a material nature (for securitisation related regulations in the United States, and for regulations covering the definition of capital and the internal ratings-based (IRB) approach in the European Union). All other elements in both jurisdictions were either compliant or largely compliant.
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Given the importance of making the banking system more resilient, it is essential that the Basel framework is implemented consistently and according to the globally-agreed timelines. The Basel Committee therefore urges the G20 Finance Ministers and Central Bank Governors to call on (i) All Basel Committee jurisdictions to meet the globally agreed deadline; (ii) The European and United States authorities, and others who undergo a Basel Committee regulatory consistency assessment, to close any identified gaps between their regulations and Basel III and; (iii) All jurisdictions to ensure their implementation of Basel III remains timely and consistent with the internationally agreed package of reforms. The Basel Committee also continues to perform detailed analysis of the variations in risk-weighted assets across banks, across jurisdictions and over time, both for assets in the banking book and in the trading book. This report includes preliminary conclusions of this analysis. More detailed assessment reports, potentially including policy recommendations, where appropriate, will be considered by the Committee later in 2012 and in early 2013.
Basel standards
In June 2004, a package of reforms known as Basel II introduced more risk-sensitive minimum capital requirements for banks, including an enhanced measurement of credit risk, and capture of operational risk. Basel II also reinforced the requirements by setting out principles for banks to assess the adequacy of their capital and for supervisors to review
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such assessments to ensure banks have the necessary capital to support their risks. It also strengthened market discipline by enhancing disclosure requirements. The deadline for implementation of the Basel II framework by member jurisdictions was the end of 2006. In July 2009, the Committee introduced enhancements to the Basel II framework in response to lessons from the financial crisis. These reforms, referred to as Basel 2.5, relate to the measurement of risks for calculating regulatory capital for securitisation and trading book exposures (Pillar 1), risk management and supervisory review (Pillar 2) and disclosure (Pillar 3). A deadline for implementing these reforms was set for end 2011. In December 2010, the Basel Committee published Basel III, a comprehensive set of reforms to raise the resilience of banks, supplementing Basel II and 2.5 in a number of dimensions. Basel III addresses both firm-specific and broader, systemic risks by: Raising the quality of capital, with a focus on common equity, and the quantity of capital to ensure banks are better able to absorb losses; Enhancing the coverage of risk, in particular for capital market activities; Introducing capital buffers which should be built up in good times so that they can be drawn down during periods of stress; Introducing an internationally harmonised leverage ratio to serve as a backstop to the risk-based capital measure and to contain the build-up of excessive leverage in the system;
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Introducing minimum global liquidity standards to improve banks resilience to acute short term stress and to improve longer term funding; and Introducing additional capital buffers for the most systemically important institutions to address the issue of too big to fail. The implementation period for Basel III capital requirements starts from 1 January 2013 and includes transitional arrangements until 1 January 2019. The transitional arrangements are available to give banks time to meet the higher standards, while still supporting lending to the economy. The liquidity requirements, leverage ratio and systemic surcharges come into force in a phased approach starting from 2015. The implementation of these rules will, therefore, be assessed later6 and are not covered in this report.
Design of the Committees Basel III Implementation Review Programme

In January 2012, the Group of Central Bank Governors and Heads of Supervision (GHOS), the Basel Committees oversight body, endorsed the comprehensive process proposed by the Committee to monitor members implementation of Basel III. The process consists of the following three levels of review: Level 1: ensuring the timely adoption of Basel III; Level 2: ensuring regulatory consistency with Basel III; and Level 3: ensuring consistency of outcomes (initially focusing on risk-weighted assets).
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The Basel Committee has published three Level 1 progress reports. It has completed a Level 2 review of Japan, and has released preliminary reports on the European Union and the United States. In addition, it has commenced an assessment of Singapore. The Committees Level 3 reviews are conducting detailed assessments of banks models to compute capital charges for the banking and trading book, based on test portfolios, information obtained from questionnaires and visits to individual banks. The Basel Committee has worked in close collaboration with the Financial Stability Board, (FSB) given the FSBs role in coordinating the monitoring of implementation of regulatory reforms. The Committee designed its programme to be consistent with the FSBs Coordination Framework for Monitoring the Implementation of Financial Reforms (CFIM) agreed by the G20. The objectives and the process of each of the three levels of review are as follows.
Level 1: Timely adoption of Basel III

The objective of the Level 1 assessment is to ensure that Basel III is transformed into domestic regulations according to the agreed international timelines. It does not include the review of the content or substance of the domestic rules. Each Basel Committee member jurisdictions status is reported in a simple table.
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Separately, the Financial Stability Institute (FSI) of the Bank for International Settlements is surveying non-Basel Committee member countries and has published the results.
Level 2: Regulatory consistency

The objective of the Level 2 assessments is to ensure compliance of domestic regulations with the international minimum requirements. The Level 2 assessments are conducted by teams of 6-7 specialists with a diverse range of technical skills from independent jurisdictions. The reviews take place over a period of six months and include a detailed self-assessment, on-site visits and an assessment of the materiality of divergences. Multiple layers of cross-checking and peer review exist to ensure a fair and rigorous process and consistent treatment across reviews. All Basel Committee members will be assessed over time. The Committee decided to prioritise its reviews, focusing first on the home jurisdictions of global systemically important banks (G-SIBs). The first three reviews of the draft regulations in the European Union and the United States, and final rules in Japan have been concluded in September and the reports are available on the BIS website.
Level 3: Risk-weighted assets consistency

The objective of the Level 3 assessments is to ensure that the outcomes of the rules are in line with the intended policy objectives in practice across banks and jurisdictions.
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It extends the scope of Levels 1 and 2, both of which focus on national rules and regulations, to supervisory implementation at the bank level. The Committee has established two expert groups, one for the banking book and one for the trading book. These groups are identifying and analysing areas of material variability and inconsistencies in the calculation of risk-weighted assets (RWAs, or the denominator of the Basel capital ratio). Depending on the outcome, the work may result in policy recommendations to address identified inconsistencies.
Progress and findings to date Level 1

Basel II, which was due to come into force from end 2006, has been implemented in full by three-quarters of member jurisdictions. Of the five countries that have not yet fully implemented Basel II, two are home countries of G-SIBs China and the United States. Both countries are in the process of assessing their banks progress toward meeting all the qualifying criteria for the advanced approaches. The other countries that are still in the process of implementing Basel II are Argentina, Indonesia and Russia. Basel 2.5, which was due to be implemented by Basel Committee members by end 2011, has been implemented by 20 of the 27 member jurisdictions. China, Saudi Arabia and the United States have issued final regulations for Basel 2.5 that come into effect from 1 January 2013.
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Basel III regulations are due to come into effect from 1 January 2013. While progress can be observed, only eight of the 27 Basel Committee member jurisdictions have thus far issued final regulations Australia, China, Hong Kong SAR, India, Japan, Saudi Arabia, Singapore and Switzerland. This means there is now a high probability that just six of the 29 global systemically important banks identified by the FSB in November 2011 will be subject to Basel III regulations from the globally agreed start date.
Level 2
The assessment of the European Union analysed the 5th Danish compromise versions of the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD4). The assessment judged 12 of the 14 key components as either compliant or largely compliant. A materially non-compliant rating was assigned in two areas: Definition of capital and internal ratings-based (IRB) approach to credit risk. The review identified a number of areas of material (or potentially material) deviation in the draft regulations relating to the definition of capital, which are described in more detail in the report. For IRB credit risk, the material finding relates to the permanent partial use which allows IRB banks to risk-weight sovereign exposures according to the standardised approach (eg subject those claims denominated and funded in local currency to a 0% risk weight). A subsequent review will take place on the final regulations once available.
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It should be noted that the European Commission disagrees with these conclusions and believes that the findings overstate the degree of divergence from the Basel standards and that the section gradings have not been assigned consistently across jurisdictions. The assessment of Japan was based on final regulations that will come into force from end March 2013 in line with the end of the fiscal year in Japan. Each of the 13 key components was assessed as either compliant or largely compliant. For capital buffers (capital conservation and countercyclical), the domestic rules are not yet in place and hence the finding is not yet assessed. The Japanese authorities plan to issue the rules by 2015, ie one year before the 2016 deadline. The overall grade of compliant is based on three facts/observations (i) The number of gaps is relatively low, (ii) Gaps were found to be non-material, both in isolation and in aggregate, and (iii) The review recognised secondary legislation as generally binding. The assessment of the United States was based on final rules implementing advanced approaches, the final rule on market risk and three notices of proposed rulemaking (NPRs) issued in June 2012. The assessment has highlighted the overarching issue of prolonged parallel run for banks on the advanced IRB and the advanced measurement approach (AMA), the only available options for credit and operational risk in the United States.
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At the time of the report, none of the core US banks had received permission to exit the transitional parallel run. As a result, US banks continue to determine their capital requirements based primarily on the Basel I framework, and the review noted there is little incentive for some core banks to move onto the more advanced approaches. The US assessment team judged 12 of the 13 key components as compliant or largely compliant. A materially non-compliant rating was assigned to securitisation exposures. It was noted that the US regulatory agencies proposed implementation must conform with the prohibition on the use of external credit ratings, as required by the Dodd-Frank Act. The US authorities were unable to demonstrate that their alternative formulation of the rules would not result in weaker capital requirements than the Basel requirements. This will be subject to further follow-up analysis once final rules are in place. The US authorities believe that the US implementation of securitisation is likely to be at least as robust as the Basel standards.
Level 3 Analysis of risk-weighted assets in the banking book

The Committee is also evaluating sources of material differences in risk-weighted assets (RWAs) across banks in the banking book.
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The Committee is assessing the extent to which differences in credit risk parameters based on the IRB approach for credit risk are driven by differences in risk levels or differences in practices in the latter case the Committee will discuss whether the variations are consistent with relevant Basel standards.
Review of existing studies

The Committee has reviewed a wide range of existing analyses of RWAs across banks and countries to assess methodologies and identify possible drivers of RWA differences. The various studies highlighted many potential drivers, most of which suggested that RWA differences are driven by both risk-based and practice-based factors, although the relative focus on different drivers vary and no study could pinpoint the definitive causes of RWA differences. The review highlighted important lessons for the Committees own analytical work: There is a need to carry out both top-down and bottom-up analyses while recognising the limitations of each method; Better analysis would be facilitated by using more complete (including non-public) data sources, and by collecting new and better data directly from selected banks; and An assessment of differences in specific practices by banks, national supervisors, and other sources such as accounting standards authorities can help better identify and understand ultimate drivers of RWA differences.
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Top-down analysis
Drawing on these lessons, the Committee is undertaking further top-down analysis using supervisory data collected by the Committee as part of ongoing capital monitoring. The analysis covers 56 large, internationally active banking organisations and 44 non-internationally active banking organisations in 15 jurisdictions. Preliminary findings indicate that corporate and retail exposures are the largest contributors to credit RWA and show the greatest variability in portfolio risk-weights across banks and countries. Risk-weights for bank and sovereign exposures may vary significantly across banks as well, but these asset classes are less significant contributors to credit RWA variations because of their low absolute risk-weights. Probability of default (PD) appears to be a significant source of RWA variability for the corporate, bank and sovereign asset classes. Loss given default (LGD) appears to be the more important risk parameter for the retail asset class, although LGD also is an important contributor to RWA variability for corporates.
Bottom-up portfolio benchmarking

The Committee is also conducting a bottom-up portfolio benchmarking exercise using a test portfolio of common exposures to supplement its top-down analysis. Thirty-three banks from 13 jurisdictions participated in the exercise by reporting PD and LGD estimates for a set of sovereign, bank, and corporate exposures.
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The data submitted by the banks is being reviewed to assess the variability of PD and LGD estimates across banks for common obligors and exposures.
Range of practices and on-site visits

Recognising the importance of overlaying the analytical work with an assessment of differences in bank and regulatory practices, the Committee has developed a list of potentially important practice-based drivers of RWA differences. This work draws on existing supervisory knowledge and judgement of the significance and prevalence of different practices. Based on this initial list of drivers and taking into account the preliminary findings from the top-down analysis, the Committee has identified certain risk measures (like probability of default) as areas where thematic reviews would be fruitful. Depending on the results of these thematic reviews as well as the top-down and bottom-up analytical work, there may be a need to conduct more focused reviews of practices through on-site visits to banks in 2013.
Future direction
In early 2013, the Committee expects a final report summarising all findings regarding the relative importance of various sources and drivers of RWA variation, as well as the extent to which RWA differences do or do not reflect underlying differences in risk. Based on the conclusions of the work, the Committee may consider changes related to reporting and disclosure, as well as possible narrowing of the range of practices in some areas.
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Finally, the Committee will consider recommendations or options for ongoing monitoring and supervisory activities to foster RWA consistency in the future.
Analysis of risk-weighted assets in the trading book

The Committee is working on completing the analysis of variability of market risk measures across banks. The analysis is primarily based on publicly available information, but also considers the variability of supervisory data. Furthermore a test portfolio exercise has been undertaken, in which 15 large, internationally active banks participated. The Committee expects to publish some results of this analysis by the end of this year.
Publicly available information and supervisory data

The analysis based on publicly available information so far reveals material differences in the ratio of the regulatory measure of market risk (market-risk RWA or mRWA) to total trading assets across the selected sample. To the extent that such differences are driven by differences in risk taking for example as a result of differences in business models or trading strategies the variation should not be a cause for concern. An analysis of the composition of trading assets provides some support to this view, as it shows that banks with a higher ratio of mRWA to total trading assets typically have a greater proportion of risky trading assets on the balance sheet, including distressed debt and illiquid equity.
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However, even after addressing these factors, there remains material unexplained variation in mRWA across banks. Other possible factors that might explain such a variation are: Differences in supervisory approaches (such as the timing of Basel 2.5 adoption); Differences in the use of capital add-ons or multipliers; Methodological choices; or The degree of reliance of banks on internal model approaches versus standardised approaches. A key finding is that data available in public information generally does not appear sufficient to fully explain the variation in mRWA across banks, nor to explain the variation in mRWA for a single bank over time. Limits to the detail of public disclosure can be explained by banks desire to keep their trading strategies and positions private for competitive reasons. However these shortcomings in disclosure make cross-bank comparison difficult. Some banks provide more detailed and useful disclosures than others and minimal guidance across jurisdictions adds to inconsistencies in content. In some jurisdictions, Basel II Pillar 3 reports were not available for the analysis. The Committee is therefore considering broadening its analysis to investigate the utility of consistent supervisory data in explaining differences in mRWA.
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An initial finding is that supervisory data collection, while consistent within jurisdictions, is not consistent across jurisdictions. Some jurisdictions collect only limited additional data for supervisory purposes. It must be noted, however, that in some jurisdictions efforts are underway to improve the regulatory data collection related to banks trading books. These supervisory efforts may suggest options for more consistent patterns of disclosure across banks.
Test portfolio exercise

To further examine the modelling choices that potentially drive differences in mRWA, the Committee conducted a test portfolio exercise. The test portfolios and accompanying questionnaires were designed to cover a range of trading portfolios and trading strategies, which closely represented but were generally less complex than banks actual portfolios and trading strategies. A total of 15 large, internationally active banks from nine jurisdictions participated in the exercise. The participating banks calculated for each hypothetical test portfolio the outcome of their internally modelled risk measures and provided detailed information regarding their modelling assumptions through supplemental questionnaires. This allowed the Committee to identify modelling choices that drive potential variation in mRWA. To investigate the results in more detail, a programme of on-site visits was initiated in which 9 participating banks were visited by international teams of supervisors.
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The objective of the visits was to gain further understanding of the market risk models that the banks use and to investigate in more detail the causes of variability identified across banks. The initial results from the test portfolio exercise suggest there is generally less variability observed for internal models that have been in use for a long time. In addition, the variability is generally less for models where there are more regulatory constraints.
Next steps
The Committee will further elaborate on the initial findings and possible policy options. Regarding the analysis of public data, one expectation of the outcome of this exercise could be suggestions related to improvements in public disclosures for mRWA calculations. With regard to the analysis of the test portfolio exercise, a final quantification of the level of variability of each internal model for each portfolio in the exercise is expected. The findings will also serve as input for the Committees current fundamental review of the trading book. The analysis suggests that there is a direct relationship between complexity of risk metric/product and the associated variability of the metric across banks. The current test portfolio exercise was based on a set of plain vanilla portfolios and excluded the most complex market risk models that are used by banks.
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The Committee believes it is important to consider more complex products and models in a future exercise. A follow-up test portfolio exercise including more complex portfolios is therefore being considered for 2013.
Further work Level 1

The Committee will continue to publish progress reports every six months. The next report will be published in April 2013 showing the position as at end March 2013.
Level 2
A Level 2 assessment of Singapore is underway and the report will be published in April 2013. A review of Switzerland will commence in early 2013 followed by China in the second quarter. Reviews of Australia, Brazil and Canada will commence in the second half of 2013. Follow-up reviews of the European Union and the United States will commence after final regulations are published and will cover the final rules in their entirety. The reviews will assess whether identified gaps have been rectified but will also check for issues that were not present in the draft regulations. At present, the Committee is conducting a lessons learnt review to reflect on the experience of the first three Level 2 reviews.
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Level 3
Findings of the Level 3 assessments for the banking book and trading book will be reported to the Committee around the end of 2012 or early 2013. Further analysis will be conducted in 2013, and, subject to decisions at a later stage, will continue on an ongoing basis. Further policy development work may be necessary to address the findings.
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Feedback on comments received from stakeholders to the EBA, EIOPA and ESMAs Joint Consultation Paper
on its proposed response to the European Commissions Call for Advice on the Fundamental Review of the Financial Conglomerates Directive
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The Irish banking sector five challenges

Address by Mr Matthew Elderfield, Deputy Governor of the Central Bank of Ireland, to the Association of Compliance Officers in Ireland, University College Cork, Cork Completing the task of fixing the Irish banking system is not an end in itself. A healthy functioning banking system is essential to the economic well-being of Ireland. It is essential for breaking the damaging link between a distressed banking system and weak public finances. And it is important for economic recovery that the banks are once again in a position to lend to small businesses and homeowners. But despite the considerable effort that has gone in to recapitalising, shrinking, restructuring and otherwise reforming the banking system, the process is by no means complete and significant challenges remain. How much longer will this process take and what can be done to speed it up? It may be a source of considerable frustration that this process is not yet over, but considering the severity of the banking crisis in Ireland, compounded with the on-going Eurozone debt crisis, it is perhaps not a surprise. What then are the remaining challenges that need to be tackled to speed up and complete the process of fixing the banks?
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I would highlight such challenges: problem portfolios, balance sheet restructuring, profitability, culture and capital. Let me take some time today to talk about each of these in turn.
Problem portfolios
While the banks have transferred their troubled commercial property loans to NAMA (and are selling down their non-core portfolios), they retain their legacy portfolio of mortgage, SME and other assets which have a high level of arrears, impairment and embedded losses. A lot of work has been undertaken to assess the quality of these assets and to ensure both that adequate capital is held against them and that adequate accounting provisions are held (following new guidance from the Central Bank). So, a much greater level of capital has been set aside against the risk of loss and higher levels of prudent provisions are now in place. However, more work remains to be done in order to develop a more precise and clear picture of the performance and degree of embedded losses in these portfolios. This is the first challenge. Efforts to date have involved, in the first instance, a top down estimate of portfolio losses and, more recently with the assistance of Blackrock (a consultant used by the Central Bank), a bottom-up loan by loan loss forecast exercise based on conservative modeling assumptions. But there is a remaining task: a case-by-case re-underwriting, involving where possible recovery and where necessary restructuring, of troubled loans. This is crucially important for a number of reasons.
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While the banks still have uncertainty about the granular performance of their loan portfolios, they will be unsure of the exact capital buffer that is in place and the extent to which they have adequate capital for extreme loss developments. To my mind, this encourages an attitude of hoarding capital and provides disincentives to lending. At the end of the summer, there was much debate around a widely reported Central Bank analysis of lending to the small business sector, where we found that loan rejection rates were significantly higher than other EU jurisdictions, excepting Greece, and which to our mind pointed to supply constraints in the banking sector (in addition to problems over credit quality). Uncertainty about the current loan book and the exact losses that will crystallise (and therefore consume capital) are likely a factor in constraining lending. Absent an exercise of even further recapitalisation, the best option is more specificity and understanding of the performance of the legacy loan portfolios and an exercise in facing up to losses and modifying loans as necessary. The banks mortgage portfolios are a case in point and have involved close attention by the Central Bank. At this event last year, I explained how we were initiating a project to require mortgage arrears resolution strategies from all lenders in Ireland. We received these in November of last year and provided feedback to the banks, highlighting the need for more effort on a number of fronts.
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One major area of concern was the lack of operational capacity in the banks to deal with customers in arrears so we required senior management to commit to a step change improvement in that capacity. The plans we received showed significant improvement and we are continuing to monitor progress closely. We also pressed the banks to work harder to develop specialist strategies for their buy to let portfolios. And, crucially, we insisted that the banks develop a broader range of techniques to deal with loans in arrears, drawing on the ideas of the so-called Keane group. In a slight simplification of the position, the banks were relying heavily on the provision of interest only arrangements or the capitalisation of interest arrears, even though these techniques were clearly unsuitable for a sizeable group of customers with unsustainable mortgages as a result of a severe reduction in income. The banks were required to identify a broader range of techniques, including loan modification arrangements such a split mortgages and the introduction of mortgage to rent schemes, and to pilot these during Q3 of this year. These pilots are now mostly concluded (although are dragging on in one or two cases) and the banks are now in starting the process of rolling out the new arrangements more widely. This process offers the prospect of restructuring loans where necessary to avoid customers continually re-defaulting. The Central Bank has studiously avoided prescribing the detail of the loan modification arrangements adopted by the banks and it must necessarily be for the banks themselves to undertake the case-by-case review of customers that is required.
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However, I would observe that there is significant variability in the approaches that the banks are taking to loan modification. That is natural and understandable, and I would not expect a standard approach across so many different institutions, with different portfolios and different types of owners, for so many different customers. But there are some key parameters in the typical loan modification arrangements that might perhaps merit a close side-by-side comparison in due course. For example, a crucial new technique is that of the provision of a split mortgage. This involves rightsizing the performing part of the mortgage based on affordability, as determined by current income, and warehousing the non-performing part. This is to be welcome, but the treatment of the warehoused element merits close attention. For example, is there shared risk between the bank and the customer regarding this element? And is it realistic that full interest accrues on this warehoused element? As the banks move out of their pilot phase on these new techniques and adopt them in their mortgage arrears resolution strategies, our code in this area requires them to publish full details on their websites. So there will shortly be an opportunity for some comparative analysis of the different arrangements that are being promulgated and therefore some public and customer feedback on the design choices that have been made.
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One important message today is that these efforts underway for mortgage arrears need to be matched for the banks SME portfolios. Earlier in the year, the Central Bank commissioned an in-depth analysis of the leading banks operational capacity for SME loan review, recovery and resolution. The results were in many respects dismayingly similar to those regarding mortgage arrears operations. For example, the reviews found the following: limited specialist skills, limited ability to scale up to conduct restructuring and resolution activity, inconsistent quality and depth of financial analysis of borrowers, incomplete financial information collected from borrowers, lack of portfolio segmentation and limited use of KPIs. More fundamentally, it appeared that portfolios were largely subject to rescheduling and extended forbearance rather than a determined effort to restructure loans and deploy a wide range of workout options. Given the extent to which many SMEs entangled themselves in property investment, there is clearly a difficult task facing the banks. The message from this review work is that here too we need to see a step change in operational capacity and a mindset change in terms of tackling, rather than deferring, problems. So, while we will not be rolling out the same extensive regulatory framework as is in place for mortgages and mortgage arrears (due to the different consumer protection standards that are relevant), a key area of regulatory focus in the coming months will be to press the banks to effectively re-underwrite their SME portfolio and more decisively tackle the challenge of recovering and as necessary restructuring problem loans. The banks need to raise their game on the handling of problem SME loans and the Central Bank intends to press them to do just that.
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Balance sheet restructuring

The second principle challenge facing the Irish banks is of one of balance sheet restructuring. By this, I mean the process of disposing of certain assets in order to strengthen the financial position of the bank and to shrink the size of the balance sheet so that its funding position is more sustainable. (I should note that I havent set out funding as one of the principal five challenges, which is perhaps unexpected, but this is on the grounds that improving the banks liquidity position and capacity to fund themselves with reduced reliance on the central bank will flow from successfully addressing the other challenges. And indeed while all these are necessary conditions for improved funding, they are not sufficient, as it is clear that sustained access to wholesale markets apart perhaps from heavily collateralized transactions such as covered bonds and the like is only realistically likely to occur after the Irish sovereign has fully returned to the market. So: funding is an important and pressing issue, but one that will only be solved after both the foundations of a stronger banking system and sovereign market access have been re-established.) Ireland has demonstrated strong progress with the challenge of balance sheet restructuring. The first phase of this exercise, as is well known, involved the implementation of NAMA. This allowed the transfer of hard to value and poorly performing commercial property assets out of the banking system to improve the balance sheet strength of the Irish banks. The second phase of this exercise, which is now well progressed, has involved the identification and disposal of so-called non-core portfolios.
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This has less to do with cleaning out poor quality assets although there are some in this category but rather reducing leverage in the balance sheet and reliance on central bank funding, by rightsizing the banks balance sheets to a sensible proportion relative to their on-going ability to fund themselves. Progress in the disposal of non-core assets has been impressive, with most banks hitting or exceeding their targets and doing so at a lower cost to capital, by achieving better prices, than had been budgeted in our stress test exercise. The environment for asset disposals has, however, been getting more difficult, as the Eurozone crisis has widened and the imperative to deleverage has touched other banks as well. The remaining challenge, then, in this space is to make sure that the asset disposal process remains on track and is concluded successfully. However, the Irish authorities have been keen to emphasise that this process should not be at the expense of fire sale prices, so the current market environment may provide a constraint on the ability to reach the endpoint to a predefined schedule. Should that be the end of balance sheet restructuring? One area of debate is whether it is advisable to undertake a third phase of restructuring involving a select number of banks and certain portions of their core portfolios. The objective here would be to trim back the core balance sheets by identifying poor performing or hard to value mortgage assets for transfer out of the banking system. However, important technical issues remain to be solved regarding the suitable vehicle for these assets, and how that would be funded.
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In short, there may be an opportunity for a new phase of balance sheet restructuring to provide a further strengthening of the banking system but this is not yet assured.
Profitability
The profitability challenge should, I hope, be obvious. It is important that the banks regain profitability in their core businesses so that they can stand on their own feet and no longer rely on taxpayer support. In post-crisis Ireland, where it often seems that regard for the banks among the general public is at an all-time low, the prospect of the institutions which have caused so much economic distress, and required so much taxpayer support, earning ever-increasing profits from their activities is understandably met with dismay by those hard pressed consumers that are being charged more. But it is surely preferable that the banking system is able to operate based on the commercial arrangements it has with its customers rather than continuing to have dependence on government and taxpayer assistance. By breaking the nexus between banks and Government, both will be able to access funds at a cheaper rate driving down costs to both bank customers and the taxpayer. The banking system needs to generate retained earnings to bolster its capital position of its own accord, and therefore needs to re-establish its profitability. How is the profitability challenge going? Further balance sheet restructuring will help if it strips out poor performing or high risk assets.
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Also, crucially, recognition of impaired assets and a granular and diligent re-underwriting of problem portfolios will allow loan book losses to be put in the past. These developments will help, but more is needed to be done, especially while domestic demand remains depressed and inhibits new business growth. At the centre of the profitability equation for the banks is a need to improve their net interest margin. On aggregate, the net interest margin for the three main Irish banks has fallen sharply, from 1.83% in 2007 to 0.82% by the first half of this year. Net interest margins remain highly compressed for the banks and will continue to do so while prevailing interest rates are low. Progress on profitability will only be possible in the interim due to gradual re-pricing of assets to reflect the cost of funds. I should also note that in my view we are getting close to the position where the changing circumstances arising from successful implementation of the IMF/EU programme and the introduction of the banking union should permit the full removal of the government guarantee. This will favourably impact on profitability as a result of reduced fees. Realistically, however, the prospects for significant improvement in net interest margins as a driver of profitability will be limited for the immediate future in light of the macro-economic environment. What is in the banks own hands, however, is to rigorously tackle their operating costs. The banks need to continue their efforts in this area and the management
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teams should be commended for tackling tough decisions around staffing levels and branch closures, which are clearly difficult but necessary measures. As a note of caution, it is important that this process of rationalisation does not compromise the risk management infrastructure and IT/operational framework in the banking system. These would be short-term cost savings that sowed the seeds for later problems and painful expense, as weve seen in the past and indeed quite recently. So, the Central Bank will encourage bank management to stick to their cost-cutting agenda, but to do so with careful deliberation. They do need to maintain the capacity to deliver the needed services to the economy and the general public.
Culture
While most of the challenges are financial in nature, there is one that is not but is nevertheless absolutely essential: We need to see a substantial, deeply rooted and sustained change in the culture that operates within the Irish banking system. Cultural change is evidently a complicated, laborious and time-consuming process and will need to touch on the number of dimensions, but at its essence we need to see a fundamental shift in attitudes to risk management and to the treatment of consumers. The financial crisis exposed a corrosive influence at the heart of the way the Irish banks were run and that has had to be decisively tackled. The Central Bank has acted to initiate change in this area and has encouraged improved governance and standards of behaviour.
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We have introduced a corporate governance code, which is fully enforceable, designed to improve the rigour of oversight of bank management and to broaden the gene pool of bank boardrooms. A new fitness and probity regime is now in place to more rigorously police those who work in the financial services sector. Some 71 of the 73 executive and non-executive directors who were in place at the time of the guarantee have now or will shortly depart the system. But the work of cultural change is by no means complete indeed it still has a long way to go and must necessarily be driven by the new boards of the Irish banks. They need to set the tone at the top and clearly articulate their expectations of ethical conduct amongst their management team and their staff at large. They need to ensure that the ranks of senior and middle management are subject to renewal and refreshment, to bring some fresh blood into the mix without the baggage of the past and with the motivation to lead the process of change. New standards of behaviour need to be backed up when hard cases of individual conduct come to a head, and not avoided. Recognition of the importance of good risk management, compliance and treating customers fairly needs to become embedded, hardwired into the processes, remuneration, objectives, communications and way of thinking in the Irish banks until it becomes second nature. This is a hard-to-measure and difficult task but needs to be kept at the top of the senior management and Board agenda.
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It is important to speed the recovery of the banking system, by helping renew the social contract between the banks and society at large and, more tangibly, ensuring that lapses in risk management or consumer care do not lead to further losses, consumer detriment and reputational damage which impede the banks and the economys path to recovery.
Capital
Finally, then, let us turn to the banks capital challenge and the question of whether or not they have adequate economic and regulatory capital to operate safely and provide the lending necessary for the economy. As I will explain, this is a complex question and is impacted by a number of factors, some of which appear favourable and some of which do not. Answering this question also involves a considerable number of judgement calls, including the question of the speed with which we want to get to the point that there remains absolutely no doubt about the banks ability to meet both any future losses and the planned higher international capital standards that are coming down the track. The factors impacting the banks capital position are numerous and, of course, are closely related to the previous challenges that Ive outlined. The extent to which problem loans are successfully recovered or necessarily written off or restructured will be a key factor, as will the extent of progress on balance sheet restructuring (and the costs this imposes along the way). The banks ability to return to profitability will allow them to retain earnings so that the capital requirements of the future can be met on their own. But what other elements will bear on the capital challenge?
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On the positive side, the current starting point is a strong one due to the significant capital injections that have taken place as a result of the previous stress tests of the banking system. Current capital ratios for the leading domestic banks include a healthy buffer above minimum requirements: for example, the total capital ratio for AIB is 19.9%, Bank of Irelands is 14.3% and PTSBs is 21.5%. Above these requirements, the banks have a further buffer of contingent capital instruments to absorb additional potential losses, which is another positive. Also, as noted previously, since the last stress tests the losses on disposal of non-core assets has turned out to be less than predicted. And also in the positive, albeit tentatively, are some early signs of stability in the housing market, at least in the Dublin area. However, there are also adverse developments which could impact the next in-depth assessment of capital. While housing prices may have shown signs of stability in the Dublin area, they are still significantly depressed and may have further to decline outside Dublin. The macro-economic environment remains very difficult, with domestic demand depressed and the continuing crisis in the Eurozone weighing on recovery and confidence. The position on mortgage arrears has continued to deteriorate since the last stress test (although, positively, are so far within stress levels) and the introduction of insolvency legislation creates uncertainty as to the future trajectory of losses.
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And, as Ive mentioned in previous remarks, we know that in the medium term the Irish banks need to close the gap to meet new international capital standards under Basel 3 and CRD IV. Since we are talking about the speed of the recovery of the banking system and the question of time, it is perhaps useful here to make the distinction between current capital requirements and what one might call the stressed capital position of the banks. Very simply put, the current capital position is the calculation of the banks capital requirements against current prevailing minimum regulatory standards and in light of the banks current accounting position. As I have just noted, the current capital position of the banks is healthy due to the significant injections of taxpayer and private funds that have taken place. This healthy position appears assured for the immediate future given the buffer between current capital levels and minimum European requirements. However, in the medium term the position becomes more uncertain, principally due to the anticipated strengthening of the minimum EU standards, uncertainty around profitability and uncertainty around the exact size of future losses in problem portfolios. This is where the stress capital position comes in: this is an exercise in projecting forwards the level of losses (and of profitability) and doing so with an overlay of stress to provide an added degree of comfort and conservatism. As you know, this method has been used to good effect to force a significant recapitalisation of the system already.
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How much uncertainty or risk is there in the medium term capital position for the banks? Im afraid Im going to disappoint you and say that we need to wait and see and do another thorough, rigorous and professional job of assessing that very question. This will take place during the course of next year and the Central Bank will again conduct its own independent assessment of the banks loan losses, again with the assistance of Blackrock, rather than rely on the banks own calculations. We will, as before, call it as we see it. But in the design of this exercise by ourselves, by the troika, by the European Banking Authority and by the prospective new Eurozone banking supervisor, the ECB (there will be a lot of chefs in this one!) there will be some important judgement calls regarding the severity of the stress parameters and the methodology to be applied. Fundamentally, there is a public policy choice around living with a currently healthy capital position until the point of need of public support, if indeed that is the case. Call this a just-in-time approach to backstops, if you like. Or, alternatively, the stress design can be calibrated to frontload anticipated new regulatory requirements or potential tail events while discounting the prospect of the banks earning their own way to full capital health. The benefit of this latter approach is that it more speedily gets the banks to a position of undeniable capital resilience, so that they should have no deterrent from lending and the residual risk of future support at a later date is eliminated.
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But this frontloaded design choice is of course potentially costly in terms of adding to the sovereign debt burden. And in this respect, there is a sixth and most fundamental challenge of all, namely breaking the damaging link between the banking system and the government finances. It is clear that this in itself is an essential component of the successful completion of the financial programme for Ireland and a speedy recovery of the Irish banking system. It is hard to think of the Irish banks returning to unsecured market funding before the government does so. And it is hard to think of the Irish banks capital position being definitively resolved before the impact of bank debt on government finances has been resolved. This has been the lesson of the Irish programme so far. That huge strides have been made in tackling the banking system problems through decisive and costly actions, but that there are limits to the public policy measures that can be taken without European assistance. The encouraging news is that this was recognised by European policymakers in the Euro group summit at the end of June. The damaging linkage between banking systems and sovereign finances has been recognised and it has been accepted that borrowing to recapitalise banking systems adds to the negative feedback loop between the two. I look forward to the outcome of the continuing discussions on the Summit conclusions so they are translated into a specific policy proposal that is indeed effective in breaking the banking-sovereign link.
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However, there are key steps that need to take place before this can be achieved, most notably the development of the banking union and centralised Eurozone banking supervision. But that is a topic for another day. For now, my point is that in addition to the five domestic challenges for the Irish banking system to more speedily achieve recovery, there is a sixth European challenge where there are positive signs but much work still to be done. This dependence on European developments, however, is no excuse for the banks to delay in tackling the five challenges I have discussed. With apologies in advance for the risk of oversimplification, let me sum this all up in the following way. One way to think about this is that the Irish banks are now out of the critical ward, with more healthy vital signs, following radical surgery and an extensive transfusion of blood from the Irish taxpayer. But as they stagger back to work they are still weak and arent contributing to society as they should. They need to demonstrate dedication in getting fully fit: they need to face up to their remaining ailments by recognising losses and continue to slim down both their balance sheets and their costs. The banks now have the uncomfortable task of telling the neighbours who donated blood to them that they need to charge them more as customers. And the banks need to approach their new situation with a new culture to show theyve truly changed their ways.
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These measures, which are in the hands of the banks own management and do not depend on Europe, will help speed them to full recovery.
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FSB releases reports on progress in implementing the SIFI framework

The FSB is releasing three documents on latest steps in implementing the FSBs policy framework for addressing the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs).
1. Update of group of global systemically important banks (G-SIBs)

An initial group of G-SIBs was published in November last year. This updated list of G-SIBs is based on end-2011 data. This year, the G-SIBs are shown allocated to buckets corresponding to their required level of additional loss absorbency. This allocation is provisional and will be based in the future on the best and most current available data prior to implementation. The additional loss absorbency requirements for G-SIBs will be phased in starting from 2016, initially for those banks identified as G-SIBs in November 2014, and are to be fully met by 2019. The timelines for the other policy requirements relating to global SIFIs (G-SIFIs), and in particular the timetable for implementation of resolution planning requirements for newly designated G-SIFIs, have also been further specified.
Update of group of global systemically important banks (G-SIBs)
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1. In November 2011 the Financial Stability Board published an integrated set of policy measures to address the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs). In that publication, the FSB identified an initial group of G-SIFIs, namely 29 global systemically important banks (G-SIBs), using a methodology developed by the BCBS. 2. The November 2011 report noted that the group of G-SIFIs is to be updated annually based on new data and published by the FSB each November. 3. The FSB and BCBS have updated the list of G-SIBs using end-2011 data. The list of banking groups identified as G-SIBs is reduced by one overall, from 29 to 28. Compared with the list published in November 2011, two banks have been added to the G-SIB list, and three banks have been removed from it. 4. As noted in 2011, from this year, the list of G-SIBs shows their allocation to buckets corresponding to their required level of additional loss absorbency. Additional loss absorbency requirements for G-SIBs will be phased in starting from 2016, initially for those banks identified as G-SIBs in November 2014. 5. The quality of data used in applying the identification methodology and to allocate G-SIBs into buckets for additional loss absorbency has improved considerably over the last year. In addition, several of the underlying data items included in the methodology have been refined to make the calibration more robust. The BCBS will continue to work to address remaining data quality issues and adopt any necessary methodological refinements before the loss absorbency requirements go into effect.
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The scores and the corresponding buckets for G-SIBs are provisional and will be based in the future on the best and most current available data prior to implementation. 6. The group of G-SIBs will be updated in November 2013. 7. The November 2011 report set out the policy requirements relating to G-SIFIs, together with the timetable by which those requirements were to be met. For this updated list, as well as for future updates, the following time-lines relating to the requirements will apply: i) Financial institutions no longer designated as a G-SIFI will continue to be subject to the requirement for recovery and resolution plans to the extent that the firm is assessed by national authorities to be systemically significant or critical in the event of failure. Authorities are encouraged to continue to apply the other resolution requirements to support resolution planning; however, once a financial institution is no longer designated as a G-SIFI, implementation of those requirements will no longer be subject to peer review by the FSB under its resolvability assessment process. ii) As set out in the November 2011 report, the additional loss absorbency requirements for G-SIBs will begin to apply from 2016, applying initially to G-SIBs identified in November 2014, using the allocation to buckets for higher loss absorbency at that date. The requirements will be phased in starting from January 2016 with full implementation by January 2019. iii) G-SIFIs are required to meet higher supervisory expectations for risk management functions, data aggregation capabilities, risk governance and internal controls. G-SIBs designated in November 2011 or November 2012 must meet the higher expectations for data aggregation capabilities and risk reporting by January 2016. G-SIBs designated in subsequent annual updates will need to meet these higher expectations within three years of the designation.
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8. The FSB and the standard setting bodies are extending the SIFI framework to other systemically important financial institutions. i) The FSB and BCBS have finalised a principles-based, minimum framework for addressing domestic systemically important banks (D-SIBs). National authorities should begin to apply requirements to banks identified as D-SIBs in line with the phase-in arrangements for the G-SIB framework, i.e. from January 2016. ii) The International Association of Insurance Supervisors (IAIS) has issued for public consultation its proposed assessment methodology for identifying global systemically important insurers (G-SIIs) as well as policy measures to be applied to G-SIIs. An initial designation by the FSB of insurance groups as G-SIIs is planned in April 2013. iii) The FSB, in consultation with IOSCO, will finalise a proposed assessment methodology for identifying systemically important non-bank non-insurance financial institutions over the course of 2013.
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G-SIBs as of November 2012 allocated to buckets corresponding to required level of additional loss absorbency
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2. Progress report on Resolution of Systemically Important Financial Institutions

Progress in reforming national resolution regimes and advancing recovery and resolution planning for G-SIFIs is encouraging overall. Getting the right legislation in place is essential to countries having the necessary powers to advance resolvability of G-SIFIs and the legal capacity for cross-border border co-operation. Reforms to align resolution regimes with the FSBs Key Attributes of Effective Resolution Regimes for Financial Institution are not complete and still ongoing in several FSB jurisdictions. Some headway has been made in G-SIFIs resolution planning. Cross-border crisis management groups are now established for nearly all the G-SIFIs designated by the FSB in November 2011 and have initiated discussions on high-level resolution strategies.
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Operational resolution plans and institution-specific cooperation agreements to implement the strategies and plans are on track to be completed during the first half of 2013. However, effective implementation is contingent on the requisite legal frameworks being in place and may also require some adaptation of firms financial and organisational structures. The FSB has further work underway to support implementation of the Key Attributes. This includes the development of an assessment methodology for the Key Attributes and further guidance on the application of the Key Attributes to the resolution of non-banks, including insurers, investment firms and financial market infrastructures. The FSB will be publishing shortly for consultation draft guidance on key aspects of recovery and resolution planning.
Resolution of Systemically Important Financial Institutions Progress Report Summary

Since the adoption of the FSB Key Attributes of Effective Resolution Regimes for Financial Institutions (the Key Attributes) as a new international standard for resolution regimes in November 2011, many jurisdictions have initiated reforms to align national resolution regimes and institutional frameworks with the Key Attributes. Overall, progress is encouraging.
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Implementation of the Key Attributes in national resolution regimes

Recent reforms focus on extending the resolution tools to include powers such as bail-in, transfer and bridge bank powers, and on widening the scope of resolution regimes to cover non-bank financial institutions that could be systemically critical if they fail, including investment firms, financial market infrastructures (FMIs) and insurers (particularly insurance groups with non-traditional insurance activities). The Key Attributes will need to be applied in a manner that reflects the specificities and objectives of resolution of particular sectors, such as protecting insurance policy holders in resolution; facilitating the rapid return or transfer of holdings of client assets in resolution to protect the interests of customers of investment firms; and ensuring the continuity of critical operations and services of FMIs.
Recovery and resolution planning for G-SIFIs

High importance is being given to the effective implementation of the Key Attributes that are directed at global systemically important financial institutions (G-SIFIs). This includes the requirements for cross-border crisis management groups (CMGs), institution-specific cross-border cooperation agreements (COAGs), recovery and resolution plans (RRPs) and resolvability assessments for all G-SIFIs. Considerable but uneven progress has been made in implementing these requirements, guided by CMGs which are now established for nearly all the G-SIFIs designated by the FSB in November 2011. In the course of that work it became clear that recovery planning, resolvability assessments and the development of COAGs are inter-dependent and iterative processes, and progress in these areas is
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largely dependent on a clearly articulated, high level resolution strategy for a firm. Accordingly, the priorities of CMGs were adapted to focus on the development of resolution strategies by end-2012. Recognising that certain aspects of the recovery and resolution planning requirements would benefit from deeper examination and building on the experience of its Members to date, the FSB has developed guidance that it is releasing for public consultation on: (i) The nature of the stress scenarios and triggers for recovery actions that should be used in G-SIFIs recovery plans; (ii) The development of resolution strategies and associated operational resolution plans tailored to different group structures, drawing on two stylised approaches to resolution - single point of entry and multiple point of entry; and (iii) The identification of the critical functions that would need to be maintained. This guidance is expected to assist those CMGs, authorities and firms at earlier stages of the recovery and resolution planning process and to promote consistency in the approaches of CMGs. Implementation of the remaining G-SIFI resolution planning requirements is on track to be completed during the first half of 2013, after which the implementation of the resolution planning requirements in relation to each G-SIFI will be reviewed through resolvability assessments by resolution authorities and CMGs, and through a resolvability assessment process that the FSB expects to launch in 2013. For financial firms that are no longer designated as G-SIFIs, the implementation of those requirements will not be evaluated through the FSB assessment process.
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However, such firms will still be required to have RRPs, and national authorities are encouraged to continue to apply the other requirements proportionately to those firms.
Introduction
The global financial crisis provided a sharp and painful lesson of the costs to the financial system and the global economy of the absence of effective powers and tools for dealing with the failure of systemically important financial institutions (SIFIs). In November 2011, the G20 endorsed the Key Attributes of Effective Resolution Regimes for Financial Institutions (the Key Attributes) as a new international standard for resolution regimes, while in June 2012 the G20 Leaders reiterated their commitment to make national resolution regimes consistent with the Key Attributes and expressed their support for the on-going elaboration of RRPs and COAGs for all G-SIFIs. This report describes the progress so far in implementing the Key Attributes, including the specific requirements aimed at G-SIFIs, and the additional work that the FSB is undertaking to advance the effective implementation of the Key Attributes. - Section 1 provides an overview of the status of reforms of national resolution regimes and the FSBs initiative to evaluate progress through a first thematic peer review of effective resolution regimes. - Section 2 reports on additional work underway to support implementation of the Key Attributes, which includes the development of an assessment methodology, work on the application of the Key Attributes to resolution regimes for the non-banking sector, including insurers, FMIs and firms with significant holdings of client assets, and the sharing of relevant information for resolution purposes between all authorities having a role in resolution.
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- Section 3 discusses the status of implementation of the set of resolution planning requirements that specifically apply to G-SIFIs as well as the work on further guidance to support their implementation.
1. Implementation of the Key Attributes 1.1 Overview

The Key Attributes set out twelve essential features that should be part of resolution regimes in all jurisdictions (see Text Box 1). Their objective is to enable authorities to resolve any financial firm that could be systemically significant or critical in the event of failure, irrespective of its size, the nature of its business or its geographical reach, without severe systemic disruption and without exposing taxpayers to loss.
Text Box 1: The twelve Key Attributes

The Key Attributes set out the core elements considered necessary for an effective resolution regime for any type of financial institution, including banks, insurers, securities and investment firms and FMIs: 1. Scope - The regime should cover any financial institution that could be systemically significant or critical if it fails. 2. Resolution authority - The regime should be administered by a resolution authority (or authorities) with a statutory mandate to promote financial stability and the continued performance of critical functions. 3. Resolution powers - The regime should provide for a broad range of resolution powers, including powers to transfer the critical functions of a failing firm to a third party; powers to convert debt instruments into equity and preserve critical functions (bail-in within resolution); powers to impose a temporary stay on the exercise of termination rights under financial contracts (subject to safeguards for counterparties) and impose
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a moratorium on payments and on debt enforcement actions against the failing firm; and powers to achieve the orderly closure and wind-down of all or parts of the firms business with timely pay-out or transfer of insured deposits. 4. Set-off, netting, collateralisation, segregation of client assets - The segregation of client assets should be effective in resolution. Financial contracts, including netting and collateralisation agreements, should be enforceable. However, entry into resolution and the exercise of any resolution powers should not in principle constitute an event that entitles any counterparty of the firm in resolution to exercise acceleration or early termination rights under such agreements provided the substantive obligations under the contract continue to be performed (as would be the case if the contracts were transferred to a sound financial firm or bridge institutions). 5. Safeguards - All creditors should receive at a minimum what they would have received in a liquidation of the firm (no creditor worse off than in liquidation safeguard). Resolution powers should be exercised in a way that respects the hierarchy of claims, subject to some flexibility for authorities to depart from the general principle of equal treatment of creditors of the same class where necessary to contain the potential systemic impact of a firms failure or to maximise the value for the benefit of all creditors as a whole. Rights to judicial review should be available for affected parties to challenge actions that are outside the legal powers of the resolution authority. 6. Funding of firms in resolution - Resolution regimes should include funding mechanisms that can provide temporary financing to continue critical operations as part of the resolution of a failing firm.
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Such funding should be derived, or recovered, from private sources. 7. Legal framework conditions for cross-border cooperation - Resolution regimes should empower and encourage resolution authorities wherever possible to act to achieve a cooperative solution with their foreign counterparties. Authorities should be able to give effect in their jurisdiction to resolution measures taken by a foreign resolution authority. 8. Crisis Management Groups (CMGs) - Home and key host authorities of all G-SIFIs should maintain CMGs with the objective of enhancing preparedness for, and facilitating the resolution of a G-SIFI. 9. Institution-specific cross-border cooperation agreements (COAGs) COAGs should be in place between the home and relevant host authorities that need to be involved in the preparation and management of a crisis affecting a G-SIFI. 10. Resolvability assessments - Resolvability assessments should be carried out for all G-SIFIs. Authorities should have appropriate powers to require the adoption of appropriate measures to ensure that a firm is resolvable under the applicable regime. 11. Recovery and resolution planning - Recovery and resolution plans (including high level resolution strategies) should be in place for all firms that may be systemic or critical in the event of failure. 12. Access to information and information sharing - Jurisdictions should remove legal, regulatory or policy impediments that hinder the domestic and cross-border exchange of information - in normal times and during a crisis - necessary for recovery and resolution planning and for resolution.
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1.2 Status of reforms of national resolution regimes

Reforms are underway in many jurisdictions to align national statutory resolution regimes and institutional frameworks with the Key Attributes. In the US, the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which provides for powers to resolve systemically important financial institutions and requires the preparation of resolution plans, represents an important step towards implementation of the Key Attributes. Likewise, the adoption by the European Commission of a proposal for an EU regime for bank recovery and resolution is critical for advancing consistent reforms across the EU. A number of FSB member jurisdictions are in the process of reforming their statutory regimes or have recently introduced legislative changes or other actions to implement the Key Attributes:
- Australia - Australia undertook comprehensive reforms of its crisis resolution framework, which included the introduction of a deposit guarantee regime in 2008. It recently released a consultative document with proposals to further strengthen powers to resolve financial institutions, including insurers and FMIs, as well as non-regulated entities within a financial group in resolution. - Germany - In Germany, reforms came into force in 2011 that strengthened and expanded crisis management and resolution powers. They include transfer and bridge bank powers, the establishment of a special restructuring fund, and the introduction of a two-stage recovery and reorganisation procedure for banks.
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- Netherlands - In May 2012, the Netherlands introduced a new Act on Special Measures for Financial Institutions which provides a range of new resolution powers to the De Nederlandsche Bank (Dutch Central Bank) and the Dutch Ministry of Finance. These powers include the powers to carry out a sale of a problem institution to a private party or bridge institution by transfer of shares; and the powers to transfer assets and liabilities of a problem institution to a private party or bridge institution, in case of guaranteed deposits with funding from the deposit guarantee scheme. - Spain The powers of the Spanish resolution authorities were significantly expanded in August 2012: Banco de Espaa was provided with additional early intervention powers; the Fund for Orderly Restructuring of Banks (FROB) was given powers to provide temporary financial assistance under a restructuring plan approved by Banco de Espaa; and a new legal framework for the resolution of banks was established. That framework enables the FROB to carry out the restructuring or resolution of a failing bank, overriding shareholders rights where necessary, and includes powers to impose losses on subordinated liabilities (limited bail-in). Resolution tools in Spain now include: sale of assets or business lines of a failing bank; and transfer to a bridge bank or asset management company. - Switzerland - Switzerland introduced legislative changes in 2008, 2011 and 2012 to strengthen its resolution regime. These included the introduction of a recovery and resolution planning requirements, bridge bank powers and extension of the Swiss Financial Market Supervisory Authoritys (FINMA) resolution powers to insurers and other types of financial institutions.
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- United Kingdom - The introduction of the Special Resolution Regime for UK banks in 2009 gave UK authorities a broad range of resolution powers for failing UK banks. The Financial Services Act adopted in 2010 required banks to have RRPs. UK deposit taking banks and systemic investment firms were required to have completed RRPs by June 2012. In August 2012, the UK Treasury published a consultation paper, accompanied by draft legislation, setting out proposals on enhancing the mechanisms available for dealing with the failure of systemically important non-bank financial institutions and FMIs. The proposal covers four broad groups: investment firms and parent undertakings; central counterparties (CCPs); other FMIs (such as payments systems); and insurers. - United States - The orderly liquidation authority established under Title II of the Dodd-Frank Act applies to financial companies and certain of subsidiaries that could be systemically significant or critical in failure. The Dodd-Frank Act also introduced a resolution planning requirement. Legislative reforms will be necessary in many jurisdictions to fill remaining gaps in the implementation of the Key Attributes. In many jurisdictions the scope of application of the resolution regime remains limited to domestically incorporated banks and does not extend to non-bank financial institutions that could be systemically significant or critical if they fail, such as large investment firms or CCPs. Nor is it clear in many cases whether the national regime extends to branches of foreign financial institutions.
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A number of jurisdictions do not have the full range of resolution tools called for by the Key Attributes, such as bail-in powers or the authority to impose temporary stays on acceleration or early termination rights in financial contracts. The absence of a clear mandate of resolution authorities to seek cooperation with their foreign counterparts and the lack of legal capacity to give effect to foreign resolution measures may pose significant impediments to cross-border resolutions, if not addressed.
1.3 Thematic peer review to evaluate implementation in FSB member jurisdictions

The reform of resolution regimes have been identified as a priority area under the FSB Coordination Framework for Implementation Monitoring (CFIM). As a result, the implementation of the Key Attributes by FSB member jurisdictions will undergo intensive monitoring and detailed reporting, with a first thematic peer review of resolution regimes already underway. The objective of the peer review is to evaluate FSB member jurisdictions existing resolution regimes and any planned changes to those regimes using the Key Attributes as a benchmark. The review will provide a fuller picture of the status of reforms and the progress made by different jurisdictions across different financial sectors (banking, insurance, securities, and FMIs). The findings will be published in early 2013.
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2. Work underway to support effective implementation 2.1 Overview

The FSB has further work underway to support implementation of the Key Attributes. An assessment methodology is being developed as guidance for jurisdictions when implementing the Key Attributes and as a tool for the conduct of assessments in the context of peer reviews. The FSB is working with sectoral standard setters to ensure that the methodology reflects sector-specific considerations and to develop further guidance as necessary. In response to external events, including the failure of MF Global, the FSB is undertaking further work on the protection of client assets in resolution. The FSB is also working to address barriers to information exchange amongst relevant authorities, since these have the potential to thwart the development of resolution strategies and plans and their implementation in a crisis.
2.2 Development of a methodology to assess implementation

The FSB is working with representatives of national authorities, the European Commission, the IMF and World Bank, and standard setting bodies (Basel Committee on Banking Supervision (BCBS), Committee on Payment and Settlement Systems (CPSS), International Association of Deposit Insurers (IADI), International Association of Insurance Supervisors (IAIS) and International Organization of Securities Commissions (IOSCO)) to develop an assessment methodology for the Key Attributes.
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The methodology will complement the Key Attributes by providing criteria against which implementation of each individual Key Attribute can be assessed, and explanatory notes about particular criteria where the FSB considers that further detail or explanation would be useful. It is intended as guidance for jurisdictions when implementing the Key Attributes and as a tool for the conduct of assessments in the context of peer reviews within the FSB framework for implementation monitoring or IMF and World Bank assessments of resolution regimes in the context of Financial Sector Assessment Programs (FSAPs) and Reports on the Observance of Standards and Codes (ROSCs). The FSB plans to consult publicly on a draft of the methodology in the second half of 2013.
2.3 Sector-specific considerations

The Key Attributes are an umbrella standard for resolution regimes for all types of financial institutions that can potentially be systemically important in failure. Sector-specific resolution regimes should therefore be consistent with the objectives and relevant requirements of the Key Attributes. However, not all resolution powers and features of resolution regimes set out in the Key Attributes are relevant for all sectors. Different types of financial firms - even within a particular sector - have distinctive features that need to be reflected in the way in which the powers and tools set out in the Key Attributes are applied when resolving such entities (see Text Box 2). As a consequence, the Key Attributes may require some adaptation for sector-specific application.
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The FSB is working with standard setters to ensure that the assessment methodology deals comprehensively with the application of individual attributes to different types of financial institutions and sectors. The IAIS is currently analysing the Key Attributes from the perspective of the resolution of insurers and the protection of policy holders. The IAIS consultation document on globally systemically important insurers (G-SIIs) that was released in October 2012 includes a proposal to consider whether to develop a specific template for assessing the resolvability of G-SIIs. It also proposes that resolvability assessments assess the extent of ex ante separation of traditional and non-insurance activities from traditional insurance activities, and that the authorities consider and take all necessary actions to ensure effective resolution, including removing obstacles to the separability of non-traditional and non-insurance activities from traditional insurance activities during a stressed event. The IAIS also proposes, where necessary, to explore with members the need to develop further guidance for inclusion in the FSBs assessment methodology for the Key Attributes. Similarly, in July CPSS-IOSCO published a consultative report on recovery and resolution of FMIs. The report analyses how the Key Attributes apply to FMIs in a manner that achieves the objective of avoiding systemic disruptions by ensuring the continuity of critical operations and services of FMIs. The outcome of that analysis and public consultation will be incorporated into the assessment methodology for the Key Attributes. CPSS-IOSCO are working to provide further guidance on how FMIs should produce viable and robust recovery plans and how these should fit alongside resolution plans.
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Text Box 2 Sector-specific considerations

Banks The full range of resolution powers specified in the Key Attributes should be available to resolution authorities with responsibility for the resolution of banks that could be systemically significant or critical in the event of failure. Insurers As an international standard the Key Attributes generally also apply to resolution regimes for insurance firms that could be systemically significant or critical in the event of failure. The Key Attributes directed at G-SIFIs (see Text Box 3) apply to any insurer that is designated as a G-SII. The Key Attributes recognise that two resolution tools portfolio transfer and run-off are likely to be particularly relevant for the resolution of an insurer. However, when insurers also engage in either non-traditional insurance business or non-insurance business some of the other resolution powers set out in Key Attribute 3 that are not generally aimed at traditional insurance business may be necessary. Financial Market Infrastructure - The key objective of resolution regimes for FMIs needs to ensure uninterrupted continuity of the critical operations and services of a failing FMI. Accordingly, it should ensure the timely completion of payment, clearing and settlement functions by an FMI throughout the period that it is in resolution. The regime should enable authorities to preserve those systemically critical operations and services, either by arranging their orderly transfer to another FMI or bridge institution; by providing participants sufficient time to establish and to move to an alternative arrangement; or by the restoring the FMIs ability to provide those services as a going concern (including by allocating any shortfall in the FMIs resources across participants or other creditors of the FMI).
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To achieve these outcomes and taking into account the specificities of different types of FMIs, statutory resolution regimes for FMIs should provide for a broad set of tools and powers consistent with those in the Key Attributes and resolution authorities should apply them in a manner that is consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures. Securities and investment firms - Ensuring the rapid return of client money and assets or their transfer to a sound firm or bridge institution is a key objective of the resolution of securities and investment firms. Resolution authorities therefore require clear powers to transfer holdings of client assets to a performing third party or bridge institution, without the consent of the affected clients (see below 2.4). In order for that power to be exercisable effectively, the regulatory framework needs to include clear rules requiring the segregation and identification of client assets, and compliance with those rules is enforced. As with the exercise of other resolution powers, arrangements are needed to give effect to transfers, or to facilitate recovery by a resolution authority or liquidator, of client assets that are located in other jurisdictions.
2.4 Resolution of firms with significant holdings of client assets

The Key Attributes state that an effective resolution regime should ensure the rapid return of segregated client assets and call for clear, transparent and enforceable arrangements that promote the effective segregation of client assets and prompt access to segregated client funds in resolution. Greater understanding is needed of how those objectives can be achieved in the case of financial firms with significant holdings of client assets, and particularly where those assets are held in different jurisdictions.
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The transfer of holdings of client assets to a private sector firm or bridge institution may be the preferred resolution option, given that it maintains continuity of the services provided to the clients and minimises any interruption of access by clients to their assets. Resolution regimes should therefore include a power for resolution authorities to transfer holdings of client assets to a performing third party or bridge institution. The power should be available especially for banks, non-deposit-taking investment firms or broker-dealers, and FMIs that could be systemically significant or critical in the event of failure. No formal arrangements or procedures are currently in place between jurisdictions to facilitate transfers or return of client assets in a cross-border resolution. A foreign resolution authority, foreign administrator or liquidator generally needs to obtain the assistance of the local courts. However, the court process may take time which, as a practical matter, may represent a procedural impediment to rapid transfer or recovery, even where resolution authorities have powers to transfer client assets and assets are segregated and identified. Rapid transfers in a cross-border context could be facilitated if the home resolution authoritys transfer powers were matched by broad transfer powers of the host authority and the latter were able to use those powers to effect a transfer of assets located in its jurisdiction made by the foreign home authority. The FSB has work underway to elaborate further on the nature of the powers resolution authorities need to transfer holdings of client assets to a third party or bridge institution, in particular where the firm in resolution is holding client assets in a foreign jurisdiction.
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Where client assets are held by entities that are located in another jurisdiction, for example, an affiliate of the firm in resolution, a third-party custodian, or other intermediary, differences in the respective national laws relating to way in which client assets are held and protected may give rise to legal disputes as to ownership and entitlement to the assets, and complicate transfers or the rapid return of the assets to clients. The likelihood of disputes, which may take considerable time to resolve, is exacerbated in cases of correlated failures where both the firm that originally received the client assets and the firm that holds them are subject to resolution or insolvency procedures, since the administrators or insolvency appointees of both firms will have a statutory responsibility to maximise value for the clients and creditors of the firm to which they are appointed. Insufficient protection of client assets, and uncertainty about the ownership rights of clients where the firm exercises rights of use over collateral or re-hypothecates client assets, also increases the likelihood of runs as clients remove assets from a stressed firm in order to protect their rights. These effects increase the risk of disorderly failure and may undermine authorities ability to minimise contagion and preserve financial stability through resolution. Accordingly, when developing resolution plans and conducting resolvability assessments, authorities need to consider the feasibility of executing a transfer of custodial functions to another firm. The FSB is working to develop more explicit guidance on this necessary aspect of resolution planning and resolvability assessments which will specify how the handling of clients assets should be taken into account by authorities when developing resolution plans for firms that hold a significant amount of client assets domestically or in other jurisdictions. Authorities and firms should have a clear understanding, in particular, of:
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(i) The applicable law governing holdings of client assets, in particular where they are held through a chain of intermediaries located in foreign jurisdictions; (ii) Any rights of re-use that may be exercisable; (iii) The rules that apply where there is a shortfall of client assets; (iv) Arrangements in place that ensure that the identity of clients and their assets can be established rapidly and with certainty; and (v) the existence of arrangements, including porting arrangements for CCPs, that would facilitate transfers in a crisis.
2.5 Information sharing for resolution purposes and confidentiality

To arrive at a group-wide resolution plan and resolvability assessment, home and host authorities will need to share views and information in the CMGs on the functions they consider to be critical and on possible strategies for ensuring the effective resolution of the group. In principle, it should be possible to share relevant information between all authorities that have a role in resolution, subject to adequate confidentiality safeguards. However, differing terms and conditions for information sharing across jurisdictions complicate cross-border cooperation. Constraints on the timely sharing of information between authorities that have responsibilities related to resolution also hamper cooperation. Particular hurdles may arise where information generated for supervisory purposes needs to be shared with non-supervisory authorities that also have a role in resolution, such as central banks (that are not acting in a supervisory capacity), resolution authorities and ministries of finance.
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The Key Attributes stipulate that sharing of information within CMGs with other authorities with a role in the resolution of a particular firm should be possible under the legal frameworks of all jurisdictions, subject to specific conditions being met to protect the confidentiality of the information. The recipient authority should be subject to confidentiality requirements that are equivalent to those that apply to the disclosing authority, with effective sanctions for breach; and should commit not to disclose the information to third parties or the public, to seek prior consent for any onward disclosure of information, and to undertake best efforts to resist disclosure where compelled by statute or legal process, including by employing legal means to challenge an order to disclose. Professional secrecy obligations should generally prohibit officers and employees of authorities from disclosing information acquired in the course of discharging their mandates. In jurisdictions with Freedom of Information legislation, exemptions from disclosure requirements should be possible for resolution related information received from foreign authorities. The negotiation of institution-specific cross-border cooperation agreements (COAGs) amongst relevant home and host authorities, as required for each G-SIFI under the Key Attributes (see below), is intended to put in place a more predictable and explicit framework for sharing information for resolution and resolution planning purposes. It will also require authorities to determine whether their legal framework provides the appropriate gateways for information sharing, or whether they need to be revised to allow the sharing information for resolution purposes with the full range of authorities involved in resolution. Many jurisdictions legal regimes already have appropriate scope for authorities to improve cross-border and domestic information-sharing for resolution purposes.
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However, important work remains to be done to address the practical and policy concerns involved in sharing recovery and resolution information. The FSB is examining how to address remaining obstacles and improve the on-going work, including institution-specific COAGs currently being developed, to facilitate information sharing for resolution purposes.
3. Key Attributes directed at G-SIFIs 3.1 Overview

In November 2011, the FSB released an initial list of institutions designated as G-SIFIs on the basis of a methodology developed by the BCBS. The FSB announced that this list will be reviewed and updated annually. Firms designated as G-SIFIs are subject to specific resolution planning requirements relating to CMGs, COAGs, RRPs and regular resolvability assessments (see Text Box 3).
Text Box 3: Key Attributes directed at G-SIFIs

Crisis Management Groups (Key Attribute 8) - CMGs are mandatory for all G-SIFIs. CMGs establish a mechanism for information exchange, cooperation and coordination between the relevant authorities of the home and key host countries of the G-SIFI. Such arrangements enhance preparedness for a crisis and facilitate the management of any such crisis and, if necessary, the orderly resolution of the firm.
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Institution-specific cross-border Cooperation Agreements (COAGs) (Key Attribute 9) - COAGs must be in place for all G-SIFIs. COAGs support the operations of the CMGs by setting out the objectives and processes for cooperation between the home and relevant host authorities that need to be involved in planning for and carrying out resolution of a G-SIFI. They should also define the roles and responsibilities of the authorities pre-crisis (that is, in the recovery and resolution planning phase) and during a crisis; and set out the processes for information sharing and coordination in the development of resolution strategies and the RRPs for the G-SIFI. Recovery and Resolution Plans (RRPs) (Key Attribute 11) - RRPs, consisting of a recovery plan and a resolution plan, are required for all G-SIFIs and any other firms that could be systemically significant or critical if they fail. - The recovery plan (prepared by the firm) should identify options to restore financial strength and viability when the firm comes under severe stress. The responsibility for developing, maintaining and executing the recovery plan lies with the firm. - The resolution plan (prepared by the authorities) should set out how resolution powers would be used to preserve the firms systemically important functions, with the aim of making the resolution of any firm feasible without severe disruption and without exposing taxpayers to loss. It includes a resolution strategy agreed by the home authorities in cooperation with key host authorities and an operational resolution plan that provides further detail on how the authorities would implement the strategy. The home resolution authority should lead the development of the group resolution plan for a G-SIFI in coordination with the firms CMG.
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Host resolution authorities may maintain their own resolution plans for the firms operations in their jurisdiction, cooperating with the home authority to ensure that the plan is as consistent as possible with the group plan. RRPs are expected to be regularly updated and evolve over time. They should be subject to at least annual reviews by the relevant CMG. To promote ownership at top level and ensure that key decision makers are sufficiently informed and involved in the process, the resolution strategies should also be subject to regular reviews by top officials of home and relevant host supervisory and resolution authorities. Resolvability assessments (Key Attribute 10) - Resolvability assessments evaluate the feasibility of resolution strategies and their credibility in light of the likely impact of the firms failure on the financial system and the overall economy. Resolvability assessments should help identify any remaining barriers to resolution, and should inform the development and further improvement of the resolution plan.
3.2 Status of implementation of the Key Attributes directed at G-SIFIs

Considerable but uneven progress has been made in implementing the G-SIFI-specific recovery and resolution planning requirements. However, it is important to recognise that resolution planning is an iterative process, in which strategies and plans are developed and amended to take account of changing circumstances, including changes in financial markets, firms internal organisation and structures, and in national legal resolution regimes and funding arrangements.
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As such, they need to be maintained as living documents which are improved and updated over time. - Crisis Management Groups - CMGs have been established for nearly all of the 29 G-SIFIs designated in November 2011. CMG membership includes the prudential supervisor, central bank and, where it is a separate authority, the resolution authority of the home and key host countries. In some cases, the finance ministry of the home or host jurisdiction participates in a restricted manner restrictions being necessary to protect the confidentiality of firm-specific supervisory information. Senior level engagement, with meetings at the level of Heads of Supervision and General Counsel, has proved critical in advancing recovery and resolution planning work within CMGs. - Recovery plans - Initial reviews of recovery plans have taken place for most G-SIFIs, though in-depth reviews are still in progress. These reviews have highlighted a need for greater severity in the hypothetical stress scenarios and for a more exhaustive analysis with regard to impediments to the implementation of recovery measures, taking into account interconnections between group entities and constraints arising from the legal framework. - Resolution strategies and operational plans, resolvability assessments and cooperation agreements - CMGs have been focusing more recently on developing a clearly articulated resolution strategy for their respective G-SIFIs. These strategies outline, at a high level, the strategic approach to resolution that is likely to be adopted should the need arise, but they do not prescribe the precise course of action that the authorities will pursue or preclude the development of fall-back options, given the need to consider the circumstances existing at the time of a resolution.
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The resolution strategies should give the necessary direction to the next stage of work in the CMGs, which should aim to develop detailed operational resolution plans to implement the strategies and to finalise COAGs. Home authorities for each G-SIFI are to propose a basic resolution strategy to key host authorities for discussion within CMGs, with top-level participation, before the end of 2012. As this work has progressed, it has become clear that certain aspects would benefit from deeper examination, including of the emerging lessons and that it would be beneficial to document this in the form of guidance to CMGs (see Section 3.3).
3.3 Further guidance for the recovery and resolution planning process
To support the work described in Section 3.2, the FSB will shortly be releasing a consultative document (Recovery and Resolution Planning: Making the Key Attributes Operational seeking comments from the public on specific aspects of recovery and resolution planning for G-SIFIs: (i) The nature of the stress scenarios and triggers for recovery action that should be used in G-SIFIs recovery plans, and the extent to which plans link specific scenarios and triggers to specific recovery options; (ii) The development of resolution strategies and operational resolution plans tailored to different group structures, drawing on two stylised approaches to resolution: a single point of entry approach by which group resolution takes place primarily through action by the home authority at the level of the parent or holding company; and a multiple point of entry approach whereby resolution actions are taken by multiple authorities along national, regional or functional lines; and
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(iii) The identification of the critical functions and critical shared services that would need to be continued in resolution for reasons of systemic stability.
3.4 Coordination with host jurisdictions with a systemic G-SIFI presence

For reasons of operational efficiency, participation in CMGs should be limited to authorities from the home and key host jurisdictions. However, the failure of a G-SIFI may have an impact on financial stability in other host jurisdictions that are not included in the CMG. The Key Attributes therefore provide that home authorities of G-SIFIs should establish a process to ascertain which other jurisdictions assess the local operations of a G-SIFI as systemically important to the local financial system, and should ensure that appropriate arrangements for communication, cooperation and information sharing with such non-CMG jurisdictions are in place. Home authorities and CMGs may also wish to consider for this purpose the principles that the BCBS has developed to identify domestic systemically important banks. The FSB will develop further guidance for arrangements and procedures for cooperation and information sharing with host authorities for which a G-SIFIs operations are locally systemic but that are not represented on the CMG.
3.5 Review process to assess G-SIFI resolvability

Implementation of all G-SIFI resolution requirements, including resolution strategy, planning, resolvability assessments and COAGs, will be reviewed through resolvability assessments conducted by the resolution authorities and CMGs as well as through a resolvability
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assessment process for G-SIFIs that the FSB expects to launch in 2013. The process should ensure adequate and consistent reporting on the implementation of all G-SIFI resolution requirements across institutions. It should help identify instances of incomplete implementation and highlight material recurring issues that need to be addressed at policy level.
3. Progress report on Increasing the Intensity and Effectiveness of SIFI Supervision

This report concludes that further steps are needed to make supervision more proactive and effective. It notes that the IMF-World Banks Financial Stability Assessment Programs continue to indicate that problems exist in countries meeting the requirements for effective supervision. The report makes further recommendations to support continuous improvement in SIFI supervision, in particular of G-SIFIs: - More intense SIFI supervision. Supervisors should be more proactive in assessing succession planning, risk culture, the effectiveness of Boards and senior management, and stress testing processes at firms. - Assessment of effective supervision. Governments should commit to implement the various standard setters Core Principles for effective supervision, including official mandates, resources and independence of supervisors. The IMF and World Bank should actively monitor progress. - Operational risk. The BCBS should update its capital requirements for operational risk by the end of 2014, as operational risk has been a prominent factor in recent loss events at financial institutions.
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- Supervisory colleges. The FSB and standard setters should intensify efforts to increase the effectiveness of supervisory colleges, including through the adequate exchange of information and cooperation within core supervisory colleges.
Increasing the Intensity and Effectiveness of SIFI Supervision Progress Report to the G20 Ministers and Governors Executive Summary
In the aftermath of the financial crisis, the Financial Stability Board (FSB) and the G20 Leaders identified as a priority the need for more intense and effective supervision particularly as it relates to systemically important financial institutions (SIFIs). Increasing the intensity and effectiveness of supervision is a key pillar of the FSBs SIFI framework, along with requiring higher loss absorbency and facilitating the resolvability of failing financial institutions. In this third report, members of the FSB Supervisory Intensity and Effectiveness group (SIE) observe that weak risk controls at financial institutions are still being witnessed and there remains room for improvement in supervision to ensure that it is effective, proactive and outcomes-focused. The International Monetary Fund (IMF) and World Bank Financial Sector Assessment Program (FSAP) continue to identify problems in the fundamental requirements for effective supervision, such as the core principles for official mandates, resources, and independence. To some extent this underscores a point made in 2010: changes in supervisory intensity and effectiveness are challenging to implement quickly as it takes a change in the preconditions for supervision, as well as changes in culture and different types of skills and resource levels.
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This report covers areas where supervisory practice is becoming more robust, while noting areas where supervisory practice still needs to be improved. One major change in many countries is a move to more extensive and deeper engagement with systemically important firms. This is evidenced by more frequent interaction with Boards, and in some cases more proactive engagement with firms in relation to their process for filling critical roles. Such efforts require seasoned judgement by supervisors. For some, this will be seen as stepping into areas that typically reside within the remit of the firms management; for supervisors it reflects the significant externalities that exist with SIFIs, thereby requiring more robust succession planning and appointment processes for key positions, particularly leaders of key control functions. In addition, this report discusses the need for supervisors to become more active in explicitly assessing risk culture at firms. While light-touch supervision has been clearly rejected, supervisors are re-considering the range of approaches required to ensure effective supervision. For example, during the 1990s and early 2000s there was a move away from detailed assessments of profits and losses (P&L) and financial data (which were very time consuming) toward assessments of controls within financial institutions a necessary move as financial institutions became more complex. However the pendulum may have swung too far away from analysis of the fundamental, strategic risks that underlie the sustainability of financial institutions business models.
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The SIE will explore this issue further, with a view to identifying best practice approaches that could be adopted. In order to remain effective, supervisory focus needs to change with changing risks and circumstances. As an example, this report highlights the importance of zeroing in on operational risk at G-SIFIs, which has been a key risk in recent loss events at financial institutions. This risk will continue to increase as financial institutions seek new ways to generate earnings, such as further expanding into wealth management and other revenue generating areas with low risk-weighted assets and required capital. To the extent that operational risk provides a broad, high level threat to the firms business strategy, supervisors should satisfy themselves that Boards and senior management dedicate sufficient attention and resources to the management of operational risk with regard to prevention and control. Moreover, aspects of operational risk, such as business continuity and information security, cannot be addressed by adding capital. No supervisory system can catch everything. The main responsibility for identifying and managing risk rests with each firms management, whose risk managers, compliance and internal audit personnel will always greatly outnumber the resources available to supervisors. The more and more sophisticated activity of financial institutions has increased the array and intensity of the risks to which institutions are exposed.
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Risk-based supervision seeks to address this through deploying limited supervisory resources to the riskiest institutions and areas, prioritised based on an assessment of the risks therein. Other institutions and areas will, however, continue to present risks and supervisory authorities will lack the resources to examine everything. As such, supervisory approaches and areas of focus need to be periodically reviewed to confirm that, for instance, institutions and areas previously classified as low or moderate risk still warrant this assessment. Effective supervision requires finding the right balance between focusing on areas of higher risk while also ensuring some periodic coverage of all aspects, including, for example, those that might prove risky ex post. Striking the right balance is an ongoing challenge; however, regulatory developments since the global financial crisis should allow supervisors to explore and leverage off deeper information sets and analysis. This may include the information that can be made available from central repositories and other centralised sources of financial data to track anomalies in the market, and information from implementation of recovery and resolution plans which provide supervisors with new insights. The financial system is composed of institutions of many forms and shapes. While supervisory approaches to second-tier institutions in some countries might still rely on more traditional, risk-based approaches that call for a lesser degree of (or no) supervisory intensity, both the events during the crisis (e.g. Northern Rock) and recent events (e.g. the Spanish crisis) clearly demonstrate that small institutions can pose their own challenges to stability as a result of geographic and product concentration.
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The overall supervisory strategy needs to be mindful of such vulnerabilities. Finally, supervisors need to be equipped with the mandate, independence and resources to reduce the likelihood of SIFI failures. Resource constraints at supervisory authorities was an area identified in the 2011 FSB report as hampering progress toward improving the intensity and effectiveness of supervision. To get at the crux of this issue, SIE members completed a survey aimed at assessing the resource constraints at supervisory authorities, particularly in the oversight of SIFIs and G-SIFIs. In addition, the IMF reviewed nine recent FSAP assessments regarding the adequacy of supervisory resources. Collectively, they describe some of the challenges supervisory agencies face in building the capacity required for the supervision of financial institutions, in particular of G-SIFIs. An immediate challenge is determining the supervisory staff required, not only in regard to numbers but also seniority and skill mix. In summary, while the intensity of supervision has increased since the crisis, much remains to be done to support continuous improvement in SIFI supervision, in particular of G-SIFIs. When done well, however, effective and high quality supervision leads to more robust discussions with institutions and early responses to inadequately controlled risk-taking, from which both sides gain. To support continuous improvement, the report draws some recommendations that flow from the discussions among members of the SIE group.
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List of recommendations: More intense SIFI supervision

The following recommendations are aimed at intensifying SIFI supervision but they are also applicable for the supervision of financial institutions more generally. 1. Supervisors should adopt proactive approaches to assess succession planning and set performance expectations for key positions within SIFIs (e.g. CEOs, CROs, Internal Auditors), elements that should no longer be regarded as only internal matters for financial institutions. At a minimum, supervisors should require that firms have robust processes in place to ensure effective talent management and succession planning for leaders of control functions and other key positions. They also should be informed of the rationale for appointments to such positions in advance of the appointments being made. 2. Supervisory interactions with Boards and senior management should be stepped up, in terms of frequency and level of seniority, as should the assessment of the effectiveness of Boards and senior management. Supervisors should satisfy themselves that SIFIs have a robust process in place to assess applicants for Board-level or senior management positions and should be informed of the rationale for Board appointments in advance of such announcements. 3. Supervisory authorities should continually re-assess their resource needs; for example, interacting with and assessing Boards require particular skills, experience and adequate level of seniority.
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Multi-year resource plans, supervisory training programs, long-term career paths and development of soft skills, such as leadership and communication skills, are essential. The SIE will review supervisory approaches to and emphasis on training programs in the coming year. 4. Supervisors of G-SIFIs need to ensure that the stress testing undertaken for G-SIFIs is comprehensive and commensurate with the risks and complexities of these institutions and should advance further with the implementation of the BCBS Principles for Sound Stress Testing Practices. 5. Supervisors should further explore ways to formally assess risk culture, particularly at G-SIFIs. Establishing a strong risk culture at financial institutions is an essential element of good governance. Metrics such as audit findings not being closed and employee survey results could allow conclusions about culture to be reached on an ongoing basis and before major issues arise due to weak risk cultures. Supervisors should also expect financial institutions to be proactive in this regard. The SIE will discuss supervisory practices and approaches toward assessing risk culture. 6. Supervisors need to evaluate whether their approach to and methods of supervision remain effective or have, for example, moved too far toward focusing on adequacy of capital and control systems, and away from detailed assessments of sources of profits and financial data. The SIE will explore this further, including resource implications relative to the benefits of increasing focus in the latter areas.
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7. Supervisors need to consider putting in place additional data management and analysis processes for the information available from a range of sources, such as that collected by trade repositories and other centralised sources of financial data, so that key players in markets and market anomalies are identified. Supervisors should explore how this new information could be useful in the supervision of SIFIs. 8. By the end of 2013, the FSB SIE group should report on progress toward addressing these issues and set out best practices or recommendations for how to enhance the effectiveness of supervision in each of the above areas.
Assessment of effective supervision

9. The FSBs initiative on promoting adherence to regulatory and supervisory standards focuses on banking supervision, insurance supervision and securities regulation and views the IMF-World Bank FSAPs and ROSCs as central mechanisms for promoting implementation of the BCBS, IAIS and IOSCO core principles. However, there are differences in the assessment methodology and ratings nomenclature in regard to the: (i) Use of discretion in the assessments to take account of proportionality and materiality; (ii) Degree to which standards are aspirational versus minimum requirements; and (iii) Messages communicated given the different terminology for ratings, particularly when applied to core principles that address similar areas. As the FSB places increased reliance on FSAPs and ROSCs and focuses on SIFIs (which can be from any sector), the FSB, in collaboration with
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the IMF, World Bank and standard setters, should examine the pros and cons of harmonising the assessment methodology and ratings nomenclature. 10. Emphasis must continue to be placed on the fundamental requirements for effective supervision, particularly in regard to official mandates, resources, and independence as FSAPs and ROSCs continue to indicate problems in these areas. The BCBS, IAIS, and IOSCO core principles provide a clear benchmark for what is needed to achieve effective supervision, and the enhanced BCBS and IAIS core principles raise the bar by placing greater emphasis on these issues. Governments should commit to implementing the BCBS, IAIS and IOSCO core principles for effective supervision and the IMF/World Bank should actively monitor progress toward full implementation through FSAPs and ROSCs. In addition, the FSB should enhance its monitoring of these areas, leveraging for example on the FSB Implementation Monitoring Network exercise, to ensure that adherence to these core principles becomes a matter of ongoing attention and public disclosure. 11. The IAIS should follow-up on its findings from the self-assessment exercise against ICP 23 on group-wide supervision, including the challenges and prerequisites for effective group-wide supervision and ensuring supervisors have the powers to act at the level of the holding company. The IAIS should report to the SIE by end 2013 on the progress made toward achieving group-wide supervision and equipping supervisors with the appropriate powers to act at the level of the holding company.
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Operational risk
12. The recent spate of high-profile, and potentially solvency-threatening, operational risk events and failures have added some urgency to fundamentally reviewing the BCBS approach toward capital for operational risk. The BCBS should update its capital requirements for operational risk by the end of 2014. 13. The BCBS should conduct a peer review on implementation of its Principles for the Sound Management of Operational Risk by June 2014. The BCBS should supplement the review with an assessment of the additional guidance needed on operational controls within capital markets and trading businesses. 14. The BCBS should conduct a study of its Supervisory Guidelines for the Advanced Measurement Approaches by end 2015 to assess whether any changes are necessary to enhance their effective implementation and to bring more consistency to supervisory approaches in this area. 15. The IAIS should maintain its timeline for launching a peer review in 2014 to assess effective implementation of ICP 16 on enterprise risk management for solvency purposes and ICP 17 on capital adequacy, as both principles cover operational risk.
Supervisory colleges
16. The FSB, in collaboration with the standard setters, should intensify efforts to increase the effectiveness of supervisory colleges, particularly for G-SIFIs. Given the strong interest and expectation of colleges expressed through the G20 process, it is critical that the FSB further consider ways to ensure
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adequate exchange of information and cooperation within core supervisory colleges, as well as avenues to promote joint decision making processes in the future. The FSB should submit a report to the September 2013 G20 Summit which sets out policy recommendations to address the issues identified as hindering the effectiveness of core supervisory colleges. 17. The BCBS and IOSCO should monitor the establishment and composition of core (and universal) colleges as well as assess the activity of new colleges and frequency of existing colleges (as the IAIS does) and report progress to the FSB on an annual basis.
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Agencies Provide Guidance on Regulatory Capital Rulemakings

The U.S. federal banking agencies issued three notices of proposed rulemaking in June that would revise and replace the current regulatory capital rules. The proposals suggested an effective date of January 1, 2013. Many industry participants have expressed concern that they may be subject to a final regulatory capital rule on January 1, 2013, without sufficient time to understand the rule or to make necessary systems changes. In light of the volume of comments received and the wide range of views expressed during the comment period, the agencies do not expect that any of the proposed rules would become effective on January 1, 2013. As members of the Basel Committee on Banking Supervision, the U.S. agencies take seriously our internationally agreed timing commitments regarding the implementation of Basel III and are working as expeditiously as possible to complete the rulemaking process. As with any rule, the agencies will take operational and other considerations into account when determining appropriate implementation dates and associated transition periods.
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The Federal Reserve Board on Friday launched the 2013 capital planning and stress testing program, issuing instructions to firms with timelines for submissions and general guidelines. The program includes the Comprehensive Capital Analysis and Review (CCAR) of 19 firms as well as the Capital Plan Review (CapPR) of an additional 11 bank holding companies with $50 billion or more of total consolidated assets. The aim of the annual reviews is to ensure that large, complex banking institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress. Capital is important to banking organizations, the financial system, and the broad economy because it acts as a cushion to absorb losses and helps to ensure that any such losses are borne by shareholders, not taxpayers. Institutions in the CCAR and CapPR programs will be expected to have credible plans that show they have sufficient capital to continue to lend to households and businesses even under severely adverse conditions, and are well prepared to meet Basel III regulatory capital standards as they are implemented in the United States. Firms' capital adequacy will be assessed against a number of quantitative and qualitative criteria, including projected performance under the stress scenarios provided by the Federal Reserve and the institutions' internal scenarios. Boards of directors of the institutions are required to review and approve capital plans before submitting them to the Federal Reserve.
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"The Federal Reserve has been focused--and will remain focused--on ensuring the nation's largest financial institutions have enough capital to weather severe, unexpected conditions and still continue lending to households and businesses," Gov. Daniel K. Tarullo said. The 19 bank holding companies in the CCAR have increased their aggregate tier 1 common capital to $803 billion in the second quarter of 2012 from $420 billion in the first quarter of 2009. The tier 1 common ratio for these firms, which compares high-quality capital to risk-weighted assets, has more than doubled to a weighted average of 10.9 percent from 5.4 percent. One part of the CCAR and CapPR reviews is an evaluation by the Federal Reserve of institutions' plans to make capital distributions, such as dividend payments or stock repurchases. The Federal Reserve will approve dividend increases or other capital distributions only for companies whose capital plans are approved by supervisors and who are able to demonstrate sufficient financial strength to continue to operate as financial intermediaries under stressed macroeconomic and financial market scenarios, even after making the planned capital distributions. In a change from prior years, following the Federal Reserve's assessment of the initial capital plans, CCAR firms will have one opportunity to make a downward adjustment to their planned capital distributions from their initial submissions before a final Federal Reserve decision is made. As in 2012, the Federal Reserve will release summary results for the 19 CCAR firms including its projections of capital ratios, losses, and revenues under the Federal Reserve's severely adverse scenario. In 2013, the Federal Reserve will release two sets of post-stress data for each firm.
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One set will reflect the capital distribution assumptions prescribed in the stress testing rule mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act to enhance comparability of results. The other will include ratios based on each firm's own planned capital actions as proposed in their initial CCAR capital plan submissions, as well as ratios based on any adjustments made to planned capital distributions. While the aims of CapPR are the same as CCAR, there are a number of important distinctions. For example, the Federal Reserve's assessment of capital plans under CapPR will not be based on supervisory estimates derived from independent supervisory models, but instead solely on an assessment of the firms' own capital plans and internal capital planning and stress testing practices that support them. Further, the Federal Reserve will not publish a summary of bank-specific results for CapPR in 2013. The Federal Reserve wanted to give firms as much time as possible to prepare their submissions and therefore is issuing the instructions ahead of the release of the macroeconomic and financial market scenarios. The Federal Reserve will require institutions to use the scenarios in both the stress tests conducted as part of their capital plans and in the stress tests that are part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Federal Reserve expects to release the scenarios at 4 p.m. EST on Thursday, November 15. Institutions will be required to submit their capital plans no later than January 7, 2013.
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The following is a full version of the Group of 20 communique:

1. We, the G20 Finance Ministers and Central Bank Governors, met to assess progress on the fulfillment of the mandates given to us by our Leaders, to promote robust growth and job creation and to address ongoing economic and financial challenges. 2. We will do everything necessary to strengthen the overall health and growth of the global economy. Our main focus in the period ahead will be to rebuild confidence and to reduce risks and volatility in international financial markets; contribute to a faster pace of economic recovery and job creation, and promote the foundations for strong, sustainable, and balanced growth. We are firmly committed to open trade and investment, expanding markets and resisting protectionism in all its forms. 3. We have made significant progress in implementing the commitments established in the Los Cabos Growth and Jobs Action Plan. Substantive measures have been adopted in Europe, including the launch of the European Stability Mechanism, the decision of the ECB on Outright Monetary Transactions, the agreement by European leaders to establish a single supervisory mechanism for banks, the adoption and ongoing implementation of the Compact for Growth and Jobs, and the reforms and fiscal consolidation carried out by a number of European countries. Other countries with policy space have implemented actions to support aggregate demand.
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Major central banks have taken further unconventional measures in line with their respective mandates which are welcomed. 4. Global growth remains modest and downside risks are still elevated, including due to possible delays in the complex implementation of recent policy announcements in Europe, a potential sharp fiscal tightening in the United States, securing funding for this year's budget in Japan, weaker growth in some emerging markets and additional supply shocks in some commodity markets. The reduction of global imbalances has not been sufficient, and in many countries the process of necessary deleveraging by the private and public sectors is ongoing and unemployment remains high. Complete and timely implementation of all of our policy commitments is critical in order to continue to reduce risks and secure a durable and strong recovery. 5. We are committed to build on the policy measures taken in recent months. Current reform momentum in the EU on structural, fiscal and financial fields needs to be continued with the view to improving competitiveness and promoting financial stability. In this respect, we welcome the recent decision by European leaders to agree on a legislative framework by January 1st 2013 on a single supervisory mechanism. We look forward to the operational implementation of the single supervisory mechanism in the course of 2013 and to the completion of the technical discussions on the future of the ESM direct bank recapitalization instrument, within a broader strategy of completing the architecture of the EMU.
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6. We will ensure our public finances are on sustainable paths, in line with the medium-term Toronto commitments in the case of advanced economies. In light of the weak pace of global growth, they will ensure that the pace of fiscal consolidation is appropriate to support the recovery. Countries which have fiscal space will let the automatic fiscal stabilizers operate as appropriate. Those with sufficient space stand ready to support demand as needed in the shortrun should economic conditions deteriorate. The United States will carefully calibrate the pace of fiscal tightening to ensure that public finances are placed on a sustainable long-run path while avoiding a sharp fiscal contraction in 2013. In Japan further progress in medium-term fiscal consolidation is needed. By the next Summit, advanced economies agree to identify credible and ambitious country-specific targets for the debt-to-GDP ratio beyond 2016, where these do not currently exist, accompanied by clear strategies and timetables to achieve them. 7. The weak pace of global growth also reflects limited progress towards sustaining and rebalancing global demand. We commit to achieving external and internal adjustment in a way that supports and sustains growth and leads to global rebalancing. In this regard, we reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, avoid persistent exchange rate misalignments and refrain from competitive devaluation of currencies; to boost domestic sources of growth in surplus economies, and boost national savings in deficit economies.
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We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. We commit to the implementation of ambitious structural reforms aimed at promoting output and employment. We have also made progress in strengthening our Accountability Assessment framework by agreeing on a set of measures to inform our analysis of our fiscal, monetary and exchange rate policies. We will consider a range of indicators and approaches to assess spillover effects, progress towards commitments on structural reforms, and our collective achievement of strong, sustainable and balanced growth. 8. We welcome the continuation of the process to strengthen IMF resources to safeguard global financial stability and enhance the IMF's role in crisis prevention and resolution. Since the Los Cabos Summit, additional pledges have been received from more members, and total commitments add up to US$461 billion. Furthermore, we welcome the formalization of the first set of bilateral borrowing agreements under the agreed modalities comprising US$286bn, which represent more than half of the Los Cabos' 2012 pledge. We call for the finalization of the remaining bilateral agreements. 9. We welcome IMFs Executive Board decision on the use of US$2.7bn of additional resources from the windfall gold sales profits for the Funds Poverty Reduction and Growth Trust and call on the membership to provide the assurances needed for this to take place. This effort reinforces the international communitys will to reduce poverty by boosting financial assistance to low income country members.
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10. We remain committed to the full implementation of the 2010 Quota and Governance Reform. Although significant progress has been achieved, as of October 2012 the conditions for the entry into force of the 2010 Quota and Governance Reform have not been fully met. We reaffirm the urgency of making these important reforms effective and call on members who have yet to complete the process to do so as soon as possible. The process of IMF reform will enhance its legitimacy, relevance and effectiveness. 11. We are committed to completing the comprehensive review of the quota formula, to address deficiencies and weaknesses in the current quota formula, by January 2013 and to complete the next general review of quotas by January 2014. We agree that the formula should be simple and transparent, consistent with the multiple roles of quotas, result in calculated shares that are broadly acceptable to the membership, and be feasible to implement based on a timely, high quality and widely available data. We reaffirm that the distribution of quotas based on the formula should better reflect the relative weights of IMF members in the world economy, which have changed substantially in the view of a strong GDP growth in dynamic emerging markets and developing countries. We reaffirm the importance of continuing to protect the voice and representation of the poorest members of the IMF. We call on the IMF membership to develop the consensus needed to complete the review by January 2013.
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12. We welcome the strengthening of the IMF's surveillance framework through the adoption of the new Integrated Surveillance Decision, and we welcome the introduction of the Pilot External Sector Report to strengthen multilateral analysis and enhance the transparency of surveillance. A transparent and evenhanded framework of surveillance is key to achieve ownership and traction of policy recommendations by the IMF, thus making surveillance more effective. 13. We note the World Bank and other International Organizations' (IOs) progress report on implementation of the G20 action plan to support the development of local currency bond markets. We look forward to full implementation of the action plan in 2013 to ensure a broad ownership of the diagnostic tool among potential users, and further reporting on progress by the World Bank. We welcome ongoing regional initiatives to promote local currency bond markets. We will deepen work on these issues under Russias Presidency. 14. We acknowledge the importance of long term financing, particularly for infrastructure investment, recognizing that work on this subject will foster an environment more conducive to long-term investment, effectively helping to boost jobs and growth. We ask that the World Bank, IMF, OECD, FSB, UN and relevant IOs undertake further diagnostic work to assess factors affecting long-term investment financing including its availability. We look forward to receiving this work in early 2013 to provide a sound basis for any future G20 work.
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15. We remain committed to the full, timely and consistent implementation of the financial regulation agenda, and discussed the latest FSB reports on the progress in implementation of agreed reforms. We endorse the conclusions and recommendations of the fourth progress report on the implementation of the G20 commitments to OTC derivatives reforms and the BCBS report on implementation of Basel III. We agree to put in place the legislation and regulation for OTC derivatives reforms promptly and act by end-2012 to identify and address conflicts, inconsistencies and gaps in our respective national frameworks, including in the cross-border application of rules. We agree to take the measures needed to ensure full, timely and effective implementation of Basel II, 2.5 and III and its consistency with the internationally agreed standards. We look forward to receiving for our April meeting the BCBS report on the consistency of measurement of risk-weighted assets. We endorse the Charter for the Regulatory Oversight Committee which will act as the governance body for the global Legal Entity Identifier system to be launched in March 2013. 16. We acknowledge progress made in the design and implementation of policy measures to strengthen the resilience of the financial system and reduce systemic risks. In particular, we welcome the publication by the FSB of an updated list of global systemically important banks, the BCBS framework for dealing with domestic systemically important banks, and the International Association of Insurance Supervisors (IAIS) consultation paper on policy measures for global systemically important insurance companies. We commit to make the necessary changes to resolution regimes to enable authorities to resolve SIFIs.
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We welcome the initial integrated set of policy recommendations to strengthen the oversight and regulation of shadow banking together with expanded data monitoring. We call for finalized policy measures by the St. Petersburg Summit for oversight and regulation for shadow banking that can be peer-reviewed. 17. We also welcome the recommendations to increase the intensity and effectiveness of SIFI supervision, and the FSB's roadmap to accelerate implementation of the FSB Principles for Reducing Reliance on Credit Rating Agency Ratings. We encourage further work to enhance transparency of and competition among credit rating agencies and ask IOSCO to provide a report on ongoing work at our meeting in April. We support measures to strengthen the transparency of financial institutions and recognize the contribution of the Enhanced Disclosure Task Force. Recognizing the need for adequate statistical resources, we endorse the progress report of the FSB and the IMF on closing information gaps, and in particular look forward to the implementation of the data reporting templates for global systemically important financial institutions. We are concerned about the slow progress achieved toward a single set of high quality accounting standards. We encourage the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) to complete work promptly, and report to our next meeting. In relation to LIBOR, EURIBOR and other financial benchmarks, we welcome actions taken and ongoing reviews to identify measures to address weaknesses and restore confidence in benchmark and index setting practices and welcome the coordinator role of the FSB as agreed.
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We ask IOSCO to provide by our April meeting a report on the next steps on the functioning of credit default swaps markets. We expect the FSB to continue monitoring, analyzing and reporting on the unintended consequences of regulatory reforms on EMDEs. 18. We welcome the FSB's progress in implementing the measures endorsed at Los Cabos to strengthen its capacity, resources and governance. We look forward to its establishment as a legal entity by our next meeting and its full implementation by September 2013. We call on the FSB to report back on how it intends to keep under review the structure of its representation. 19. We welcome the observed increase in jurisdictions' adherence to international regulatory and supervisory cooperation and information exchange standards, as stated in the FSB status report, and call for further progress. 20. We remain committed and encourage the FATF to continue to pursue all its objectives, and notably to continue to identify and monitor high-risk jurisdictions with strategic Anti-Money Laundering /Counter-Terrorist Financing (AML/CFT) deficiencies. We look forward to the completion in 2013 of the revision of the FATF assessment process. We encourage all countries to adapt their legal framework with a view to complying with the revised FATF's Recommendations, in particular the necessity to identify the beneficial owner of corporate vehicles, and we look forward to the assessment of the effectiveness of the measures countries take and their compliance with the global standards in the next round of Mutual Evaluations.
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21. We commend the signings of the Multilateral Convention in Cape Town and further progress made towards transparency as reported by the Global Forum whose membership has increased. We look forward to a progress report by the Global Forum on the effectiveness of information exchange practices by April 2013. We welcome and endorse the improved OECD standard with respect to information requests on a group of taxpayers and encourage all countries to adopt it when appropriate. We will continue to implement practices of automatic exchange of information and call on the OECD to analyze the safeguards, mechanisms and milestones necessary to increase its use and efficient implementation in a multilateral context. We also welcome the work that the OECD is undertaking into the problem of base erosion and profit shifting and look forward to a report about progress of the work at our next meeting. 22. We welcome the work stated in the final 2012 Global Partnership for Financial Inclusion (GPFI) progress report on implementing the five recommendations set out in 2011 and the progress on implementing the G20 Principles for Innovative Financial Inclusion, including through concrete actions by developing and emerging countries to meet their commitments to the Maya Declaration. We commend the additional commitments to the Maya Declaration made in Cape Town in 2012, and encourage countries to measure progress through national data collection efforts. We welcome the decision to establish the Alliance for Financial Inclusion (AFI) as a permanent network for knowledge creation, exchange and policy dialogue. 23. We welcome the first GPFI Conference on Standard-Setting Bodies and Financial Inclusion as a substantial demonstration of growing
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commitment among Standard Setting Bodies (SSBs) to provide guidance and to engage with the GPFI to explore the linkages among financial inclusion, financial stability, financial integrity and financial consumer protection. We also commend the work done to continue improving SMEs financing and their environment. 24. Together with the implementing partners, we look forward to updates on the G20 Financial Inclusion Peer Learning Program and encourage the commitment to other initiatives that promote Financial Inclusion. 25. For advancing the financial consumer protection agenda, we acknowledge the work done by the International Financial Consumer Protection Network (FinCoNet) to support the exchange of best practices and look forward for a progress report by the G20 Summit in St. Petersburg in 2013. We also welcome the implementation of the action plan by the G20 OECD Task Force on Financial Consumer Protection and progress achieved in Cartagena, including in the field of national strategies and financial education for women, by the OECD International Network on Financial Education (INFE). 26. We welcome the number of proposals received in response to the 2012 Mexico Financial Inclusion Challenge: Innovative Solutions for Unlocking Access. We congratulate the finalists and the winner. 27. In Los Cabos, Leaders recognized that excessive commodity price volatility has significant implications for countries, increasing uncertainty in the economy, and endorsed the conclusions of a report on the macroeconomic impacts of excessive commodity price volatility on growth.
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Ahead of the 2013 Summit, we will report progress on the G20's contribution to facilitate better functioning of commodity markets, considering possible areas for further work outlined in the report. 28. We reaffirm our commitment to improve transparency and functioning of commodity markets. We welcome the progress made in the implementation of the Agricultural Market Information System (AMIS) which will provide more transparency on physical markets for agricultural commodities. We welcome the IEF's recommendations to improve the reliability of the JODI-Oil database. We welcome the report prepared by the IEA, the IEF and the OPEC on increasing transparency in international gas and coal markets and ask these organizations to propose practical steps by mid-2013 that G20 countries could take to implement them. We welcome progress on the JODI-Gas database and look forward to working with it in 2013. We welcome the report on recommendations to improve the functioning and oversight of oil Price Reporting Agencies, and ask IOSCO to liaise with the IEA, IEF and OPEC to assess the impact of the principles on physical markets and report back. We also ask IOSCO to report progress on the implementation of the principles in 2013. We reaffirm our commitment to enhance transparency and appropriate regulation in financial commodity markets, and thus we welcome IOSCO's report on the implementation of its Principles for the Regulation and Supervision of Commodities Derivatives Markets.
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29. In Los Cabos, Leaders highlighted that green growth and sustainable development policies have strong potential to stimulate long term prosperity. We will voluntarily self-report again in 2013 on our efforts to incorporate green growth and sustainable development policies into structural reform agendas, taking into account the outcome of the UN Conference on Sustainable Development (Rio+20). We will report back to our leaders on the progress made to rationalize and phase-out over the medium-term inefficient fossil fuel subsidies that encourage wasteful consumption, while providing targeted support for the poorest. We will develop a voluntary peer review process on such fossil fuel subsidies and present a report on the outcomes to our Leaders in 2013. We welcome the OECD report on pension funds financing green initiatives. 30. Recognizing that the UNFCCC is the forum for climate change negotiations and decisionmaking at the international level, we acknowledge that climate finance is a relevant issue to be discussed amongst G20 Finance Ministers and Central Bank Governors. We welcome the progress report by the G20 Climate Finance Study Group on ways to effectively mobilize resources for climate finance. We will continue working towards building a better understanding of the underlying issues among G20 members taking into account the objectives, provisions and principles of the UNFCCC, and report back to our Leaders in 2013. 31. We recognize that disaster risk financing policies are necessary for an overall Disaster Risk Management (DRM) strategy.
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We appreciate and welcome the combined efforts made by the World Bank and the OECD, with the support of the United Nations, to broaden the participation in the discussion on DRM by highlighting the central role that financial policymakers play to support other areas of Government and civil society in dealing with disasters. We welcome the G20/OECD voluntary framework for disaster risk assessment and risk financing which provides a detailed guideline that aims to facilitate the implementation of more effective DRM strategies. We encourage further efforts by the World Bank and OECD in cooperation with other relevant international organizations to leverage the voluntary framework in order to address remaining challenges. 32. We commend Mexico for chairing the G20 in 2012 and look forward to Russia's presidency in 2013.
The Finance Track

The Finance Track in the G20 focuses on financial and economic issues; these include providing solutions to the current economic problems, economic stabilization and structural reforms, increasing international coordination for crisis prevention, correction of external, fiscal and financial imbalances, providing resources to increase global liquidity, and strengthening the international financial system. The Finance Track is composed of all G20 Finance Ministers and Central bank Governors who meet regularly during the year to discuss the current economic global problems and take coordinated actions towards their solutions; these meetings are attended also by International Organizations such as the IMF, World Bank, OECD or the Financial Stability Board. Organizationally, the track operates with working groups formally established within the G20 but also through close cooperation with international financial entities.
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Currently the Finance Track of the G20 is organized in the following major areas: I. Framework for Strong, Sustainable and Balanced Growth Working Group (Co-chaired by Canada and India) II. Financial Regulation III. Financial Inclusion, Financial Education and Consumer Protection IV. International Financial Architecture Working Group (Co-chaired by Australia and Turkey) V. Energy and Commodities Markets Working Group (Co-chaired by Indonesia and United Kingdom) a. Commodities Markets Subgroup (Co-chaired by Brazil and United Kingdom) b. Energy and Growth Subgroup (Co-chaired by Korea and United States) VI. Disaster Risk Management VII. Climate Finance Study Group (Co-chaired by France and South Africa) The G20 has been a very effective forum of international coordination and cooperation for crisis mitigation and to foster economic growth and strengthen financial regulation. It has also increased its scope to other relevant economic issues such as financial inclusion and education, disaster risk management, green growth or climate finance. Under the Mexican presidency, the Finance track launched the 2012 G20 Agenda on December 13-14th 2011 with a seminar in Mexico City. In preparation to the Leaders Summit in Los Cabos in June, Finance Ministers and Central Bank Governors have met on February and April to discuss current relevant economic problems and have taken coordinated actions for their solution.
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On time, stocks and flows: Understanding the global macroeconomic challenges

Claudio Borio Bank for International Settlements
Introduction
It wasnt meant to be like this. The financial crisis that began in 2007 shattered the illusion of uninterrupted prosperity that had prevailed in much of the Western world. It was not the first time that this had happened. Doubtless, it will not be the last. Five years on, much of the advanced country world is still struggling to return to robust, sustainable growth. And the crisis has kept morphing before our eyes; it has now engulfed sovereigns too. The euro area is the new epicentre. But will the tremors stop there? In what follows, I will seek to provide a broad framework for thinking these issues through. How did we get here? Why? Where might we go from here? How might we extricate ourselves from our predicament? These are hard questions.
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No one really knows the answers. But all of us have a perspective and a narrative that goes with it. This is just another one one that draws heavily on work done at the BIS. I will try to look below the busy and at times chaotic surface of the world economy. The idea is to identify what one might call the shifts in its tectonic plates those deep forces that, slowly but cumulatively, can fundamentally reshape what we see on the surface and that economists call economic regimes. I will highlight three such forces: financial liberalisation, the establishment of credible anti-inflation monetary frameworks, and the globalisation of the real side of the world economy. Each of them, taken in isolation, is undoubtedly a good thing. All of them together are worth having and fighting for. Yet I will argue that a failure of policy to adjust to them has played an important role in the crisis and its aftermath. It has given rise to the re-emergence of powerful financial cycles, whose booms and busts have caused havoc in the economy and have left us where we are today. But what is the link between all this and the title of my remarks? In fact, the title highlights two key aspects of the story. First, time.
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As the three deep forces gained full strength from the mid-1980s, they shaped an environment where, in Burns and Mitchells terminology, economic time has slowed down relative to calendar time. That is, the macroeconomic developments that matter take much longer to unfold. The length of the financial cycle is much longer that of the traditional business cycle, of the order of 16 to 20 years or more compared with up to eight years. Yet the planning horizons of market participants and policymakers have not adjusted accordingly indeed, if anything, they have shrunk. This is a critical reason why the current problems have arisen and why it has proved so hard to solve them. And it has major implications for the sustainability of growth, for financial regulation, for fiscal policy and for monetary policy. We then come to stocks and flows. In the new environment, stocks have come to dominate economic dynamics, in particular the large stocks of assets and, above all, debt. Stocks build up above trend during financial booms, as credit and asset prices grow beyond sustainable levels, and generate stubborn overhangs once the boom turns to bust. Stocks raise serious policy challenges. In the presence of policy responses that react too little to booms and too much to busts in jargon, that are asymmetric stocks grow over consecutive business cycles. It takes longer to deal with them.
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And doing so is also politically more difficult, because of the serious impact on income and wealth distribution, both within and across generations. This is true of both private and public debt. Failure to deal with stocks effectively could entrench instability in the system. If this diagnosis is right, the remedy is not hard to find, although it may be extraordinarily difficult to implement. In a nutshell, it is to lengthen policy horizons, to put in place more symmetrical policies, and to tackle the debt problems head-on. Much of my discussion will seek to make these guidelines more concrete. The ultimate risk of a failure to adjust is that of yet another epoch-defining shift in the tectonic plates the risk of a reversal that will take us back to an era of financial and trade protectionism as well as inflation. The structure of my remarks is as follows. The first section lays out the broad canvas. It considers the changing character of economic fluctuations, highlighting the role of the financial cycle and its link to structural institutional arrangements, policy decisions and horizons. The second section turns to the policy challenges. It begins with a brief summary of the current situation, seen through the lens of the financial cycle.
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It then explores, in turn, the immediate or more conjunctural challenge of how to return to self-sustaining and sustainable growth and then the longer-term or more structural challenge of how to adjust policy frameworks to address the financial cycle not to be interpreted sequentially, though. The discussion covers financial (specifically prudential) regulation and supervision, fiscal and monetary policies. While my focus is on the global economy, I will also note the specificities of the European situation.
I. The broad canvas Stylised facts: an economic historians perspective

Imagine a future economic historian looking back at the big macroeconomic trends from the first oil shock of the early 1970s to our present day. What would he see as he cast his gaze over a longer historical timespan? Consider, in turn, the most salient outcomes, the intellectual backdrop, the features of banking crises, and institutional setups. In terms of outcomes, he would no doubt be struck by the major shift in the behaviour of inflation: from high and variable to low and stable, with the inflexion point around the early 1980s. At the same time, he would also note a major increase in financial crises, especially banking crises, with serious macroeconomic consequences, in both advanced and emerging market economies. Reading the contemporary economic texts to understand the intellectual backdrop, he would surely find it ironic that the view prevailing at the time had regarded price stability as a guarantee of macroeconomic stability.
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And that, in much of the West during the early 2000s, there had even been talk of a so-called Great Moderation: a golden age of stable output and low inflation. This conviction had hardly been dented by the banking crises that had hit emerging market economies and even some advanced ones during the 1980s and 1990s, not least the Nordic countries and Japan. To paraphrase Reinhart and Rogoff, what seemed to be at work was not just the this-time-is-different syndrome but the no less insidious we-are-different syndrome. It had taken the Great Financial Crisis, as contemporaries had quickly called it, which had erupted in 2007 to shake this complacency. The historian would also note that the experience of those years had been by no means unique. Similar economic fluctuations, where low inflation had coexisted with occasional banking crises, had been quite common in the Gold Standard days, when countries had pegged their currencies to gold. Indeed, a long economic boom with low and stable inflation had ushered in that other defining moment in economic history the Great Depression in the United States in the early 1930s. Then, just as later on, there had been talk of permanent prosperity, of an end to the tyranny of the business cycle. Our historian would then go one level deeper. He would ask: Are banking crises, like Tolstoys famous unhappy families, all different? Or are they more like his happy ones, which are all alike?
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It is all too easy, he would note, to spot the idiosyncratic features of a crisis. Structured products, for instance, had not existed in the early 1930s. Or, to take just another example, the crises in Japan and Nordic countries had caused havoc in bank-based financial systems; by contrast, the subsequent Great Financial Crisis had originated in the United States, with its securitisation-intensive, capital markets-based financial system. Or, again, the crisis in Finland had followed the collapse of its main trading partner, the Soviet Union; but no obvious external shock had been at work in 2007. And he could go on. Yet, he would quickly realise that focusing on idiosyncrasies would mean falling victim to the we-are-different syndrome in another guise. A fuller understanding of crises requires a focus on what they have in common, not on how they differ. Only then can one find reliable remedies. After all, had not the Japanese bank-based financial system been hailed as superior ahead of the countrys banking crisis? And had not much the same been said of the US market-based financial system ahead of its own meltdown? Our historian would then look for common patterns. Soon enough, an obvious one would leap out at him: crises tend to be preceded by major financial booms and followed by protracted busts that leave deep scars in the economic tissue.
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In other words, they are closely associated with peaks in the financial cycle. The joint behaviour of credit and asset prices, in particular property prices, capture these cycles remarkably well. And since banking crises are rare events in any given country, it is natural for these cycles to be very long. Their order of magnitude is between 15 and 20 years. As he read further, our historian would realise that the close association between crises and financial booms and busts had, in fact, been recognised early on in the economics profession, as far back as the 19th century. During the post-war period, economists such as Kindleberger and Minsky had kept the concept alive at the margins of the field. Their work had inspired policy-oriented research ahead of the Great Financial Crisis. But it had gone largely unheeded, drowned in the contagious enthusiasm for the Great Moderation. Memories are short; hubris long. But our historians intellectual curiosity could not stop there. He has established that financial cycles foment banking crises, with damaging macroeconomic consequences. He has also noted that financial cycles were a common feature both of the gold standard era and of the period running from the mid-1980s to our present day. Could the two periods have yet more in common?
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Yes, would be our historians answer. And this conclusion would refer to the tectonic plates of the global economy to the institutions that embody its economic regimes. The two eras had seen the coexistence of monetary policy frameworks that delivered reasonable price stability with liberalised financial markets and highly integrated markets for goods, capital and labour. In fact, they had come to be known as the first and second waves of globalisation. The successful fight against inflation dated back to the early 1980s, and had gradually spread across the world thereafter. By the mid-1980s policymakers had largely liberalised domestic financial markets, and by the end of that decade, in the words of Padoa-Schioppa and Saccomanni, the global financial system had turned from government-led to market-led. The integration of goods and factor markets had started much earlier in the post-war period, but it had taken a quantum leap in the 1990s, when the former communist countries had entered the capitalist production system. As Thomas Friedman had put it, the world had become flat once again, he should have added.
Stylised facts: an interpretation

Is this similarity between deep structures and economic outcomes just a coincidence? I would suggest not.
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But now it is best to part company with our economic historian, as we move further away from the realm of stylised facts to that of (we hope) informed conjectures and their policy implications. It stands to reason that the three powerful forces have interacted so as to deeply shape economic fluctuations. Their conjunction has made economies more vulnerable to large and prolonged financial booms and busts financial cycles that can inflict severe damage on the economy. During the boom financial imbalances develop: (private sector) balance sheets become overextended on the back of aggressive risk-taking. The imbalances sow the seeds of their own destruction, and hence of economic weakness, unwelcome disinflation and financial strains down the road. The boom can turn to bust either because incipient inflation eventually does emerge, forcing the central bank to tighten or, more often, because the imbalances collapse under their own weight. One may call this property of the economy excess elasticity. The analogy is with an elastic band, which one can stretch further and further until at some point it snaps. These financial booms and busts necessarily take a long time to unfold. As they emerge, they slow down economic time relative to calendar time. How might the tectonic forces interact to produce this outcome?
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First, financial liberalisation makes it more likely for financial factors in general, and booms and busts in credit and asset prices in particular, to drive economic fluctuations. Rather than being tightly bound by cash flow constraints, the economy is propelled by loosely anchored perceptions of asset values and risks, critically supported by easier credit availability. Indeed, the link between financial liberalisations and subsequent credit and asset price booms is well documented. Second, the establishment of regimes yielding low and stable inflation, underpinned by central bank credibility, can make it less likely for signs of unsustainable economic expansion to show up first in rising inflation and more likely for them to emerge first as unsustainable increases in credit and asset prices (the paradox of credibility). After all, stable expectations make prices and wages less sensitive to economic slack: this is precisely what policymakers and economists have expected all along. Finally, the globalisation of the real economy has given a major boost to global potential growth what economists would call a sequence of pervasive positive supply shocks or an outward shift in the global economys production possibility frontier. Think of the huge boost to production capacity as China and other former communist countries joined the world trading system. By the same token, however, it has surely helped to keep inflation down and provided fertile ground for credit and asset price booms.
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Policy and horizons: pre-crisis role

So much for the big picture the tectonic plates, so to speak. But what about the role of decisions made by the policymakers who were confronted with these forces? With hindsight at least, it has become clear that policymakers inadvertently added fuel to the fire ahead of the Great Financial Crisis. They put too much faith in markets ability to self-correct. They failed to fully understand that the changing landscape called for adjustments in policy frameworks. And, even when they did understand, they found it too hard to change course: too much reputational capital was at stake and, anyway, why fix what aint broken? Consider, in turn, prudential, monetary and fiscal authorities. Prudential authorities converged on frameworks that concentrated too much on the safety and soundness of individual institutions and too little on that of the system as a whole frameworks in which the macroeconomy and the financial cycle hardly figured. They focused too much on individual trees and too little on the wood. In current jargon, they had too much of a microprudential focus, as opposed to a macroprudential one. Monetary authorities, still burnt by the Great Inflation experience, focused narrowly on stabilising near-term inflation. They could not justify raising interest rates if inflation was low and stable, let alone falling, even if financial imbalances were building up.
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As a result, the imbalances proceeded to grow unchecked. And fiscal authorities failed to realise that financial booms were hugely flattering the fiscal accounts and that the busts would at some point present them with a huge bill a burden over and above the better known, but just as intractable, one resulting from ageing populations. Underlying these failings was a natural tendency to overestimate sustainable output and growth. The notion that inflation was the sole harbinger of unsustainability was especially insidious. Financial factors, again, did not figure in this picture. That was the relentless message of the prevailing intellectual macroeconomic paradigm, both a reflection of the Zeitgeist and a contributor to it. Short policy horizons played a key role in all this. Much of macroeconomic policy centres on the notion of the business cycle. As conceived and measured, the business cycle has a duration of eight years at most. And yet we have seen that the financial cycle lasts at least twice as long. Since the financial cycles booms and busts have major consequences for economic activity, not taking them into account can create serious biases in policymaking. It is as if, on the open sea, sailors successfully rode out the smaller waves but remained blissfully unaware of the tsunami rolling beneath them a wave that would surge and crash only once it reached the shore.
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To illustrate this, consider the experience of several advanced economies in the mid-1980s to early 1990s and in the period 200107. In both episodes, policymakers reacted strongly to collapses in equity prices the global stock market crashes of 1987 and 2001 that ushered in economic slowdowns or actual recessions. They cut policy rates and, to a varying and smaller degree, loosened the fiscal reins. In both episodes, however, credit and property prices the most relevant indicators of the financial cycle continued to increase, as if getting their second wind. Financial imbalances built up further. And a few years later, the credit and property price booms collapsed, in turn, causing serious financial damage and dragging down the economy with them. This is what happened to Japan in the first episode and to the United States and United Kingdom in both. From a medium-term perspective, consistent with the length of the financial cycle, the slowdowns or contractions in 1987 and 2001 can thus be regarded as unfinished recessions. The initial over-reaction to short-term macro-economic developments, followed by an under-reaction to the further build-up of financial imbalances, caused more serious problems down the road. But short horizons are not just an issue for policymakers. They are an even bigger one for the private sector, especially for financial market participants.
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Here, traders horizons may be as short as a day, or minutes or even microseconds. More generally, horizons rarely extend beyond one year, constrained by the rhythm of financial reporting conventions. Moreover, they have, if anything, been shrinking: technology has been surging ahead; the spread of fair value accounting has telescoped the indefinite future into the ephemeral present; tighter monitoring has come to mean more frequent monitoring. These short horizons are embedded in risk measurement tools, such as value-at-risk, in common trading strategies, such as momentum trading, and in credit techniques, such as securitisation. For instance, risk models rely on extraordinarily short data histories, hardly ever extending beyond a few years, and they project outcomes over a very short future, mostly days and at the very most one year. Short horizons are probably best captured by the famous words of Chuck Prince, then CEO of Citigroup, to the effect that as long as the music is playing, you have to get up and dance. This was just before the crisis broke. The end result is that market participants expectations, once embedded in market prices, appear highly extrapolative: they follow the trend until it is too late. Hence what one might call the paradox of financial instability: the financial system looks strongest precisely when it is most vulnerable. Credit growth and asset prices are unusually strong, leverage measured at market prices is artificially low, and risk premia and volatilities sag to rock-bottom levels precisely when risk is at its highest. What looks like low risk is, in fact, a sign of aggressive risk-taking. The recent crisis has simply confirmed this all over again.
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A vicious cycle has set in. The interaction between market participants instincts, the relentless 24/7 media razzmatazz and the response of policymakers becomes ever stronger; as a result, horizons become ever shorter. So, the search for the culprits for the Great Financial Crisis brings very much to mind Agatha Christies famous thriller, Murder on the Orient Express. Who was the murderer then? As it turns out, all the passengers on the train were. Who is the culprit now? As it turns out, we all are.
II. Post-crisis challenges The legacy of the crisis: a balance sheet recession
The foregoing analysis casts light on the recession that followed the financial crisis. Not all recessions are born equal. The typical postwar recession was triggered by tighter monetary policy to stop rising inflation or a balance of payments crunch. By contrast, a post-financial crisis recession is a balance sheet recession, linked to a financial bust against the backdrop of low and stable inflation. This means that the preceding expansion is much longer, the subsequent debt and sectoral capital stock overhangs much larger, and the damage to the financial sector much greater.
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It also means that the policy room for manoeuvre is very limited: unless policy has actively leaned against the financial boom, policy buffers will be depleted. The capital and liquidity cushions of financial institutions will rupture; gaping holes will open up in the fiscal accounts; and policy interest rates will sag to near zero. Think of Japan in the 1990s. A growing body of evidence suggests that balance sheet recessions are particularly costly. They tend to be deeper, to give way to weaker recoveries, and to result in permanent output losses: output may return to its previous long-term growth rate but not to its previous growth path. Several factors are no doubt at work here: the overestimation of both potential output and growth during the boom; the misallocation of resources, notably the capital stock but also labour, during that phase; the oppressive effect of the debt and capital overhangs during the bust; and the disruptions to financial intermediation once financial strains emerge. A full five years after the beginning of the financial crisis, the symptoms of a balance sheet recession are all too evident. Banks in Europe and, to a lesser extent, the United States remain weak although in the United States it is Government Sponsored Enterprises (GSEs) that are more exposed to the mortgage market. To be sure, banks have significantly beefed up their capital ratios. But their credit default swaps, gauges of perceived creditworthiness, have returned to levels that are not that far away from those that prevailed when Lehman Brothers collapsed.
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Meanwhile, their shares have lost ground against the rest of the stock market, and they have incurred downgrades across the board in both standalone and all-in ratings. Private sector debt-to-GDP ratios, a measure of aggregate leverage, are still very high. Sovereign debt has ballooned and sovereigns have been downgraded. The policy rates of leading economies languish at their effective zero lower bound while the balance sheets of their central banks have swelled enormously. Globally, though, there are significant differences between countries. Those that have experienced domestic financial booms and busts have faced serious strains in both non-financial sector and bank balance sheets; to varying degrees, they are seeing deleveraging in both sectors. Clear examples are the United States, the United Kingdom, Spain and Ireland. Those whose financial institutions were exposed to financial booms elsewhere have also seen serious strains in their banks, but their non-financial private-sector debt-to-GDP ratios have typically risen further on the back of credit expansion. Notable examples are Germany, France and Switzerland. Indeed, in Switzerland a strong and possibly unsustainable housing boom is under way, despite rather weak economic growth. Those whose banks were not directly exposed to the financial busts in mature economies, after a brief slowdown, have proved very resilient; many of them have continued to see financial booms, sometimes eerily reminiscent of the pre-crisis ones in mature economies.
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These include several emerging market economies and some commodity-based advanced countries, among others. The situation is particularly worrying in the euro area. It is there that the perverse feedback loop between the weaknesses in the balance sheets of banks and sovereigns has been most intense. An obviously incomplete economic and monetary union has brought it into the open and exacerbated it. That said, one should not confuse the symptoms with the disease. Markets can and do lull policymakers into a false sense of security. They are far too slow to react and, when they do, they react violently. There are other major countries whose underlying fiscal positions are hardly more sustainable than those in the euro area. And yet bond markets seem to be oblivious, at least for now.
The immediate policy challenge: returning to self-sustaining and sustainable growth

The immediate global policy challenge is to return to self-sustaining and sustainable growth. Seen through the lens of the financial cycle, this raises different issues across countries, depending on their specific situation. At one end, for those largely spared by the crisis, and that have been seeing signs of unsustainable financial booms, the challenge is to contain these excesses and to avoid overestimating the strength of fiscal positions. Where the cycle might have turned already, it is to contain the damage.
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At the other end, for those that were at the epicentre of the crisis and have experienced a domestic financial boom and bust, the challenge is to deal with twin weaknesses in the financial and non-financial sector balance sheets. Somewhere in between, for those whose banks have suffered from losses on exposures to financial busts elsewhere, the challenge is to solve the banks problems, even as the non-financial sector may be in the process of leveraging up further. For all, the challenge is to ensure that the sovereign remains creditworthy or regains its lost creditworthiness. In what follows, I will leave it to the reader to draw implications for specific countries. Instead, I will focus on the general challenges that balance sheet recessions raise, ie on how to address financial busts. I will then discuss how to address booms in the following sub-section, which considers the longer-term challenge of how to adjust policy frameworks: how to address booms is by now better understood and requires less elaboration. The main policy challenge in a balance sheet recession is to prevent a stock problem from morphing into a long-lasting flow problem, weighing down on income, output and expenditures. It is therefore critical to distinguish two phases, crisis management and crisis resolution, which differ in terms of their priorities. In crisis management, the priority is to prevent the implosion of the financial system, so as to ward off the threat of a self-reinforcing downward spiral in economic activity.
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Restoring confidence is essential. If there is scope to do so, policies should be deployed aggressively. This is the phase historically linked to central banks lender-of-last resort function; together with interest rate cuts, such a course of action can be especially helpful in boosting confidence. In crisis resolution, by contrast, the priority is balance sheet repair, so as to lay the basis for a self-sustaining recovery. Here it is essential to tackle the debt overhang head-on. And policies need to be adjusted accordingly. Consider, sequentially, the roles of prudential, fiscal and monetary policy in this phase. The priority for regulation and supervision should be to induce the thorough repair of banks balance sheets and to support banks return to sustainable profitability. This means: Enforcing full recognition of losses (writedowns); Recapitalising institutions (subject to tough tests), including possibly via temporary public ownership; Sorting institutions according to their viability; Dealing with bad assets (including through disposal); Reducing excess capacity in the financial system; and promoting operational efficiencies.
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This is precisely what the Nordic countries did when they faced their banking crises in the early 1990s; and it is what Japan failed to do around the same time. This difference was no doubt a key factor behind their divergent economic performance subsequently. Before the recent crisis, the response of the Nordic countries to their crisis was universally regarded as the right way to go. Such a policy would have several benefits. It would restore confidence in the banking system. At present, for instance, market-to-book values are well below 1 and there is little uncollateralised funding on offer to banks, especially for European ones. Such a policy would also unblock interbank markets and relieve pressure on central banks just think of the Eurosystems extraordinary long-term unconditional liquidity support to banks. And it would restore incentives for allocating credit properly and avoiding inappropriate risk-taking. It is hardly a coincidence that volatile trading profits have been the main source of income since the crisis and that one global bank has recently made sizeable trading losses on its credit portfolio. Unless losses are fully recognised, viable institutions are recapitalised and unviable ones induced to exit, the incentives will stay in place for banks to take on the wrong risks at the expense of the good ones, and to overcharge healthy borrowers to the benefit of unhealthy ones.
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When the level of debt in an economy is too high and must be cut back to set the scene for a self-sustaining recovery, the allocation of credit is more important than its overall amount. The priority for fiscal policy should be to create the scope for using the public sector balance sheet to support the repair of private sector balance sheets. This applies to the balance sheets of financial institutions, through injections of public sector money (capital) subject to strict conditionality on loss recognition and possibly through temporary public ownership. But it applies also to the balance sheets of the non-financial sectors, such as households, including through various forms of debt relief. Such a prescription contrasts sharply with a widespread view among macroeconomists, who would regard pump-priming (increases in expenditures or tax cuts) as more effective during slumps. That view, however, assumes that people wish to borrow and cannot. But if they have already taken on too much debt, they are more likely to wish to cut that burden. Debt repayment would take priority over more spending. If so, even the short-term effect of untargeted fiscal expansion (the so-called fiscal multiplier) is likely to be small. Rather than jump-starting the economy, it could end up building bridges to nowhere, as the Japanese experience suggests. By contrast, the targeted use of the fiscal room for manoeuvre to support the balance sheet repair of the financial and non-financial sectors, as needed, could remove a key obstacle to a self-sustaining recovery.
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Moreover, as an owner or co-owner, the sovereign could actually make capital gains in the longer term, as was the case in some Nordic countries. Importantly, this is not a passive strategy, but a very active one. It inevitably substitutes public sector debt for private sector debt. It requires a forceful approach to addressing the conflicts of interests between borrowers and lenders, between managers, shareholders and debt holders, and so on. And it raises tricky distributional questions. It is not pure fiscal policy in the traditional macroeconomic sense: it calls for a broader set of measures, including legal adjustments, supported by the public purse. But what if the country is already facing a sovereign crisis? My sense is that, even where immediate fiscal consolidation is necessary, this use of public money is critical. The Nordic countries did it, even as they cut elsewhere. One way of alleviating the trade-offs is to obtain targeted external support. There is a clear potential for that option in the euro area, especially as part of a well sequenced and comprehensive shift towards a more complete economic union. And even as short-term steps are taken, a long-term horizon is essential. The evidence indicates that any contractionary effects of fiscal policy dissipate over time.
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And restoring the creditworthiness of the sovereign is paramount. The sovereign is the ultimate backstop for the financial system and the economy. There cannot be lasting financial and macroeconomic stability if public finances remain on an unsustainable path. What about monetary policy? The priority is to recognise its limitations and to avoid overburdening it. Monetary policy is likely to be less effective in a balance sheet recession. This applies as much to changes in short-term interest rates and guidance about future rates (interest rate policy) as it does to an aggressive use of the central bank balance sheet, such as through large-scale asset purchases and liquidity support (balance sheet policy). Overly indebted agents unwilling to borrow and a banking system unable to function blunt the impact of such policies on expenditure. As a result, as policymakers press harder on the gas pedal, the engine revs up without traction. And this exacerbates any side effects that policy may have in the crisis resolution stage. Several possible side effects may arise from a long period of extraordinarily accommodative monetary policy. First, easing can mask underlying balance sheet weaknesses. It makes it easier to underestimate the private and public sectors ability to repay in more normal conditions and delays the recognition of losses (eg evergreening).
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Second, it can blur incentives to reduce excess capacity in the financial sector and even encourage betting for resurrection. Third, it can undermine the earnings capacity of financial intermediaries, by compressing banks interest margins and sapping the strength of insurance companies and pension funds. This, in turn, weakens the balance sheets of non-financial corporations, households and the sovereign. It is no coincidence that Japans insurance companies came under serious strain a few years after its banks did. Fourth, it can atrophy markets and mask market signals, as central banks take over financial intermediation functions. Interbank markets tend to shrink and risk premia become unusually compressed as policymakers become large-scale asset buyers. Fifth, while it can help repair balance sheets by weakening the currency, this may be unwelcome elsewhere, as it may be seen as having a beggar-thy-neighbour character a point to which I will return later. Finally, over time it may compromise the operational autonomy of the central bank, as political economy considerations loom ever larger. This is especially important for central banks balance sheet policy, because of its quasi-fiscal nature. The key risk is that central banks become overburdened and a vicious circle develops. Monetary policy can gain time, but it can also make it easier to waste time, because of the incentives it generates.
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As the policy fails to produce the desired effects and adjustment is delayed, central banks come under growing pressure to do more. An expectations gap yawns open, between what central banks are expected to deliver and what they can deliver. All this makes the eventual exit more difficult and may ultimately threaten the central banks credibility. One may wonder whether some of these forces have not been at play in Japan, a country where the central bank has not yet been able to exit. Recent evidence squares broadly with the view that macroeconomic policies are less effective in balance sheet recessions. BIS colleagues find that, when considering recessions and the subsequent recoveries, monetary policy has a smaller impact on output if recessions are linked to financial crises. Moreover, in normal recessions, a more accommodative monetary policy in the downturn is followed by a stronger recovery, but this relationship is no longer apparent if a financial crisis occurs. In addition, the same study finds that in balance sheet recessions a faster pace of debt reduction ushers in a stronger recovery. And it concludes that, when used to alleviate a balance sheet recession, fiscal policy has limitations that are similar to those of monetary policy.
The longer-term policy challenge: adjusting frameworks

The longer-term policy challenge is to adjust frameworks to fully reflect the implications of the financial cycle.
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The financial cycle unfolds over a much longer horizon than the one that normally underpins policy decisions concerning output and inflation. Addressing its implications, therefore, requires lengthening the horizon and shifting the focus from period-by-period flows to their cumulative crystallisation in stocks. Lets first consider national policy frameworks and then broaden the view to the global context. The overall strategy for national policy frameworks would be to ensure the build-up of buffers in the boom phase of the financial cycle so as to draw them down in the bust phase. The buffers would make the economy more resilient to a downturn. And by acting as a kind of dragging anchor they could also curb the booms intensity. Put differently, the strategy would make policy less procyclical by making it less asymmetric with respect to the boom and bust phases of the financial cycle. For prudential policy, it would mean strengthening the systemic or macroprudential orientation of the frameworks, by adjusting instruments, such as capital standards or loan to value ratios, to reduce procyclicality. For monetary policy, it would mean providing for the option to tighten even if near-term inflation appears under control whenever financial imbalances show signs of building up. And for fiscal policy, it would mean extra caution when assessing fiscal strength during financial booms and taking remedial action. Post-crisis, policies have indeed moved in this direction, but to varying degrees.
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Prudential policy is furthest ahead. Basel III, in particular, has introduced a countercyclical capital buffer for banks as part of a broader trend to put in place macroprudential safeguards. Monetary policy has shifted somewhat. It is now generally recognised that price stability is no guarantee of financial stability, and a number of central banks have been adjusting their frameworks to incorporate the option of tightening during booms. A key element has been to lengthen policy horizons. That said, no consensus exists as yet on the desirability of such adjustments. And the side effects of prolonged and aggressive easing after the bust remain controversial. Fiscal policy is probably furthest behind. There is so far little recognition of the need to incorporate the impact of the financial cycle in assessments of fiscal sustainability or to explore the limitations of expansionary fiscal policy in balance sheet recessions. The main risk is that policies that fail to recognise the financial cycle will be too asymmetric, thus generating a serious bias over time. Failing to tighten policy in a financial boom but strong, if not overwhelming, incentives to loosen it during the bust would erode both the economys defences and the authorities room for manoeuvre. In the end, policymakers would be left with a much bigger problem on their hands and without the ammunition to deal with it.
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This is what economists call a time inconsistency problem. The root cause here is horizons that are too short and a failure to appreciate the cumulative impact of flows on stocks. This would entrench instability in the system. There are all-too-evident symptoms that this has been happening. Banks pre-crisis capital and liquidity buffers have proved woefully inadequate; post-crisis, there have been calls not to raise them and to delay the implementation of the new regulatory standards. Sovereign debt levels have reached record peace-time highs; the crisis and countermeasures have left a gaping hole in fiscal positions, which were already gradually deteriorating. No less worrying, most of the costs arising from ageing populations still loom ahead of us. And monetary policy has been far from immune. In many advanced economies interest rates are now effectively at zero; in both advanced and emerging market economies, central banks balance sheets have expanded to record highs. At the global level, policy rates, even adjusted for inflation, have been trending down for decades, even as the trend growth of the world economy a common yardstick to gauge their appropriate level has picked up. Likewise, more refined yardsticks that seek to take into account output and inflation so-called Taylor rules indicate that policy rates are globally unusually low.
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And partly as a result of purchases at the long end of the yield curve and foreign exchange intervention, bond yields have never been as low as they are now. This brings us to the global implications of national policies. In a highly integrated world, any tendencies in national policies can easily spread worldwide through a variety of channels, including other countries responses. In the case of monetary policy, exchange rates are a critical channel. Pre-crisis, easy monetary policy in the mature economies, notably in the United States, spread elsewhere, especially to emerging market economies such as China, partly through resistance to exchange rate appreciation. These other countries kept interest rates low or else intervened in the foreign exchange market and invested the proceeds in the countries with international currencies, in turn putting further downward pressure on yields there. Post-crisis, if anything, the same process has intensified. This raises tough issues. Economically, the risk is that monetary conditions for the world as a whole end up being too loose. Signs that financial imbalances have been building up, especially in several emerging market economies, are a source of concern, particularly when large mature economies have not yet returned to self-sustaining growth. The world remains unbalanced.
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Politically, one obvious risk is that countries might revert to the modern-day equivalent of the competitive devaluations of the interwar years, which proved so divisive. Worryingly, post-crisis the term currency wars has been all too often on policymakers lips. But the bigger risk is that yet another epoch-defining shift in the global economys tectonic plates might take place. As historians such as Niall Ferguson and Harold James keep reminding us, such shifts often occur quite abruptly and when least expected. So far, institutional setups have proved remarkably resilient to the huge shock of the Great Financial Crisis and its tumultuous aftermath. But there are also troubling signs that globalisation may be in retreat, as states struggle to come to grips with the de facto loss of sovereignty. This is true both globally and regionally. It is simply most visible in Europe, where a more ambitious historical experiment with greater integration has reached a watershed. Meanwhile, the consensus on the merits of price stability is fraying at the edges. As memories of the costs of inflation fade, the temptation to get rid of the huge debt burdens through a combination of inflation and financial repression grows. Taking all these hard-won gains for granted is the surest way of losing them. The future is not pre-determined; far from it. But we should not underestimate the challenges ahead.
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Conclusion
A cyclist has made a strong start to the race. But, as it happens, he has overestimated his strength. After a while, he has to pedal harder just to avoid falling over. His energies are flagging and he is on the point of collapsing from exhaustion. His mistake was to treat a long-distance race as a series of ever-shortening sprints. His horizon was too short; the cumulative effort is finally catching up. And yet, he struggles on. The global economy is not so different from this sportsman. It gained new force from a powerful wave of globalisation and the suppression of inflation. But the resurgence of the financial cycle made it feel, for a while, stronger than it really was. Market participants and policymakers did not see through this illusion. And, every time that a financial boom turned to bust, they would simply try harder, re-applying the same old nostrums. Their horizons were too short; and the cumulative impact of their efforts is catching up with them: stocks of private and sovereign debt have been growing beyond sustainable levels and the policy room for manoeuvre has been shrinking dramatically.
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Maybe it is time to change course. Maybe it is time to recognise the need to address underlying weaknesses head-on, to stop postponing adjustments to an ever-elusive better day, to stop calling for illusory monetary policy fixes for what are deeper balance sheet and structural problems. This would mean incurring some costs in the short run, but the alternative would risk creating much bigger costs further down the road. As the French say: reculer pour mieux sauter. It would be a mistake, as some have noted, to believe in the confidence fairy, but it would be an even bigger mistake to believe in the free-lunch fairy. Some signs are encouraging, others less so. Navigating the tricky waters ahead will require a balance between Gramscian pessimism of the intellect and optimism of the will: pessimism to assess the challenges ruthlessly, never underestimating them; optimism to overcome them. And, as the late Tommaso Padoa Schioppa stressed, it will require a long-term view. Keynes once famously said: in the long run, we are all dead. But, one would hope, the next generation will be very much alive. What is at stake is nothing less than the legacy of the current generation to the next. This is as true at the global level as it is in Europe.
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Introductory statement
Mario Draghi, President of the ECB, Vtor Constncio, Vice-President of the ECB, Frankfurt am Main Ladies and gentlemen, the Vice-President and I are very pleased to welcome you to our press conference. We will now report on the outcome of todays meeting of the Governing Council. Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. Owing to high energy prices and increases in indirect taxes in some euro area countries, inflation rates are likely to remain above 2% for the remainder of 2012. They are expected to fall below that level in the course of next year and to remain in line with price stability over the policy-relevant horizon. Consistent with this picture, the underlying pace of monetary expansion continues to be subdued. Inflation expectations for the euro area remain firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Economic activity in the euro area is expected to remain weak, although it continues to be supported by our monetary policy stance and financial market confidence has visibly improved on the back of our decisions as regards Outright Monetary Transactions (OMTs).
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At the same time, the necessary process of balance sheet adjustment in large parts of the financial and non-financial sectors as well as high uncertainty continue to weigh on the economic outlook. It is essential for governments to support confidence by forcefully implementing the necessary steps to reduce both fiscal and structural imbalances and to proceed with financial sector restructuring. The Governing Council remains firmly committed to preserving the singleness of its monetary policy and to ensuring the proper transmission of the policy stance to the real economy throughout the euro area. As we said before, we are ready to undertake OMTs, which will help to avoid extreme scenarios, thereby clearly reducing concerns about the materialisation of destructive forces. Let me now explain our assessment in greater detail, starting with the economic analysis. Euro area real GDP contracted by 0.2%, quarter on quarter, in the second quarter of 2012, following flat growth in the previous quarter. As regards the second half of 2012, the available indicators continue to signal weak activity. While industrial production data showed some resilience in July/August, most recent survey evidence for the economy as a whole, extending into the fourth quarter, does not signal improvements towards the end of the year. Looking ahead to next year, the growth momentum is expected to remain weak. It continues to be supported by our standard and non-standard monetary policy measures, but the necessary process of balance sheet adjustment in
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the financial and non-financial sectors and an uneven global recovery will continue to dampen the pace of recovery. The risks surrounding the economic outlook for the euro area remain on the downside. Euro area annual HICP inflation was 2.5% in October 2012, according to Eurostats flash estimate, compared with 2.6% in September and August. On the basis of current futures prices for oil, inflation rates could remain at elevated levels, before declining to below 2% again in the course of next year. Over the policy-relevant horizon, in an environment of modest growth in the euro area and well-anchored long-term inflation expectations, underlying price pressures should remain moderate. Current levels of inflation should thus remain transitory. We will continue to monitor closely further developments in costs, wages and prices. Risks to the outlook for price developments continue to be broadly balanced over the medium term. Upside risks pertain to further increases in indirect taxes owing to the need for fiscal consolidation. The main downside risks relate to the impact of weaker than expected growth in the euro area, in the event of a renewed intensification of financial market tensions, and its effects on the domestic components of inflation. Turning to the monetary analysis, the underlying pace of monetary expansion continues to be subdued.
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In September the annual growth rate of M3 decreased to 2.7%, from 2.8% in August. Monthly outflows from M3 reflected to some extent the reversal of portfolio shifts into the most liquid components of M3. Accordingly, the annual rate of growth of M1 declined to 5.0% in September, from 5.2% in August. At the same time, we have observed a strengthening in the deposit base of banks in some stressed countries, amid improvements in investors confidence in the euro area. The annual growth rate of loans to the private sector (adjusted for loan sales and securitisation) declined further to -0.4% in September, from -0.2% in August. This development was mainly due to further net redemptions in loans to non-financial corporations, which led to an annual rate of decline in these loans of -1.2%, compared with -0.5% in August. The annual growth in MFI lending to households remained unchanged at 0.9% in September. To a large extent, subdued loan dynamics reflect the weak outlook for GDP, heightened risk aversion and the ongoing adjustment in the balance sheets of households and enterprises, all of which weigh on credit demand. At the same time, in a number of euro area countries, the segmentation of financial markets and capital constraints for banks restrict credit supply. The recent results of the bank lending survey for the third quarter of 2012 underpin this assessment. The soundness of banks balance sheets will be a key factor in facilitating both an appropriate provision of credit to the economy and the normalisation of all funding channels, thereby contributing to an adequate transmission of monetary policy to the financing conditions of
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the non-financial sectors in the individual countries of the euro area. It is thus essential that the resilience of banks continues to be strengthened where needed. To sum up, the economic analysis indicates that price developments should remain in line with price stability over the medium term. A cross-check with the signals from the monetary analysis confirms this picture. Other economic policy areas need to make substantial contributions to ensure a further stabilisation of financial markets and an improvement in the outlook for growth. Structural reforms are crucial to boost the growth potential of euro area countries and to enhance employment. Policy action is also necessary to increase the adjustment capacity of euro area economies in order to complete the ongoing process of unwinding existing imbalances. Visible progress is being made in the correction of unit labour costs and current account imbalances. However, further measures to enhance labour market flexibility and labour mobility across the euro area are warranted. Such structural measures would also complement and support fiscal consolidation and debt sustainability. As regards fiscal policies, there is clear evidence that consolidation efforts in euro area countries are bearing fruit. It is crucial that efforts are maintained to restore sound fiscal positions, in line with the commitments under the Stability and Growth Pact and the 2012 European Semester recommendations.
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Full compliance with the reinforced EU fiscal and governance framework, including the rapid implementation of the fiscal compact, will send a strong signal to markets and strengthen confidence in the soundness of public finances. The Governing Council takes note of the European Council conclusions on completing Economic and Monetary Union, adopted on 18 October 2012. In the context of measures to achieve an integrated financial framework, it welcomes in particular the objective of agreeing on the legislative framework for a Single Supervisory Mechanism (SSM) by 1 January 2013 with a view to the SSM becoming operational in the course of 2013. We are now at your disposal for questions. Question: Given what you just said about the condition of the economy, and what you said in your speech yesterday, do you expect your projections for the economy to be revised downwards next month, and did you discuss a cut in interest rates? Also, considering the SME lending survey of last week, would you consider a further LTRO or possibly the purchase of corporate bonds or corporate ABS? Draghi: We will certainly monitor developments in the euro area economy and these developments will be taken into account in the December staff projections. Certainly the outlook is being revised; as you know, the European Commission has released its forecast, and there is a picture of a weaker economy, as I had the chance to say yesterday. So all this is bound to be taken into account in the staff projections in December.
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On interest rates, we always discuss all our instruments of monetary policy but, as I just said, the Governing Council decided to keep interest rates unchanged. We have not discussed what we are going to do next year in terms of monetary policy. Question: Is the ECB satisfied with the degree of relief that the mere announcement of the OMTs has already brought to the markets? And in the current environment would you then theoretically be happy to never buy a single bond, or do you think that the rest of the euro area would benefit from a Spanish bailout request by giving you the opportunity to show your resolve and thereby clear the impaired transmission mechanism? My second question is on interest rates. I know you said you did not make a decision on the future main refinancing rate. Governing Council member Ewald Nowotny said that, for him, a negative deposit rate, should you decide to cut interest rates, doesnt appear to be a realistic prospect to him. Is that an assessment that is shared in the Governing Council? Thank you very much. Draghi: We did not discuss matters related to your second question. On the first question, we certainly take note that since the OMT announcement there has been a series of market improvements that I will just quickly list. First of all, we have a return of flows from the rest of the world, in particular from US money market funds, which was +16% in September, month on month, for the third consecutive month since the announcement. So, even though overall it continues to be a small exposure with respect to euro area banks and with respect to what it was at the beginning of last year, it is going up.
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Also, this form of lending has shifted considerably from secured to unsecured lending. Only 30% was secured, and this is the lowest figure since March. And this is a positive sign. Another positive sign is that there have been some limited renewed US dollar bond placements by euro area institutions. There has been a moderate pick-up in corporate issuance. As I had the opportunity to mention on other occasions, there have been a few issues of sovereign bonds by Ireland and Portugal. The funding plans of two large sovereigns like Italy and Spain are quasi-completed if not completed. And the share of foreign holdings of these bonds issued by Spain and Italy has gone up, which is also something that we had not seen for a while. Finally, the TARGET2 balances figure, which is another sign of how imbalances in the euro area are developing, has been stable now for two or three months, which is also another good sign. So all this is encouraging, and by itself this has certainly been equivalent to a further expansion of monetary policy, because financial market conditions are considerably easier now than they were two or three months ago. On the Spanish request, I will decline to make any comment. It is entirely in the hands of governments to decide about this. The conditions of the OMTs are clear and we stand ready to act. OMTs are, as you know, a fully effective backstop that is devised to remove the tail risk for the euro area, and we stand ready to act. Question: I do need to press you again on Spain, unfortunately, because Spanish bond yields have gone up again you are nodding the longer Mr Rajoy hesitates. Would you like Spain to ask for aid?
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And my second question is: Do you consider financing conditions appropriate across the euro area right now, or do the current Italian and Spanish spreads still contain a redenomination risk? Thank you. Draghi: Again, you keep on pressing, but I will keep on answering in the same way. It is entirely up to Spain, and to the Spanish Government, to take this decision. It is not up to the ECB. As I have said many, many times, the ECB has produced the OMTs. The OMTs are a fully effective back-stop mechanism. They are a device to remove tail risk, while at the same time not removing incentives for fiscal discipline, and delivering price stability. That mechanism is in place. And the conditions for accessing that mechanism are also very, very clear. Now, for the rest, the ball is now completely in the governments side of the court, not in that of the ECB. With respect to the financing conditions, I think that, rather than focusing on the levels of the spreads or interest rates, one should look more at the fragmentation of the euro area. So, when we talk about financing conditions, for example at financing for small and medium-sized enterprises (SMEs), as was asked in the preceding question, when we are asked whether we are satisfied with the financing conditions, the answer is: no, we are not satisfied at all. We are observing a fragmentation of the euro area, a re-nationalisation of the banking systems, differences in the cost of funding that go beyond the fundamentals. Therefore, our priority now is to repair the monetary policy transmission channels, so that our monetary policy will actually deliver, will be able to deliver price stability.
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Question : you have always said that you can only fix the transmission mechanism if the OMTs are activated without the Spanish request. Then Draghi: No. OMTs will help to fix the transmission mechanism, but there are many other reasons why the transmission mechanism is not working. First and foremost among them is the lack of appropriate economic policies that are now in the process of being fixed. But let us not forget how we came to find ourselves in this situation. We know that there was a situation marked by bad equilibrium, where until three months ago we had self-fulfilling expectations, self-feeding expectations. At the same time, the countries concerned found themselves in this bad equilibrium because of policy mistakes of the past, or because of the lack of policy altogether. So the origins of the fragmentation of financial markets in the euro area are basically to be found in policy mistakes, and these have to be corrected. Question : Mr Draghi, the Spanish Prime Minister, Mr Rajoy, has said that one of the reasons why he is taking his time with the request for a European bailout is because he wants assurance that the ECBs intervention will actually bring down his countrys borrowing costs. Can you give Mr Rajoy this assurance today? Draghi: No. I think I have answered this question before. First, there is a general statement. The way the OMTs have been designed foresees, as we have discussed many times, that, as a necessary condition, the country should sign up with an ESM programme, and that a role for the IMF would be actively sought and would be welcome. But this is the necessary condition it is not also the sufficient condition. So, the Governing Council will take its final decision in total independence. And in so doing, it cannot give any assurance ex ante.
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Because we have to make our monetary policy assessment, we have to make an assessment of the actual state of fragmentation of the financial markets. So, I think there is not any automatic quid pro quo. We know that the mechanism is a fully effective back-stop, and it is in place. But it is up to the countries to take all the right steps to ensure that this mechanism can be activated. Question: My second question is on Greece. Last night, Greece managed to approve another austerity package. Is this enough and would the ECB now be willing to help make Greeces debt burden more sustainable, and if so, what could you do? Draghi: The ECB and the Governing Council certainly welcome the outcome of the vote yesterday. It is a very important step that the Greek government and the Greek citizens have undertaken. It really represents progress, especially if one compares the situation with what it was a few months ago. Another vote is expected on the budget on Sunday. The governments will discuss the Greek situation at next weeks Eurogroup meeting. The ECB ensures price stability and wants to repair monetary policy transmission channels, but it cannot undertake monetary financing. Question: Next week Greece will have to refinance 5 billion of Treasury bills and that is likely to be done again through emergency liquidity assistance. How much longer is the ECB going to tolerate that sort of behaviour and could you also please explain why emergency liquidity assistance is not a form of monetary financing? Second, do you see evidence that this sort of funding is being used increasingly elsewhere, for example in Cyprus? Are you worried about this, especially in the light of very tight fiscal policies?
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Draghi: We consider this type of financing to be temporary. We do not consider emergency liquidity assistance to be monetary financing; it is one of our instruments. We are keeping a close eye on developments in Cyprus, but it is ultimately up to the government to respond to this situation, not the ECB. Question: My first question is on inflation expectations. After OMTs were announced in September, we saw a very strong increase in gold prices, with 3 billion going into gold ETFs and ETCs just in that month. Is that a sign of speculation or of increased inflation expectations? My second question relates to unit labour costs. You said that there has been visible progress in the correction of unit labour costs. Most economists say that unit labour costs are not a good way to measure competitiveness because you have this unemployment productivity. They say that one should look at the GDP deflators because there we do not really see any great progress being made. Are they right or wrong? Draghi: The increase in gold prices is exactly that. Why this should depend on OMTs is a mystery to me. We are constantly looking at inflation expectations over several horizons, and no matter what horizon we look at, we continue to see that they are solidly anchored. To ask whether the price of a specific asset forecasts an increase in the inflation rate is always a very risky question. You see asset prices going up and down, and to infer from an increase in the price of one asset that inflation will go up, and that inflation will go up because of OMTs, which havent created any liquidity yet, is really a very rash assumption. With regard to the improvement in labour costs, yes, there has been an improvement in unit labour costs in several countries.
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This may certainly be partly the consequence of an increase in productivity, which, as the economists you mentioned correctly say, could be cyclical. However, we also observe an improvement in the current account balances of these countries. You are also right when you say that, in spite of the changes in unit labour costs in some countries, we do not observe comparable changes in the GDP deflator, which may be due to other reasons. For example, in one country unit labour costs have fallen, but there has been no change in the GDP deflator or HICP inflation rate because energy prices remain very high. The other reasons have more to do with the inertia that the components of value added show in adjusting to the new situation. Question: I have a completely different question concerning collateral framework rules. I just want to know how exactly you want to make sure that national central banks might not again bend the collateral framework rules according to their needs. How do you want to make sure that the credibility of the ECB as a risk manager will not be hurt? Draghi: Let me first make a clarification, because there has been a lot of press on this point in the last week. The first clarification is purely factual: the nominal amount of collateral being posted was not EUR 80 billion, but EUR 10 billion. The second clarification is that all this had no impact at all on our lending. So nobody received more than they should have received because of this mistake because it was a mistake.
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The impact of this is zero, but we take this mistake very seriously. And so the Governing Council has mandated the Eurosystem Audit Committee, which is chaired by Governor Liikanen, to assess the implementation of the collateral framework in the Eurosystem and we will have an initial assessment of this at our next Governing Council meeting and then we will discuss whether further analysis or further action is needed and I will keep you posted on that. Question: I would like to go back to the economic outlook. You have mentioned recently that there are some deflationary risks in some European countries. You have talked about unemployment being deplorably high. Why arent you cutting rates, why arent you considering some kind of quantitative easing? Isnt that an appropriate role for monetary policy? And my second question, back to the Greece issue: You said you wont do anything that is monetary financing, but are there things you could do that would not cross that line? Specifically, could you sell your bonds at cost to Greece or to the ESM? Could you somehow redirect your profits back to Greece? Do you have options or are you just telling the governments that you have no role in this whatsoever? Draghi: Well, let me first just point out that I never mentioned deflation. Deflation is a generalised fall in the price level across sectors and it is self-sustaining. And so far we have not seen signs of deflation, neither at the euro area level nor at country level. We should also be very careful about not mixing up what is a normal price readjustment due to the restoration of competitiveness in some of these countries. They will necessarily have to go through a re-adjustment of prices.
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We should not confuse this readjustment of prices, which is actually welcome, with deflation. Basically, we see price behaviour in line with our medium-term objectives. So, we see price stability over the medium term. Also consider that monetary policy is already very accommodative, consider the very low level of interest rates and that real interest rates are negative in a large part of the euro area, and consider how many measures we have taken in just one year: several cuts in interest rates, halving the reserve ratio, two LTROs for a gross amount of EUR 1 trillion and so on and so forth. We have gone through this together many times, so I will not repeat it. And then we had the OMT announcement, which by itself produced an easing of financial market conditions. But we will certainly continue monitoring economic activity and we stand ready to act. As I said before, we stand ready to act with the OMT once the prerequisites are in place, but we also stand ready to act with the rest of our standard monetary policy instruments. On Greece, we certainly cannot do monetary financing. I repeat this. On the profits of the SMP holdings, we already decided this at the time of the first PSI because what happens is that these profits naturally accrue to the central banks that are members of the Eurosystem. And then the central banks, in their independence or according to their legislation, will transfer these profits to the governments and then it is up to the governments to decide whether they want to re-use these profits for Greece. And the governments actually committed themselves to do so at that time.
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Question: So youre done, the ECB is done on Greece? Draghi: The ECB is as you say, by and large, done. Question: A question still relating to SMP profits. I am just trying to make a fair estimate of the scale of this profit, assuming that you have 60 billion on your balance sheet, bought at 75% of its face value, and get interest income of 5% over five years; that would mean 30 billion profit. Is that a fair estimate of the profit of the SMP holding? Draghi: I am very sorry but I am not in a position to answer this question. I can provide you with an answer later. Question: Provided that it is being paid back in full. Is it a fair estimate? Draghi: I do not have an answer now. Question: Two questions. First of all, just again on inflation. You said today that the risks were balanced on the upside and the downside. I think when you were talking behind closed doors to German Members of Parliament, you said the other day, in the text of the speech that was released anyway, that there was, if anything, a downside risk. Could you just clarify, which is it? Is it balanced or is it a downside risk? The second question is on LTROs. Your neighbours in the tower block just over there in Commerzbank said, this morning, that they plan to hand back their LTRO funding at the end of the year, as soon as they can, basically. This is essentially because they do not seem to be able to find anything useful to do with it; it costs them 0.75%; they are just parking it with the Eurosystem at 0%. Is that a worrying sign? Should these banks be finding companies to lend that money to, or are you relaxed about a sudden end to all these LTRO borrowings?
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Draghi: On inflation, I think I have always said, at least in the recent past, that risks are broadly balanced because, on the one hand, you have the downside risks that come from the weak level of economic activity and high unemployment. On the other hand, you have the upside risks that come from energy prices and the widespread use of indirect taxation, especially VAT, by countries that need to consolidate their budgets. So, the two things, by and large, balance themselves and this is the assessment that I would still maintain today. On the LTRO: no, it is not necessarily a matter of concern. Actually, in a sense, it is the best response to all those who were saying you are flooding the world with liquidity; now, you see that this is not happening. You see that, in fact, money is coming back, and the balance sheet of the ECB will shrink down correspondingly. No consequences on inflation had followed since the time when we decided on the LTRO, way back in January/December last year. Whether banks return LTRO because they do not lend it because of risk aversion or because credit demand is weak, I am not in a position to say today. But, certainly, these must be the two reasons: either they are fearful to lend and here we are talking about banks that do not have capital constraints of course so, assuming that they do not have any capital constraints, banks do not lend because either the risk aversion is too high or because there is no demand. This could be a sign of either of the two factors. The important thing with the LTROs was that, again, we removed tail risks coming from the lack of funding that would have happened in the first quarter of this year. The objective has been achieved.
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Question: Did you try to saddle the OMT horse from the other side? You said the OMT was there to avoid extreme scenarios, extreme risks. Could you foresee a scenario, an extreme scenario, where the OMT would be triggered without the conditionality in place, or without parts of the conditionality in place, because, as I said, it might be too extreme a scenario? The other thing is, after yesterdays speech, and also after the statements today, the markets are taking the view that we are going to see a rate cut next time around. Would you say that the markets are grossly misguided? Draghi: Well, on the second question, as you know, I cannot comment. On the first question, you are asking me: could there be an OMT without conditionality? The answer is no. Question : Mr Draghi, I have a question concerning the euro zone and the United States, where we just had the elections. Under the pressure of the markets in Europe, the reform process started two years ago in Italy and in Spain. In the United States it is said that there the reforms could not start. We are all wondering whether they will start now. What do you think, in your eyes, is Europes potential to catch up with the United States? Do you think that Europe can have a comeback, a sort of comeback, in the near future? Draghi: What I can say is that both the euro area as a whole and the individual countries forming the euro area and I would not have made this statement a year ago, by the way have a fundamental position, which is way more balanced than the United States, but also than other countries: Japan or the United Kingdom. The euro area has a current account balance which is basically in balance zero that, both as corporate debt and household debt, is relatively low
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all over the euro area; saving ratios are high; and as I was saying before, unit labour costs are on their way down. The fiscal consolidation that has taken place all over the euro area is amazing. When we look at the other parts of the world, it is not so amazing at all. So, deficit-to-GDP levels are on their way down everywhere, even in the countries which have the highest ones. So, all this basically poises the euro area for a recovery, which should be, or probably is going to be, slow, gradual but also solid, looking exactly at these fundamentals. So, what we have to overcome now is the sort of fragmentation; that is our major challenge ahead and I think we have made, collectively, significant progress on that route. Question: Mr Draghi, you said before that that the monetary policy stance is very accommodative at this time and you mentioned the bunch of measures taken in the past year. Is this the time, or is this absolutely not the time, to think about the point when you will abandon this strategy? Do you prepare for it, maybe in your mind, or is it not something you are thinking about at all at the moment? Secondly, through the supervisory mechanism that you welcome, the ECB will soon be giving a formal legal opinion, but could you give us your opinion now, if you have one, on the information that Paris and Berlin are in favour of a woman chairing this authority. Draghi: On the first question: we look at price stability and we will decide on our strategy and the timing of our exit depending on how we see price stability over the medium term. So far, we see no reason to change our monetary policy, looking at price stability over the medium term. On the second point: gender considerations are close to our hearts and minds.
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That goes for both the Executive Board and me personally. We understand that the European Parliament, with whom we have always had excellent relations, has valid concerns about this, and our hearts and minds are really open with respect to this. This has to do with my answer to your point about the supervisory mechanism and who might chair it. Gender concerns are very important and, actually, the ECB has been quite active on this. Let me just go through some of the things we have done in order to show you how we all care about this. We have been very active as far as our recruitment success rate is concerned and we are doing fairly well at staff level. We are not doing well at management level, so we have to improve in that respect. However, we have launched a series of actions which I think will bear some fruit here. We know we have to improve at management level. Question: You said the original financial fragmentation was a policy mistake and that structural reforms are needed. Are you satisfied with the reform path and the reform speed you see in Spain and Italy, or would you expect more and faster reforms? Draghi: I think this is an important question. In answering it, I would ask you not to take a medium-term, but a short-term perspective. Compare the situation today with how it was even less than a year ago and the conclusion is unavoidable: there has been substantial progress. Is the task finished?
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Not at all. There is a lot more to do, obviously on the fiscal consolidation path, but and this is more and more significant as time goes by also on the structural reforms. Question: But is it happening fast enough? Draghi: Again, it depends on your perspective, because if you compare the current speed of reform with the speed of reform in those countries in the previous five years, then you are bound to say that it is very fast. But if you are asking me whether it will ever be fast enough, I will put it this way: the faster it is; the sooner financial market conditions in Europe will return to normal. Question: I will take your perspective, because you said the main problem was the lack of structural reforms and that you cannot solve the problem it is up to the countries to do so. So, from your perspective, is the speed of reform fast enough for financial conditions to return to normal? Draghi: It does not matter what speed we would like to see, as it is ultimately for the citizens of these countries to decide on the speed. They should know that these structural reforms have to be made. They are unavoidable and necessary. Eventually, prosperity, growth and job creation will come out of them. The actual pace of the reforms is a combination of many factors but, first and foremost, the political realities of these countries. As I said, the sooner this process is brought forward, the quicker the euro area will get back to normal in the euro area because and let us not forget this the financial conditions in the euro area started to worsen after the financial crisis, but this was because very unsatisfactory policies were found to be in place in many countries.
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Elisabeth Ardaillon-Porier, Director Communications, announces that the President will now make an announcement regarding the euro banknotes and afterwards a video will be shown. Draghi: But before I do, I just want to go through the partial answer I gave about gender diversity, because I think it is actually quite important that I do give some time to this. As I said, we are doing very well at staff level but we should improve at management level. In order to achieve this, we have launched a number of initiatives to encourage female staff to pursue management functions, and to support them in this. These initiatives include mentoring, the diversity task force, making use of external counsellors, enhancing diversity in recruitment panels, and child-minding facilities. As I said before, my impression is that these initiatives are bearing fruit. Now, coming to the banknotes; let me read the statement. I am pleased to be able to announce that the European Central Bank and the national central banks of the Eurosystem are to introduce a second series of euro banknotes. Called the Europa series, it will include a portrait of Europa a figure from Greek mythology and the origin of the name of our continent in the watermark and the hologram. The new banknotes will be introduced gradually over several years, starting with the 5 banknote in May 2013. The Europa series has benefited from advances in banknote technology since the first series was introduced over ten years ago. Its security features have been enhanced, which will help to make the banknotes even more secure.
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Three new features the portrait watermark, portrait hologram and emerald number have been unveiled today. The first series will initially circulate alongside the new banknotes, but will gradually be withdrawn and eventually cease to be legal tender. The date when this occurs will be announced well in advance. However, the banknotes of the first series will retain their value indefinitely and can be exchanged at the Eurosystem national central banks at any time. The ECB will be revealing the details of the new 5 euro banknote in two phases starting today with three of the new security features that it contains. This will allow the public to start familiarising themselves with this three new security features. Also, in order to raise public awareness of this series, the Eurosystem will be conducting an information campaign across the euro area in 2013. I would also like to take this opportunity to thank all the Eurosystem staff who have been involved in the preparations for the new banknotes. And now I am pleased to present a short film that is showing three of the new security features embedded in the new five euro banknote. Question: President asks: What is the sense of this movie? Mr Vice-President, please answer the question. Constncio: I am just considering it like you are, because I just saw the film for the first time. In fact, the purpose is to show the three new security features that we decided to reveal today. I would like to take this opportunity to say that on 10 January 2013 the full new five euro banknote will be revealed at an event in the archaeological museum here in Frankfurt.
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We will also show the 2000-year-old Greek vase that belongs to the Muse du Louvre the vase from where the portrait of Europa was taken. So, there will be an exhibition and all the other security features of the note will be revealed in full. Today, it is just three features, and thats what was shown in the film: the hologram; the watermark; and the number five changing colour.
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Current focus of the Basel Committee: Raising the bar

Remarks by Mr Stefan Ingves, Governor of Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision (At the 7th High-Level Meeting jointly organised by the Association of Supervisors of Banks of the Americas, the Basel Committee on Banking Supervision and the Financial Stability Institute, Panama City, Panama) I am very pleased to be here for this year's High-Level Meeting, organised by ASBA, the Basel Committee and the FSI. At its meeting in March of this year, the Basel Committee discussed a number of strategies for enhancing its relationship and communications with non-Basel Committee member countries. One proposal that was readily endorsed by Committee members was to establish even closer collaboration with the FSI with regard to its High-Level Meetings. Many of our members are familiar with these well-established annual conferences, which draw together senior central bankers and supervisory officials from various regions of the world. In addition to last year's ASBA-FSI event, I have participated in several other high level meetings this year. The feedback that I and my Basel Committee colleagues have gained from these events has been both illuminating and insightful. When we met last year in San Francisco, I called for action on two items: first, guarding against supervisory complacency, and second, putting into practice the regulatory reforms that were developed to raise the resilience of banks and banking systems to future shocks.
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These two themes - putting policies into practice, and recognising supervision as an essential complement to regulation - continue to pervade the Basel Committee's work. I am going to repeat these themes today, although in doing so I am not suggesting we have failed in our efforts in the past. On the contrary, we have made good progress in both areas. But more needs to be done. I will share with you today some of the Committee's efforts to further these objectives. I will also say a few words about our ongoing policy work since there is also more to be done to fully reflect lessons learnt from the crisis.
Supervision matters
I will start with supervision. I have been quite vocal in warning that the Basel III Framework is not sufficient - by itself - to set banks and banking systems on a clear path to becoming stronger and more resilient. It must be matched in practice by good supervision. Good regulation empowers firm supervision, and firm supervision enforces good regulation. They are mutually reinforcing, and it is unrealistic to think that one can be successful without the other. Basel III provides a better rulebook by which to judge the safety and soundness of banks, but the crisis taught us that we also need better supervision. And better supervision begins with the basic building blocks, which is the Core Principles for Effective Banking Supervision.
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Core Principles for Effective Banking Supervision

Every financial crisis is an opportunity to reflect on what went wrong, what worked well and what improvements can be made. This is true for bankers and risk managers, for policy makers, and, of course, for bank supervisors. For the Basel Committee, the supervisory lessons learnt from the financial crisis prompted our review of the Core Principles. While Basel III has attracted most of the attention, its effectiveness will only be realised if it rests on a solid bedrock of supervision and implementation. The Core Principles provide such a foundation. The revised Core Principles were published in September, with the endorsement of supervisors and central bankers representing more than 100 countries that were gathered in Istanbul for the 17th International Conference of Banking Supervisors. The latest revision was conducted jointly with the Basel Consultative Group, which comprises banking supervisors from both member and non-member countries of the Basel Committee, as well as regional groups of banking supervisors, the IMF, the World Bank and the Islamic Financial Services Board. The review took account of post-crisis lessons and other significant supervisory 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. We have not sought to reinvent the wheel: many of the revisions are designed to reinforce the fundamentals of banking supervision by emphasising effective risk-based analysis, a more forward-looking perspective and early intervention.
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Given the importance of these basic principles as the foundation for any supervisory regime, it is imperative that they be implemented with determination and rigour around the globe. As many of you would already know, the revised Principles have been reorganised to highlight the difference between what supervisors do and what they expect banks to do. The principles covering supervisory expectations of banks emphasise the importance of good corporate governance and risk management, as well as compliance with supervisory standards. In addition, the review took account of several key trends and developments that emerged during the last few years of market turmoil, in particular the need for greater intensity and resources to deal effectively with systemically important banks. Our agenda for this High-Level Meeting includes an in-depth review and discussion of the revised Core Principles, so I will not go into any more detail now. Let me simply make one very important point. In discussing the revisions to the Core Principles, the Committee was clear in its objective: we wanted to raise the bar. Just as we needed to lift regulatory requirements that were too low, the status quo for supervision was not going to be acceptable either. An enhancement of supervisory capabilities is necessary if we want to keep pace with the increasingly complex, diverse and interconnected financial system. We cannot stand still. More importantly, and as I have stressed previously, we cannot allow ourselves to think that just because the problems in the banking system did not occur in our backyard this time will mean that they will not occur there in the future.
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Systemically important banks

The financial crisis that began in 2007 not only reminded us of the critical role of intensive supervision, it also reminded us of the importance of systemically important banks. During the crisis, the failure or impairment of a number of large, global financial institutions sent shocks through the financial system which, in turn, harmed the real economy. The shocks were exacerbated when it became apparent that supervisors and other relevant authorities had limited options to deal with these banks, and therefore to prevent the problems from spreading through the financial system. As a consequence, public sector intervention to restore financial stability during the crisis was not only necessary, but had to be conducted on a massive scale. In response, the Committee adopted a series of reforms that, once implemented, will raise the resilience of banks and banking systems. These reforms will have a particular impact on global systemically important banks (G-SIBs) since their business models have generally placed greater emphasis on trading and capital markets related activities, which are most affected by the enhanced risk coverage of the capital framework. But Basel III is a minimum standard, and is not enough to address the unique risks posed by G-SIBs, the moral hazard associated with the perception that these firms are too big to fail, nor the cross-border repercussions that problems in a G-SIB would create. To alleviate these problems, the Committee sought to raise the bar further for these largest banks. We developed an assessment methodology for determining global systemic importance, and prescribed additional loss absorbency requirements for banks deemed systemically important.
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The G20 Leaders endorsed these rules at their summit last year. At that time, they asked the Basel Committee and the Financial Stability Board to work on extending the framework to domestic systemically important banks (D-SIBs). There are many banks that are not significant from an international perspective, but nevertheless could have an important impact on their domestic financial system and economy compared to non-systemic institutions. The Committee has recently published its framework for dealing with D-SIBs, which is a topic of discussion for this High-Level Meeting. Our goal was to develop a D-SIB regime which was complementary to the G-SIB regime, while at the same time recognising that different jurisdictions will wish to deal with domestic priorities in different ways. The D-SIB framework therefore identifies a set of common actions that all jurisdictions are expected to undertake, but leaves the detailed nature of those actions and the specific policy responses to national discretion. My main message for today is that critical to the success of this approach and the interaction with the G-SIB framework is the need for strong and cooperative dialogue between home and host supervisors where a bank from one country is designated a D-SIB in foreign jurisdiction.
Implementation
Supervision is a top priority for the Basel Committee, and implementation of Basel III is another. We have seen signs of progress on implementation in some countries, but much more is needed. Rules and regulations have to be consistently formulated and effectively applied. The implementation process is, therefore, a continuing one.
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At its September 2011 meeting, the Basel Committee agreed to initiate a programme to review members' implementation of the Basel regulatory framework (which includes Basel II, Basel 2.5 and Basel III). This is a comprehensive programme which seeks to spur full implementation of the Basel standards within the agreed timelines - this is something that the Committee has not previously done. The Committee has no doubt that with proper implementation, the regulatory reforms - both those already announced and those still in the pipeline - will help make banking systems more resilient. That is why the G20 Leaders have also asked us to keep focus on implementation issues and finish the job. In Mexico recently, the G20 Finance Ministers and Central Bank Governors said: "We remain committed to the full, timely and consistent implementation of the financial regulation agenda - We agree to take the measures needed to ensure full, timely and effective implementation of Basel II, 2.5 and III and its consistency with the internationally agreed standards." Three baseline assessments (the European Union, Japan and the United States) covering 11 Committee member jurisdictions have been completed and the reports have been published. Preparatory work relating to the next round of country assessments is under way and includes Australia, Brazil, Canada, China, Singapore and Switzerland. A system of follow-up for those assessments already completed is being designed and will be part of the regular implementation process going forward. The Basel Committee's systematic review of implementation is helping to identify the regulatory fault lines early on by providing Committee members a detailed and a point-of-time review of the progress made and the materiality of the shortcomings.
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As intended, the assessments are developing as a means to an end rather than an end in themselves. The expectation is that our assessments will help create a dependable global regulatory environment that will also help strengthen supervisory efficacy. The assessments we have thus far conducted demonstrate the strong cooperative nature of the programme. It involves senior-level experts from different jurisdictions, technical counterparts and select industry participants from the assessed jurisdiction, and the Committee's Secretariat. The expert nature of the country assessments is central to its legitimacy. Apart from assessing the regulatory consistency and materiality of the gaps, the Basel III implementation process has drilled down to the level of individual bank portfolios, and I expect the work will help us to identify the key drivers of variations in risk-weighted assets across banks, across jurisdictions and across time. As other Basel standards and policies are completed - such as those relating to liquidity, G-SIBs and large exposures - the focus on implementation is expected to rise. The implementation work is also helping inform the Committee's ongoing policy initiatives. This is an important feedback loop for the Basel Committee as our premise is that tougher capital and liquidity rules under the Basel III Framework are entirely appropriate for reducing the likelihood of failure for systemically important banks. Assessing implementation and the application of the Basel framework among Committee members also becomes important for many non-member countries where banks from BCBS jurisdictions operate and become systemically relevant.
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Their failure may not even be seen as a viable option since these banks play a critical economic role in credit intermediation and maturity and risk transformation. Proper implementation of Basel III will enable internationally active banks in emerging and developing markets to perform their role in a safer, prudent and economically constructive fashion. When globally active banks manage their capital and liquidity prudently, they act as a source of financial stability in the relevant jurisdiction. But an important pre-condition is that such banks must play by the international norms. Collectively, the regulatory requirements and the supervisory standards should push these banks along the path of the intended post-crisis reform agenda so that even during times of stress the banking system operates without material disruption to the financing of economic activities.
Further regulatory reforms are needed

The reforms to the capital adequacy rules have been substantial, and the Basel Committee's efforts to ensure they are put into practice properly and in a timely way have been considerable. But we cannot say that our work to further improve the regulatory framework is complete.
Liquidity
Basel III's liquidity rules are the most obvious element of the regulatory framework that we are working to finalise. Forging agreement on minimum liquidity rules for international banks has been a longstanding but elusive goal for supervisors and central bankers. Indeed, Sir George Blunden, the Basel Committee's first chairman, opened the Committee's very first meeting in 1975 by noting that its mandate was "to help ensure bank solvency and liquidity".
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While the Committee's reputation has been founded on the first part of the task, it has taken 35 years - until Basel III was agreed in 2010 - to find success on the second. Liquidity is an extraordinarily difficult and multifaceted topic. There are a wide range of views on how to define liquidity, as well as on how best to supervise, regulate and manage its risk. For example, in 1984 some of the questions relating to liquidity discussed by the Committee included: What constitutes liquidity for an international bank, and how can it be measured? - What should be the role of particular asset classes within an overall approach to liquidity in an international context? - How does the degree of maturity transformation undertaken affect a bank's liquidity? - To what extent can lending in the interbank market constitute liquidity? Does the ability of banks to draw funds from the interbank market affect the extent to which they need liquid assets? - What are the basic supervisory approaches to liquidity used by the different countries represented on the Committee? - What relationship do these approaches bear to the monetary policies applied by the central banks? These questions remain highly relevant, and they are just as difficult as they were then, but I am pleased to say that the Committee has now come to grips with them.
What has changed?

While the persistently increasing globalisation and interconnectedness of our financial systems were known to be creating potential vulnerabilities, there was no consensus on how (or how urgently) to deal with it.
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Unfortunately, it took a global financial crisis to provide the necessary impetus for agreeing on the Basel III liquidity rules. So the storm clouds of the crisis at least had a silver lining in that respect. As you know, the liquidity rules are comprised of a short-term Liquidity Coverage Ratio (LCR) and a longer-term, structural Net Stable Funding Ratio (NSFR). Since these represent the first time we have had global standards, the Committee agreed that we would review and, if necessary, refine them before they came into force. And the question everyone therefore wants to know is where do we currently stand with respect to finalising them, particularly the LCR which is due to come into force in 2015? The Committee is aiming to reach agreement by its December meeting on a few outstanding issues. As any bank supervisor, central banker or risk manager can attest, this is very difficult work given the wide range of issues we must consider. It has far-reaching implications, for example, for banking, financial markets and monetary policy, and for this reason our work has been undertaken with considerable care and caution. It is important to note that several countries have already adopted the liquidity framework in their jurisdictions, including Sweden, and I am pleased to say the Swedish experience with liquidity regulation has been very positive. For more than a year now Swedish banks have been reporting their liquidity coverage ratios to Sveriges Riksbank and the Swedish FSA, and the large banking groups also disclose their LCR publicly. Furthermore, from January 2013 minimum standards for the LCR will be introduced for the largest banking groups, both on an aggregated basis and separately in euro and US dollars.
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The results so far are reassuring and there are no signs that monetary policy operations or the functioning of the interbank market have been affected by the implementation of the LCR. Given the implications and potential costs - not the least of which are the social costs - of not raising the bar for liquidity requirements and liquidity risk management in banks, we would be failing in our responsibilities if we did not push on to finalise these proposals in the near future.
Trading book and securitisation

Let me now turn to the work we are doing with respect to some of the capital rules. Following on from the changes introduced in Basel 2.5, the Committee is now undertaking a more fundamental review of the trading book and the securitisation rules. With respect to the former, we want to achieve a regulatory framework that promotes more comparable levels of capital across banks with similar trading book portfolios. We also aim to provide more transparency, and limit arbitrage between the banking and trading books. Regarding securitisation, the complexity of the products, lack of transparency and poor underlying incentives led to massive losses. The Committee's objective is to address these weaknesses by making capital requirements for securitisation products simpler, better reflective of risk, less reliant on credit ratings and without significant cliff effects.
Standardised approaches
Also on the agenda in 2013 is to improve the standardised approaches for credit and operational risk. Our aim is to ensure these approaches continue to be suitable for assessing the capital adequacy of internationally-active banks - as well as
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other banks - that are not using the advanced approaches for risk measurement. While it would be premature to say what the result of our deliberations will be, one issue to be considered will be the extent to which the revised standardised approaches could also serve as a backstop or benchmark to the models-based approaches (eg banks, when publishing their risk-weighted assets, could be required to reference the calculations based on the standardised approaches). Linking the standardised approach with the models-based approach is already being considered in the fundamental review of the trading book. Using the standardised approaches as a backstop or benchmark could help increase the comparability of risk-weighted asset calculations among banks and jurisdictions.
Large exposures
Another important regulatory policy that is under review by the Committee is the large exposures regime. The Committee's original guidance - Measuring and controlling large credit exposures - was published in January 1991. It was successful in promoting broad convergence in the supervision of large exposures, while recognising the scope for variation according to local conditions. However, it is fair to say that the regulation of large exposures has become increasingly inconsistent. While there is considerable apparent homogeneity in the general approaches being adopted, there are significant differences in the specifics. Another lesson from the crisis has been that we did not pay sufficient attention to risk concentrations.
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This makes a strong case for a more consistent and effective framework for large exposures. Such an internationally consistent framework would ensure a level playing field, reinforce consistency in underlying capital requirements (since the capital framework does not directly capture concentrations) and avoid loopholes or exemptions where risks can build up undetected. The Committee is therefore examining the merits of a more consistent approach to large exposures, and will publish its proposals for comment during the course of 2013.
Other areas for review

Let me quickly touch upon two other areas on the Committee's agenda: one a broad theme, and the other a specific initiative that is supervisory in nature.
Simplicity and comparability

I am the first to acknowledge that a number of areas of the regulatory framework have become increasingly complex over the years. As a result, the Committee has this year been evaluating ways in which it can be simplified, without materially altering its underlying objective or strength. There is a fine balance that must be achieved. The use of a regulatory measure that is too simple and blunt can provide strong, perverse incentives for banks. On the other hand, there is a limit to how much faith we should put into the complexity and sophistication of models. A specific example of the Committee's current thinking is our recent announcement on the regulatory treatment of debit valuation adjustments (DVAs).
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This is a complex issue relating to the impact of a bank's own credit risk on the valuation of derivative transactions. To precisely measure this impact, which we wished to remove from the capital base, would have been extremely complex and difficult. The maths and analysis necessary would be beyond the capabilities of the average bank supervisor - let alone a central bank Governor! The Committee therefore decided on a more simplistic, but conservative, treatment. This was criticised for not being precise enough and therefore potentially overstating the risk. But the Committee decided that there was a trade-off to be made, and that the additional precision involved in refining the approach was not worth the cost involved. The message here is not that the Committee is dismissive of the benefits or desirability of risk sensitivity, but rather that it needs to be traded off against other objectives. At some point it is inevitable that the never-ending pursuit of greater precision in risk measurement is not worth the effort - indeed, it can lead to a dangerous false sense of precision, which is best avoided.
Capital planning
Given that we have raised minimum capital requirements, capital planning will necessarily become more important - both for banks and their supervisors. Recognising this, we have established a task force to examine current industry practices and develop guidance on good capital planning processes. This work is looking at issues such as:
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- processes for establishing targets for the level and composition of capital; - monitoring and decision making with respect to capital; - linkages to strategic plans and other business planning considerations; and - coordination with the assessment of firms' risk profile and appetite. The objective of this work is not a new policy that will impose specific requirements on banks such that every bank does its capital planning in the same way. Rather, it will be sound guidance that banks and supervisors can use to help judge whether an individual bank has a robust capital planning process, given its size, shape and complexity. This will be particularly important in a Basel III world, with a number of capital constraints (CET1, Tier 1 and total risk-based ratios, and the leverage ratio) and buffers (capital conservation, countercyclical and SIB surcharges) to which banks will need to manage.
Conclusion
I would like to bring my remarks to a close by emphasising as I did at the outset that regulatory reform has two essential complements: supervision and implementation. Even strong international regulations will be ineffective if they are not implemented fully or if the associated supervisory regime is weak. Hence, the Committee is raising the bar in all three areas. First, it is obvious that we have been working to strengthen the regulatory framework. This is not just in the form of Basel III, but also the work we have completed on SIBs, and the work still in train on the trading book, securitisation and large exposures.
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Second, we have been much more proactive in making sure that the international agreements are implemented in full, on time and in a consistent manner. And, finally, we have used the revisions to the Core Principlesto also raise the bar for supervision. Doing one is not enough; neither is doing two. We need to raise the bar in all three areas if we are to achieve a robust and resilient financial system for the future.
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International monetary policy interactions: challenges and prospects

Speech by Jaime Caruana General Manager, Bank for International Settlements To the CEMLA-SEACEN conference on The role of central banks in macroeconomic and financial stability: the challenges in an uncertain and volatile world Punta del Este, Uruguay Let me start by thanking both CEMLA and SEACEN for the opportunity to address you today. Such meetings are an excellent opportunity for central banks from the Americas and Asia to compare notes and learn from each others experience. After all, didnt the so-called Tequila crisis of the mid-1990s prefigure the Asian financial crisis of a couple of years later? In Jackson Hole at the end of August, I asked why the cooperation that we take for granted in regulating banks generally seems to be regarded as unnecessary, or even uncalled for, when it comes to monetary policy. Today I should like to sharpen the focus and discuss international monetary interactions. No doubt this is a matter of some controversy. At the same time, with a number of emerging market central banks having shifted to easing policy in 2012, there may be a window of opportunity for less disagreement and more understanding on the subject.
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Let me state my message at the outset. I want to make the case for a better understanding of monetary policy interactions and for incorporating them more systematically in policy. I shall first set the context, then discuss policy interactions, and conclude by addressing the risks and challenges of the way forward.
1. The context
Lets step back and take a global perspective on monetary policy. It is hard to avoid a troubling observation. For the world as a whole, monetary policy has been unusually accommodative for a very long time. By this, I mean for 10 years or more. What evidence leads to this observation? Successive BIS Annual Reports have laid out two strands of evidence.
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An admittedly quite simple and common approach is to compare real policy interest rates with real growth rates. As can be seen from Graph 1, real policy rates have fallen short of real growth by some measure and with some frequency, for the world as a whole, for advanced economies and for emerging economies. Another, more constructed, approach is to examine the gap between actual policy rates and those that obey simple Taylor-type rules, which link policy rates in a mechanical way to inflation and the output gap. True, estimating their underlying parameters poses challenges. Both the steady-state real interest rate and potential output are exceedingly hard to measure. That said, for a variety of standard specifications, there is clear evidence of a tendency for policy rates to deviate from this simple standard by some margin, with some frequency and for quite some time, at both the global and regional level (Graph 2).
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This is all the more so if we take into consideration two additional factors. First, these benchmarks do not incorporate commitments to keep interest rates low for a prolonged period or the wide range of balance sheet measures that many central banks have taken, such as large-scale bond purchases and liquidity support. Second, they also ignore the fact that, especially during financial booms, real-time estimates of potential output are biased upwards, thereby underestimating the degree of policy easing. And we know that a number of economies, not just emerging market ones, have been experiencing such booms lately. Thus, whichever way the data are cut, it is hard to escape the conclusion that, globally, policy rates have been unusually low for an unusually long time. Now, why is this so?
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Such low rates to some extent reflect an asymmetry in monetary policy frameworks. In particular, pre-crisis, it was thought that no monetary policy response was appropriate to evidence of tailwinds from rapid credit growth amid booming asset prices as long as near term inflation remained under control. At the same time, a very strong response was seen as the right way to address the headwinds of a financial crisis.
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Admittedly, post-crisis, the centre of gravity of the debate has been shifting towards a more preventive use of monetary policy to limit risks from the build-up of financial imbalances. Even so, there has been a strong revealed preference for relying almost exclusively on macroprudential tools. But well beyond policy frameworks, on a global level, low average policy rates also result from policy interactions. After all, global outcomes reflect decisions of groups of policymakers in individual economies who take the decisions of policymakers in other economies as inputs to their decisions. Thus, we can think of monetary policy as a dense web of interactions, with both global and important regional strands. But what are those interactions exactly? And why should they have led to looser monetary policy globally? Let me first trace the channels through which monetary policy in one country affects conditions in another and then discuss the induced policy responses. I will focus very much on financial channels, which I think are particularly powerful.
2. Policy interactions: transmission channels

In discussing transmission channels, let me distinguish between the impact on the exchange rate and asset prices, on the one hand, and on quantities, notably capital flows, on the other. While the two are obviously related, it is analytically helpful to keep them distinct to avoid the temptation of overstating their link.
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This point is well known, but is easily forgotten in discussions of policy. In particular, prices can adjust substantially with no change in underlying quantities. Prices need only to respond strongly to incipient portfolio adjustments to ensure that agents are content with the positions they already hold. Moreover, what is true of transactions in general is also true in particular of transactions between residents and non-residents, ie capital flows. Exchange rates can adjust and asset prices move in sync quite closely without necessarily giving rise to capital flows. And to the extent that transactions are involved, these need not be between a resident and a non-resident. For example, the BIS triennial foreign exchange survey reveals that from a third to three quarters of all foreign exchange transactions of major emerging market currencies take place among non-residents. As another example, it has long been observed in Australia that most of the change in Australian dollar bond yields happens while Australias own markets are closed: the news that moves them most is not the employment report in Australia but that in the United States. Turning then to the asset price channels, the first and most obvious one is the exchange rate. A reduction in the policy rate or the announcement that it will be kept low for some time should, all else equal, put downward pressure on the exchange rate. While the strength of the impact is not easily predictable, this is precisely one of the usual ways monetary policy is expected to operate.
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In addition, balance sheet policies can have a similar effect, as when central banks engage in large-scale bond purchases to push longer-term bond yields lower. There is considerable evidence that such operations have been quite successful in reducing yields. How far this, in turn, has induced exchange rate depreciation is less clear, in part because of policy responses, to which I shall return. A second channel operates via government bond yields themselves, regardless of whether they fall as a result of expectations of lower future policy rates or of direct bond purchases. I have already noted the example of Australian bond yields, but the effect is much more general. It simply reflects the thorough integration of global bond markets. For instance, one study has found broad effects of the announcement of the Federal Reserves bond buying on Canadian, UK, German, Japanese and Australian government bonds. A follow-up study suggests that bond yields fell in these markets not because of lower expected policy interest rates, but because of a lower term premium. Yet another study has found similar effects in the bond markets of East Asia and Latin America. A third channel operates via other asset prices, and for much the same reasons. Here too, the degree of market integration is crucial.
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The effects are stronger for highly global markets, such as equities, and weaker for highly domestic ones, such as real estate. Consider now the channels that operate via quantities. A direct, if sometimes neglected, channel works through assets and liabilities denominated in foreign currency, notably in the major international currencies such as the US dollar and, to a lesser extent, the euro and the yen. In particular, as interest rates are reduced in any of these currencies, emerging market borrowers find it cheaper to borrow in them and those who have already borrowed enjoy lower financing costs. Thus, a substantial stock of foreign currency debt directly transmits the policy of the major central banks to other countries. The pre-crisis experience in central and Eastern Europe provides striking evidence of the relevance of this channel. Borrowers there found it attractive to fund themselves at lower euro or Swiss franc rates, notably in the form of mortgages. When local central banks raised rates, not only did they not raise the cost of existing foreign currency loans, but they also saw borrowers take on more of them. This channel, of course, is not confined to central and eastern Europe. There is something like $7 trillion in US dollar credit to borrowers who reside outside the United States. At times since the crisis, its growth rate has been as high as 20% year on year.
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We finally come to capital flows more generally a much discussed channel. Easier monetary conditions in core economies tend to encourage capital flows to economies where interest rates are higher. Quite apart from being one of the mechanisms that puts upward pressure on exchange rates think of carry trades between residents and non-residents and on asset prices, such as through portfolio investments, gross capital flows have often helped to pump up credit booms. There is, for instance, considerable evidence that the cross-border component of credit tends to grow faster than domestic credit during such episodes. Moreover, in a cross section of emerging markets in 200308, the resulting rise in the share of cross-border credit is associated with a rise in the overall ratio of bank credit to GDP. Bank inflows bear watching when one is concerned about rapid credit growth. To be sure, the link between easier monetary conditions in core economies and capital flow surges is far from mechanical, and its strength varies greatly over time. Other factors can play a key role, including changes in risk attitudes and domestic conditions. We are all familiar, for instance, with market participants talk of risk-on/risk-off, which conditions capital flows. These factors are only partly influenced by those monetary conditions themselves.
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Moreover, as I shall explain in a minute, the link is shaped by the policy response in recipient economies. That said, it would be hard to deny the link. In particular, in the risk-on mode, wide interest rate differentials act as a magnet for debt capital flows.
3. Policy interactions: responses

So much for the transmission channels; what about the policy responses? These depend on circumstances. In some cases, major central bank actions may amount to no more than background noise or may even strengthen the policy response by the local central bank to domestic conditions. In other circumstances, however, they may constrain domestic policy and give rise to difficult trade-offs. Such circumstances may explain the unusually accommodating monetary conditions we have seen pre- and post-crisis. Two different concerns may result in a central banks choosing a looser monetary policy in response to an accommodative monetary policy elsewhere. The authorities may seek to prevent a loss of trade competitiveness. Alternatively, or concomitantly, they may seek to prevent the financial stability and macroeconomic consequences of gross capital inflows, which can help finance a build-up of financial imbalances. In both cases, doubts about the self-equilibrating behaviour of the exchange rate play a key role.
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Let me take each in turn. Concern over loss of competitiveness is long-standing, especially for countries that rely on manufactured, rather than commodity, exports. And it can be exacerbated by strategic considerations, namely a first-mover disadvantage. The first country to allow an appreciation can lose competitiveness if its trading partners successfully resist it. Perhaps if all allowed appreciation at the same time, the concern over competitiveness would be much allayed. Focusing on bilateral exchange rates, such as vis--vis the US dollar, as opposed to the more relevant effective exchange rate, may add inertia and exacerbate the link with monetary conditions in a specific country, potentially adding to the risk of instability. Concern about the financial stability implications of cross-border flows, especially their impact on credit expansion and asset price booms, is more recent. Financial crises in both emerging markets and advanced economies have made it more salient. The potential for withdrawal of cross-border credit has led authorities to build up war chests of foreign exchange reserves. And since damage can be done not only by the reversal of such flows but also by their preceding surge, authorities avoid large interest rate differentials, for fear of attracting capital inflows. Regardless of whether the focus is on competitiveness or financial stability, the perceived risk of overshooting in the exchange rate adds to the worries.
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Such overshooting can do lasting damage to competitiveness, as lost markets and productive capacity are not easily regained. And it can add strength to the capital inflows and credit booms, by inducing expectations of further capital gains on investments and falling borrowing costs. The end result is predictable: a looser monetary policy stance and resistance to exchange rate appreciation. The monetary authorities may pre-emptively take interest rates lower than they would otherwise. Or they may intervene in foreign exchange markets and accumulate reserves in an effort to avoid reducing interest rates in response to loosening by major central banks. These responses, in turn, can condition policy in the major advanced economies. After authorities intervene by buying major currencies, they invest the proceeds in major government bonds. Bond buying by foreign exchange reserve managers can lower yields in major bond markets just as such buying by the domestic central bank. The combination of unconventional policy measures in major advanced economies and the investment of the proceeds of intervention on major bond markets can lead to quite high fractions of official investment in such bond markets. Foreign official holdings of US Treasuries at end-June 2011 were $3.5 trillion, and Federal Reserve holdings were $1.6 trillion. These official holdings of $5.1 trillion amounted to over half of the outstanding $9.5 trillion.
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Such large players can make for substantial interactions even in a very large market. Some express concerns that emerging market economies resistance to currency appreciation puts more upward pressure on freely floating currencies. In any case, it is the strategic setting of low policy rates and the diffusion of low bond yields that can lead to a global easing of monetary conditions. These mechanisms have been at work both before the crisis and since. Just recall the massive increase in foreign exchange reserves, although it has slowed to a crawl in emerging markets over the last year. And while it is tough to prove that interest rates have been kept lower than otherwise for the reasons suggested, the message of Taylor rules is strongly suggestive. Even more telling is the frequent complaint that it is exceedingly hard to set policy rates appropriately when they are so low in the larger economies. The strategic aspects of the overall situation are apparent. The more countries find themselves in this condition, the harder it is for any one of them to deviate. This is true regardless of the specific concern underlying the policy response. As a result, a very accommodating monetary policy can become entrenched globally.
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4. Policy challenges, risks and a way forward

Monetary policy conditions that are too easy for too long can lead to problems down the road. Macroeconomic problems can emerge in the form of an inflation surprise or, as they have more recently, serious financial distress, when financial booms turn into busts. To be sure, policymakers have recognised these risks and have acted to improve the tradeoffs they face. The corresponding measures have taken various shapes and sizes and, in practice, the delineation between them can be ambiguous. Their common denominator is an attempt to restrain the impact of foreign spillovers and of the induced policy response through interest rates and, possibly, foreign exchange intervention. The first set of measures comprises standard monetary policy administrative tools although now they are sometimes re-dubbed macroprudential tools. The most common example is higher reserve requirements. They seek to tighten credit conditions without encouraging capital inflows, as an increase in interest rates might do, through in effect a tax on banks. The second set of measures comprises macroprudential tools. These target specifically systemic risk and are supported by specific governance arrangements to keep them properly focused.
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Prominent examples include higher bank capital requirements, stricter and less cyclically sensitive loan loss reserves, and lower loan-to-value or debt-to-income ratios. Other such tools include Koreas taxes on banks non-deposit short-term foreign currency funding and limits on foreign exchange forward positions. Moreover, going forward, countries will be able to implement Basel IIIs countercyclical capital buffer fully backed by reciprocity arrangements, which are designed to limit the possibility of cross-border regulatory arbitrage to my mind an often underappreciated breakthrough in international regulatory coordination. The final set of measures comprises capital controls, which specifically target transactions between residents and non-residents. These include restrictions on foreign investors access to the home bond market or on domestic firms access to global bond markets. While, to varying degrees, these three types of policy can help, they have two limitations. They may fall short of their objective; and some of them may have considerable side effects. The risk of falling short of the goal should not be underestimated. Experience indicates that, over time, administrative controls tend to become porous and subject to circumvention. Reserve requirements, for instance, boost what might be called the shadow banking sector. Capital controls can become less effective or more expensive as domestic enterprises become more multinational, so that their treasury operations span the border.
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As for macroprudential frameworks, no doubt their implementation has been a major achievement that deserves to be pursued vigorously. That said, we should keep our expectations realistic. These frameworks can certainly improve the resilience of the financial system, by building up buffers when it is cheap and easy to do so. But their ability to restrain a financial boom sufficiently is limited and uncertain. They cannot be expected to bear the whole burden. Monetary policy has to play its part, duly supported by fiscal policy. Is the risk of falling short of the objective materialising? Inflation so far has remained relatively subdued. But in a number of cases, headline inflation has been exceeding targets and has proven surprisingly resilient given prevailing views about the excess capacity across countries. Moreover, while commodity prices have come off their peaks, they can quickly pose policy challenges again, especially in economies where food makes up a large part of the consumer basket. More pressingly perhaps, risks to financial stability merit close attention. For a number of years now, several economies have experienced very rapid credit growth, sometimes accompanied by buoyant asset prices. Some of these financial booms appear to have reached maturity and possibly even to be deflating. Experience shows that, unless addressed in timely fashion, such developments can put at risk years of economic advance.
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Turning to the side effects, capital controls may deflect capital from one receiving economy to another. Might those economies thought least likely to change the rules on capital inflows ironically face the challenge of still larger flows? This brings me to broader political economy considerations. We have reached a delicate global monetary policy configuration. If this analysis is correct, there is a real risk that frictions could multiply and intensify, especially if the economic environment were to deteriorate further. They could involve not just frictions over currencies, but also over investment decisions in foreign bond markets. A world in which officials hold large portions of the largest bond markets does not strike me as an ideal one. The ultimate risk is that of a discontinuity in the international regime. We are used to fearing trade protectionism, but there is also a risk of financial protectionism financial protectionism not just through capital controls, but also through regulatory and supervisory action. In a world of multinational financial firms, uncoordinated efforts to preserve liquidity, to limit reliance on short-term funding and to avoid risks of policy shifts can further segment already fractured markets. And with very high levels of public and private sector debt, sooner or later such a world is likely to turn to inflation. The temptation to repress financial markets to inflate debts away may simply prove too strong.
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It would not be the first time. We are, of course, not facing such a scenario right now. And it is policymakers duty to prevent it from ever materialising. I believe that a keener recognition of monetary policy interactions would be an important step in the right direction. The BIS, through its committee structure and own analysis, intends to strengthen its efforts to support this process.
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Kiyohiko G Nishimura: Ageing, finance and regulations

Keynote address by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Joint Forum Meeting, Tokyo, 14 November 2012.
Introduction: Population ageing, economy and finance

It is my great pleasure to have the opportunity to speak at the Joint Forum Meeting in Tokyo. The Joint Forum has for many years been at the forefront of dealing with various cross-industry issues related to banking, securities and insurance. The Forum has thereby contributed greatly to the evolution of successful regulatory and supervisory frameworks. However, many challenges remain. For example, as economic globalization and information technology advance, cross-border and cross-industry risks have become increasingly important in financial services, and failure to regulate and supervise them effectively may result in profound economic consequences. Structured securitized products and monoline insurances are examples of such risks, as we have learned to our cost in the recent crisis. Today, I would like to consider another significant challenge, which I think is increasingly important worldwide, though not yet widely recognized as crucially important. This is the issue of population ageing and how to regulate and supervise financial products and services to cope with problems arising from it.
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Indeed, these issues are deeply related to the fundamental nature of financial services, including all financial sectors such as banking, securities and insurance. In fact, I have warned of the unpleasant and in some cases grave consequences of ignoring demographic factors in our economic thinking in a series of recent speeches and papers, especially with respect to asset price bubbles, money demand and inflation. In particular, I have pointed out that asset price bubbles are most likely to occur at the final stage of the demographic bonus in which a country enjoys the benefits of an increase in the size of the working population. In contrast, a decline in growth potential due to demographic onus is likely to result in prolonged economic stagnation once the bubble bursts. These phenomena have been observed not only in Japan, but also in other countries such as the United States and peripheral euro area countries. What underlies the recent distress in the euro area is in fact deeply rooted in the structural changes resulting from demographic transition or population ageing. Figure 1 shows the relation between changes in the working age population curve and the timing of bubble bursts. These coincided in Japan around March 1991, in the United States in December 2005, in Ireland in September 2006, and in Spain in September 2007. And this is not simply a problem affecting advanced economies: the problem is just around the corner for some emerging economies like Korea, China, and Brazil. Population ageing is likely to have a significant impact on financial services, and requires a new policy response.
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Here I would like to raise two issues: one is the necessity of cross-industry and even cross-border coordination, and the other is the question of how to deal with the fundamental uncertainty surrounding population ageing.
Necessity of cross-industry and cross-border coordination

Let me first consider the necessity of cross-industry and cross-border coordination. As a society begins to age, its older citizens become the dominant holders of financial assets.
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However, with the coming of age, many people are likely to become risk-averse in managing their financial assets, for natural reasons. Thus, a mature economy, with its lower growth potential due to ageing, faces the serious problem of how to provide risk money to promising sectors of the economy so as to encourage entrepreneurs sound risk-taking and enhance value production. To be more specific, financial products and services should enable older citizens to maintain their quality of life and help foster an environment where longevity is seen as a gift, rather than a risk. These products, in addition to retirement savings, are expected to play diverse roles. Given the improved average health of senior citizens in many countries, it is increasingly important that these financial products and services help the older population stay active and contributing to the community to the best of their abilities, while mitigating age-related risks such as illness. To provide such products, financial institutions must cooperate with other industries to take full advantage of their advanced technologies and expertise. At the same time, financial institutions should utilize their own expertise to measure, distribute, and manage the various risks as intermediates between asset-rich older citizens and prospective entrepreneurs. These attempts inevitably involve cross-industry elements. Furthermore, with the transition from a growing economy to a mature economy, it is natural for people in an ageing economy to pursue higher returns by investing their savings in growing overseas economies.
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Thus, it is also important for a mature economy to make full use of the benefits of cross-border transactions while managing the accompanying risks. This upcoming trend of cross-industry and cross-border expansion of financial products and services will pose a serious challenge to the current regulatory and supervisory frameworks. It will certainly call for a comprehensive approach. Regulation and supervision focusing only on a specific sector will likely result in a waterbed effect: problems will be simply shifted to other sectors rather than being dealt with effectively.
Fundamental uncertainty regarding life expectancy and fertility

The second issue is the fundamental uncertainty surrounding the pace of population ageing. I first note the two kinds of risk involved: the first relates to life expectancy or longevity, and the second to birth rates or fertility. I then discuss the fundamental uncertainty in measuring these risks in the economy as a whole, and the possible consequences of this for regulation and supervision. Among the various risks we face in the real world, the longevity risk is the most fundamental one. No one can tell exactly how long he or she will actually live. While economic textbooks impersonally state that efficient allocation of resources can be achieved more easily if there is no uncertainty, very few people would prefer to know the exact date on which they are going to pass away.
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As human beings we need to accept such unavoidable uncertainties, and financial services have a critical role to play in helping us manage the risks associated with such inherent uncertainties while enabling us to enjoy a life full of surprises. As the population ages, the social need increases for financial products and services to respond to the longevity risk. To provide the tools necessary to respond to the longevity risk, providers need to be able to manage the accompanying risks in the economy as a whole. To this end, financial service providers such as insurers have traditionally utilized the law of large numbers, a rule assuming that as the number of samples increases, the average figure of these samples, such as average life expectancy, becomes more predictable. The same is considered to be true for fertility. Although the exact number of children for a given couple is not known for sure, the average rate of birth per couple becomes largely predictable. The popular perception that demographic change is in general predictable is based on this law of large numbers. Unfortunately, this perception is not always true, or to put it bluntly, not true in many instances. Take Japan for example. Between the 1970s and early 2000s, the total fertility rate forecasts regularly turned out to be wrong and were consistently revised down. The government repeatedly published its forecast in which the decline in the fertility rate was declared to be only temporary and the birth rate expected to rise again soon (Figure 2.)
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Similarly, life expectancy forecasts have shown that the actual figures consistently exceeded the forecasts (Figure 3).
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These forecast errors show the fundamental uncertainty surrounding the pace of population ageing. And if the actual outcome deviates from the estimated life expectancy and longevity of the entire population in an economy, all service providers will be affected. For example, in the case of longevity risk products, even a slight deviation could significantly increase the exposures of service providers.
Avoiding patchwork and spaghetti code problems
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Regulatory and supervisory reform is often called for once such deviation causes an unexpected accumulation of losses. However, this kind of loss-induced regulatory and supervisory reform often leads to patchwork plumbing, which in turn results in a vicious circle of further losses and more patchwork. The repetition of such ad-hoc adjustments to the framework can cause what computer programmers refer to as spaghetti code problems, in which the framework becomes too complex and entangled, like spaghetti, so that no one knows how to fix the problem. Thus, we must be careful not to make over-optimistic forecasts, especially when these forecasts underlie the overall framework and any forecast error might bring about irrevocable losses. It is also important to have in advance a clear strategy on appropriate policy responses when a forecast error is observed, especially in dealing with spaghetti code risks. The performance of the framework should be subject to continuous review, and necessary measures should be readily available at all times. With these measures in place, it should be possible to prevent a mere forecast error from turning into an irreversible disorder of the whole system. In this sense, it is better to address the challenges of population ageing by incorporating a second best fail-safe mechanism into our overall institutional framework, rather than by chasing the first best solution while pretending our forecasts are always rational and unbiased.
Concluding remarks
The recent financial crisis has completely changed the landscape of financial services, both for financial institutions and for supervisors.
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Before the Lehman crisis, people tended to see only the bright side of new financial products, such as securitized products, derivatives, and cross-border transactions, believing them to be backed by advanced and innovative risk-management and investment tools. However, since the crisis revealed the risks and problems associated with them, people have come to see mostly the dark side of these services. Nonetheless, there is still an essential need for financial products and services that can help individuals and firms manage their risks, since sustainable economic development can only be achieved through sound risk taking by private entities. Moreover, financial institutions will be expected to play an even more active role as more countries face the problems arising from population ageing. This is especially relevant to satisfying the need for longevity risk management and in coping with the problems of declining fertility, since financial institutions full use of their technologies and resources is the key to solving these problems. Thus, financial service providers should be able to contribute to the economic society by providing people with the tools to address the risks and harsh uncertainties of life, while enabling them to enjoy its thrills and happy surprises. In this respect, I believe that regulators and supervisors should bear the following two things in mind: First, regulators and supervisors should always have a cross-industry and in some cases cross-border perspective, and they should also have a grand design as to how the economy can spread the risks necessary for sustainable growth, especially under population ageing.
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Second, regulators and supervisors should be aware that a desirable regulatory framework will continuously evolve, partly due to population ageing and the consequent structural changes in the economy and financial services. The current structure and regulatory framework will not last forever, and neither will sectoral classifications such as banking, insurance, and securities. For example, increased demand for longevity risk management could perhaps foster new cross-industry innovation between medical and financial services. From its unique vantage point, the Joint Forum is able to observe the signs of structural changes in financial services and to identify the need for regulatory and supervisory evolution. I sincerely hope that the Forum will continue to be attentive to new developments in financial services and lead the global debate on regulation and supervision. Now I come to the final words of my speech about ageing. Just as we mortal individuals mature and come of age, so too do institutions. Here is the Bank of Japan (Figure 4) more than a hundred years ago, in its youthful, burgeoning days.
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And here is the Bank of Japan as it is today (Figure 5), surrounded by new architectural additions to the city skyline and still the focal point of the landscape.
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The building itself has indeed matured, and in its maturity has come to fit itself perfectly to the new age. I believe the same can surely be said of the Joint Forum. Thank you for your kind attention.
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William C Dudley: Solving the too big to fail problem

Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York and President of the Committee on the Global Financial System (CGFS), at the Clearing Houses Second Annual Business Meeting and Conference, New York City It is a pleasure to have the opportunity to speak here today. I am glad to see the progress our city and region have made recovering from Sandy, but obviously significant challenges remain. I am going to focus my remarks today on what is popularly known as the too big to fail (TBTF) problem. In particular, should society tolerate a financial system in which certain financial institutions are deemed to be too big to fail? And, if not, then what should we do about it? The answer to the first question is clearly no. We cannot tolerate a financial system in which some firms are too big to fail at least not ones that operate in any form other than that of a very tightly regulated utility. The second question is the more interesting one. Is the current approach of the official sector to ending TBTF the right one?
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Id characterize this approach as reducing the incentives for firms to operate with a large systemic footprint, reducing the likelihood of them failing, and lowering the cost to society when they do fail. Or would it be better to take the more direct, but less nuanced approach advocated by some and simply break up the most systemically important firms into smaller or simpler pieces in the hope that what emerges is no longer systemic and too big to fail? As I will explain tonight, I believe we should continue to press forward on the first path. But, if we fail to reach our destination by this route, then a blunter approach may yet prove necessary. As always, my views may not necessarily reflect those of the Federal Reserve System.
What is the too-big-to-fail problem?

The root cause of too big to fail is the fact that in our financial system as it exists today, the failure of large complex financial firms generate large, undesirable externalities. These include disruption of the stability of the financial system and its ability to provide credit and other essential financial services to households and businesses. When this happens, not only is the financial sector disrupted, but its troubles cascade over into the real economy. There are negative externalities associated with the failure of any financial firm, but these are disproportionately high in the case of large, complex and interconnected firms.
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Although the moniker is too big to fail, the magnitude of these externalities does not depend simply on size. The size of the externalities also depends on the particular mix of business activities and the degree of interconnectedness with the rest of the financial industry. One important element is the importance of the services the firm provides to the broader financial system and the economy and the ease with which customers can move their business to other providers. Another is the extent to which the firms structure and activities create the potential for contagion that is, direct losses for counterparties, fire sales of assets held by other leveraged financial institutions, or loss of confidence that might precipitate runs on other firms with similar business models. The presence of large negative externalities creates a dilemma for policymakers when such firms are in danger of failing, particularly if the wider financial system is also under stress at the same moment. At that point in time, the expected costs to society of failure are very large compared to the short-run costs from providing the extraordinary liquidity support, capital or other emergency assistance necessary to prevent catastrophic failure. The markets belief that a TBTF firm is more likely to be rescued in the event of distress than other firms weakens the degree of market discipline exerted by capital providers and counterparties. This reduces the firms cost of funds and incents the firm to take more risk than would be the case if there were no prospect of rescue and funding costs were higher.
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The fact that firms deemed by the market to be TBTF enjoy an artificial subsidy in the form of lower funding costs distorts competition to the detriment of smaller, less complex firms. This advantage, in turn, creates an unfortunate incentive for firms to get even larger and more complex. The funding benefit of being seen to be TBTF causes the financial system to become artificially skewed toward larger and more complex firms in ways that are unrelated to true economies of scale and scope. Now to be clear, I dont believe that firms necessarily deliberately set out to become TBTF. Nor do I think that TBTF was the main cause of the breakdown in market discipline that preceded the financial crisis. Many factors were at work, including the failure to grasp the riskiness of new types of credit products and business models, and principal-agent problems such as the traders put. But I do think TBTF contributed to the underpricing of risk in the system and did create a bad set of incentives, and if not addressed comprehensively, would likely be an even larger problem in the future.
So how did the problem become so serious?

The TBTF problem is not new. For example, the FDIC (Federal Deposit Insurance Corporation) and other federal regulatory agencies intervened to prevent the abrupt failure of Continental Illinois, then the seventh largest bank in the United States, in the 1980s. Had Continental Illinois been allowed to fail without any intervention, the comptroller of the currency later testified, we could very well have seen a
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national, if not an international, financial crisis the dimensions of which were difficult to imagine. The comptroller went on to declare that the largest 11 national, commercial banks were too big to fail. But the problem has become more significant since that time for several reasons. First, the biggest financial institutions have become much larger, both in absolute terms and relative to the overall size of the banking system. This reflects many factors including the end of prohibitions on interstate banking, the repeal of the Glass-Steagall Act restrictions separating investment from commercial banking, the rapid growth of the capital markets, and the globalization of the economy all of which created intense competitive pressures to expand in order to gain economies of scale and scope. In commercial banking, consolidation occurred at a rapid pace. For example, Bank of America was the outgrowth of over 160 different mergers, which pushed up the size of the original acquirer from $23 billion of assets in 1980 to $2.2 trillion today. In the securities industry, some partnerships became public companies, in part, so that they could more easily obtain the capital needed to expand rapidly. For example, when Goldman Sachs went public in 1999, it had about 15,000 employees and $250 billion of assets. Just eight years later, the firm had expanded to 35,000 employees and $1.1 trillion of assets.
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In the mid-1990s, the top five banks in the United States had total assets of $1 trillion or about 14 percent of gross domestic product (GDP). The top securities firms had total assets of $718 billion, or about 9 percent of GDP. By the end of 2007, the top five banks had assets of $6.8 trillion or 49 percent of GDP. Similarly, the top securities firms accounted for $3.8 trillion, or about 27 percent of GDP. In addition, the firms off-balance-sheet exposures rose sharply. Second, the complexity and interconnectedness of the largest financial firms increased markedly. Factors behind this include the adoption of a universal banking model by some commercial bank holding companies and the rapid growth of trading businesses, especially the over the counter (OTC) derivatives market. In the early 1980s, there were no true U.S. universal banks that combined traditional commercial banking with capital markets and underwriting activities. By 2007, there were several operating in the United States, including Citigroup, J.P. Morgan, UBS, Credit Suisse and Deutsche Bank. Also, the OTC derivatives business in foreign exchange, interest rate swaps and credit default swaps had exploded from its start in the early 1980s. The total notional value of the OTC derivatives outstanding for the five largest banks and securities firms currently totals about $200 trillion.
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During this period, there was inadequate attention to the risks that were building up in the system. The regulatory and supervisory framework did not keep up with the changes in size, complexity, interconnectedness and globalization that created growing systemic risk externalities and widened the wedge between private and social costs in the event of failure. Let me mention just a few of the issues: Capital regulation was lax both in terms of the amount of capital required and the quality of that capital. As a result, many banks did not have the capacity to absorb large shocks and retain access to wholesale funding. The oversight of the largest securities firms was particularly deficient in terms of ensuring that these firms had sufficient private resources to deal with shocks. The industry was also particularly exposed because in the United States, there was (and remains) no lender of last resort backstop for the securities industry except in extremis. Although global integration brought with it a number of benefits, regulatory coordination did not keep pace with the globalization of financial firms and markets. This allowed the potential magnitude of the negative externalities associated with the failure of globally active firms to expand considerably. Policymakers allowed market structures, particularly in wholesale funding markets, to evolve in directions that were efficient from a private perspective in normal times, but amplified run dynamics and therefore externalities in times of stress.
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Examples include the growth in triparty repo activities and the reliance of many large financial institutions on funding from money market mutual funds, as well as many other elements of the shadow banking system. The TBTF problem was further aggravated by the financial crisis and the policy response. Faced with system wide stress, the Federal Reserve, with the support of the U.S. Treasury, intervened to prevent the disorderly failure of Bear Stearns, a firm that would not have been high on the list of TBTF firms a few years earlier. Meanwhile, the failure of Lehman Brothers demonstrated that the cost to society of the uncontrolled failure of a TBTF firm in a period of generalized stress was considerably greater than anticipated. Following the bankruptcy of Lehman, contagion spread by many channels, including prime brokerage, OTC derivatives positions, money market mutual funds, tri-party repo and wholesale funding markets. The loss in confidence disrupted the flow of credit throughout the global financial system, generating a global economic downturn and the worst contraction in the United States since the Great Depression. Recognition of the costs generated by the Lehman failure led to extraordinary interventions to prevent further catastrophic failures. These included the rescue of AIG, the FDICs TLGP program, the ring-fence of Citigroups poorer quality assets, and the TARP injection of capital into the largest U.S. financial institutions. Because this solidified in investors minds that TBTF firms after the Lehman debacle would be protected, this worsened the TBTF problem. The problem was exacerbated during the crisis by the acquisition of weakened firms by stronger firms, a development that was actively
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promoted by policymakers in a bid to avoid or temper the consequences of their failure. J.P. Morgan absorbed Bear Stearns and Washington Mutual and its assets grew from $1.5 trillion in 2007 to $2.3 trillion today; Wells Fargo purchased Wachovia and its assets increased from $575 billion in 2007 to $1.3 trillion today; Bank of America purchased Countrywide and Merrill Lynch, increasing its assets from $1.7 trillion in 2007 to $2.2 trillion today. This, of course, made the surviving firms even bigger and more complex. When the smoke had cleared, the situation was clearly untenable. The experience of the crisis increased the advantage from being perceived as TBTF, and, thus, strengthened the incentives to become bigger, more complex, and interconnected. The Dodd Frank Act (DFA) set out to end TBTF. One means was by eliminating the Federal Reserves discretion to provide emergency financial support through a program open only to a single financial institution, and, in general, raising the bar for broader-based emergency interventions under section 13.3 of the Federal Reserve Act. But, as the DFA recognized, simply tying the Feds hands on intervention is insufficient. It does not reduce the cost to society from the failure of a large and complex firm. In order for the non-intervention strategy to be both fully credible and consistent with the public interest, we need to tackle the underlying
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externalities and incentive problems that give rise to TBTF in the first place.
Tackling too big to fail

As I see it, solving the TBTF problem requires working on a number of different margins. These include measures that are firm-specific and those that address the structure of the financial system more broadly. One set of measures works to reduce the incentives for excessive risk-taking and to lower the probability that large financial firms fail or come close to failure. Another set lessens the disruption to the financial system and hence the cost their failure imposes on the broader economy and society as a whole. Along with measures that penalize characteristics associated with the negative externalities from failure, these changes work against the incentive to be too big to fail.
Policy measures that alter incentives and reduce the probability of distress
A number of steps have already been taken that reduce the probability of failure. For example, there has already been considerable progress in forcing firms to bolster their capital and liquidity resources. On the capital side, consistent with the Dodd-Frank Act, Basel III significantly raises the quantity and quality of capital required of internationally active bank holding companies.
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This ensures that the firms shareholders will bear all the firms losses across a much wider range of scenarios than before. This should strengthen market discipline. Meanwhile, to the extent that some of the specific activities that generate significant externalities are now subject to higher capital charges, this should cause banks to alter their business activities in ways that reduce both the likelihood and social cost of their failure. Moreover, the new Basel regime explicitly adjusts capital requirements upward based on size, complexity, interconnectedness, global exposure and substitutability attributes that are proxies for the negative externalities generated by failure. If a bank is deemed a global systemic financial institution or G-SIFI, then it will have to hold a greater amount of capital relative to its risk-weighted assets compared to a less systemic institution. The notion behind the SIFI surcharge is a simple one. The cost to society from the failure of a large, complex firm is proportionally considerably higher than the cost to society of the failure of a non-systemic firm. As a result the capital buffer for the more systemic firm should be higher so that its expected probability of failure will be lower than for the less systemic firm. The SIFI surcharge acts as a penalty for size and complexity, leaning against the funding cost advantage a firm may have because it is perceived to be TBTF. This helps level the playing field for smaller firms and reduces the incentive to seek to become TBTF in the first place.
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Domestically, we have adopted a more forward-looking approach to capital through the use of stress tests, in particular the annual Comprehensive Capital Assessment Review (CCAR) program. By promoting transparency, CCAR also strengthens market discipline. On the liquidity front, the largest, most systemically important bank holding companies will be required to hold a 30-day liquidity buffer the so-called liquidity coverage ratio or LCR. The purpose of the LCR is to ensure that such a bank will have sufficient liquid resources so if it were to encounter business difficulties and temporarily lose access to market funding, it would still have some time to address its underlying problems. With a liquidity buffer, banks will not immediately be forced to sell illiquid assets during times of stress. This should enhance their stability, and provide some protection against the fire sale externalities we saw during the crisis: forced asset sales, falling asset prices, leading to rising capital losses at other firms that led, in turn, to further funding difficulties, asset sales and so on. On the supervisory side, firms are now increasingly being evaluated on a cross-industry basis in order to identify best practices and to identify laggards that need to upgrade areas such as MIS, governance, model validation, and risk management practices. Activity restrictions are another potential means to reduce the risk of failure. The biggest initiative in this area is the Volcker Rule. By limiting proprietary trading activities, the Volcker Rules seeks to reduce trading risk and the likelihood of failure.
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In addition, the Financial Stability Oversight Council (FSOC) is in the process of identifying those non-bank financial firms that are systemically important. These firms will be subject to tougher prudential standards and supervisory oversight by the Federal Reserve. Some argue that this designation process merely creates more TBTF firms. I see it differently. The system risk externalities do not depend on whether we label them systemic or not. If these risks are present, then we should face up to the issue with tougher standards and enhanced supervisory oversight rather than leave the issue unaddressed. This has to be a superior approach relative to pretending these firms could not be TBTF and the problem doesnt exist.
Policy measures to reduce the adverse systemic consequences from failure

Because no plausible level of capital and liquidity standards will be sufficient to reduce the probability of failure to zero, it also makes sense to work on the other major margin to reduce the cost of the failure of a large, complex financial firm. We can do this by making changes so that such failures are less likely to impair the functioning of the broader financial system. In this area, although many initiatives are in train, I would conclude that we are still very far from where we need to be.
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One simple but meaningful step that already has been enacted is to put a brake on the ability of the largest and most complex firms to become even larger and more complex. To this end, the Dodd-Frank Act adds the risk to stability of the U.S. banking or financial system as an additional factor to be considered in evaluating a proposed merger or acquisition under the Bank Merger Act and the Bank Holding Company Act. As Governor Daniel Tarullo discussed in a recent speech, there is not a hard and fast rule to be applied here. But his view, which I share, is that there would be a a strong, though not irrebuttable, presumption of denial [of a merger or acquisition] by any firm that falls in the higher end of the list of global systemically important banks Another step for dealing with the firms that might be viewed by some as already TBTF is to understand better the interconnections and pathways through which the distress or failure of one firm impairs the larger system and causes harm to society. We have made progress through the supervisory process in mapping out critical activities performed by firms. Also, we have identified a number of areas, such as collateral management, where better practices could both improve the safety and soundness of the individual firm and reduce the negative externalities generated by a firms failure. Work is also underway to evaluate what changes would be required to make the future bankruptcy of large complex firms less disruptive, while also developing an alternative means for the orderly resolution of such firms outside the normal bankruptcy process.
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The costs to society of large complex financial firms failing can be reduced at least to some degree by having firms, working in conjunction with their regulators, pre-plan their own failure through the so-called living will process. The largest and most systemically important banks submitted their living wills to the Federal Reserve and the FDIC this summer. We have reviewed the first iterations of their plans and are currently drafting feedback for the firms to incorporate in their next submissions. Through such living wills, regulators are gaining a better understanding of the impediments to an orderly bankruptcy. This is the necessary first phase in the process of determining how to ameliorate these impediments over time and then doing so. In my view, this initial exercise has confirmed that we are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society. Significant changes in structure and organization will ultimately be required for this to be achieved. However, the living will exercise is an iterative process, and we have only taken the first step in a long journey. The second way to potentially minimize the negative externalities from a firms failure would be to avoid a bankruptcy proceeding altogether and instead resolve the firm under the Dodd-Frank Acts Title II orderly liquidation authority. The single point of entry model has much promise, but much remains to be done before it could be implemented with confidence for a globally active firm.
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Title II authority is U.S. law. Subsidiaries and affiliates chartered in other countries could be wound down under the bankruptcy laws of those countries, if authorities there did not have full confidence that local interests would be protected. Certain Title II measures including the one-day stay provision with respect to OTC derivatives and other qualified financial contracts may not apply through the force of law outside the United States, making orderly resolution difficult. The other essential dimension of solving TBTF is to make the financial system more robust addressing structural vulnerabilities that tend to amplify shocks rather than absorb them. If the financial system can be made more resilient, it will be better positioned to withstand the failure of a large and complex firm and continue to provide essential financial services to the real economy. I would highlight three areas of work that are critical to solving the TBTF problem. First, regulators and supervisors are pushing for changes in wholesale funding markets, a source of particular vulnerability during the crisis. This includes reforms to tri-party repo, which are underway, and necessary reforms to the money market mutual fund industry, which are being evaluated by the Securities and Exchange Commission (SEC) and the Financial Stability Oversight Council. Second, the financial market infrastructures are being strengthened to make them more robust to the failure of individual firms. The Committee on Payments and Settlement Systems and the International Organization of Securities Commissions (IOSCO) have published a set of standards for financial market infrastructures called
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Principles for Financial Market Infrastructures that will serve as minimum standards globally. All standardized OTC derivatives in the interest rate, credit default, and equities markets will soon have to be centrally cleared through central counterparties (CCPs). The clearing of standardized derivatives trades through CCPs should reduce risk in the overall financial system by facilitating the netting down of OTC derivative exposures. Such trades will also have to be reported to trade repositories and information about the trades will be made available on a post-trade basis. This should make the OTC derivatives market more transparent and, thus, reduce the risk of contagion.
The way forward

We have made some progress on the TBTF problem, particularly in reducing the likelihood that a large complex firm will reach the point of distress at which society faces serious costs. But we have a considerable ways to go to finish the job and reduce to tolerable levels the social costs associated with such failures. Further international coordination is almost certainly going to be necessary to ensure that bankruptcy regimes interact in ways that minimize negative externalities. At home we also need to ensure that different authorities and resolution regimes operate in a mutually consistent manner. In particular, we may need to revisit the SIPC regime that governs securities firms in bankruptcy.
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At present, the bankruptcy of a securities firm is very disruptive because the claims of all counterparties are typically frozen for a considerable period and the value of these claims is not easy to ascertain or monetize quickly. As I have argued above, we shouldnt focus on solving TBTF exclusively at the level of the individual firm. We need significant changes in market structures and practices as well in order to have a financial system in which the key players can fail without big social costs. We also must continue to ask ourselves the question of whether the steps in train go far enough. For example, one could make a good case that the capital surcharge for systemically important firms should be higher than that contemplated by the Basel Committee. Of course, such a judgment depends on how much other policies succeed in reducing the negative externalities their failure would generate. Critics of our approach believe it would be better to just break up firms deemed TBTF now perhaps through legislation requiring the separation of retail banking and capital markets activities or by imposing size restrictions that require firms to shrink dramatically from their current scale. My own view is that while this could yet prove necessary, it is premature to give up on the current approach: changing the incentives facing large and complex firms, forcing them to become more resilient, and making the financial system more robust to their failure. In my opinion, there are shortcomings to reimposing Glass-Steagall-type activity restrictions or strict size limits.
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With respect to Glass-Steagall, it is not obvious to me that the pairing of securities and banking businesses was an important causal element behind the crisis. In fact, independent investment banks were much more vulnerable during 2008 than the universal banking firms which conducted both banking and securities activities. More important is to address the well-known sources of instability in wholesale funding markets and give careful consideration to whether there should be a more robust lender of last resort regime for securities activities. With respect to size limitations, it is important to recognize that a new and much reduced size threshold could sacrifice socially useful economies of scale and scope benefits. And it could do this without actually solving the problem of system risk externalities that arent related to balance sheet size. Evaluating the socially optimal size, scope and organizational structure of financial firms is a complicated business, and so is establishing a viable transition path to a system of much smaller firms. It would be helpful in this regard if advocates of break-up solutions would put a bit more flesh on the bones and develop detailed proposals that address essential questions of how such downsizing or functional separation would be accomplished, and what benefits and costs could be expected. Such an analysis should answer several questions: How would you force divestiture (in good times and bad)? Should firms be split up by activity or reduced pro-rata in size?
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How much would they have to be shrunk in order for the externalities of failure to no longer create TBTF problems? How would global trading and investment banking services and network-type activities be supported? Should some activities be retained in natural monopoly form, but subject to utility type regulation? How costly would it be to replicate support services or to manage liquidity and capital locally? Are there ways of designing size limits that cannot be arbitraged by banks via off-balance-sheet structures and other forms of financial innovation? So far, advocacy for the break-up path has been strong, but without the detail to assess whether this is indeed superior to the course we are currently following. But, Im open minded. It is important to recognize that any credible approach to addressing the TBTF problem, including the one we are pursuing today, necessarily implies changes to the structure and business mix of financial firms and financial markets. Moreover, it is important to stress that not all of these adjustments will be in the private interests of these firms, and some will result in changes to the price and volume of certain financial services. These are intended consequences, not unintended consequences. Too big to fail is an unacceptable regime. The good news is there are many efforts underway to address this problem.
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The bad news is that some of these efforts are just in their nascent stages. It is important that as the crisis recedes in memory, that these efforts not flag this is a project that needs to be seen to a successful conclusion and then sustained on a permanent basis. Thank you for your attention, I would be happy to take a few questions.
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Toward Effective Governance of Financial Institutions Important Parts

Weak and ineffective governance of systemically important financial institutions (SIFIs) has been widely cited as an important contributory factor in the massive failure of financial sector decision making that led to the global financial crisis. In the wake of the crisis, financial institution (FI) governance was too often revealed as a set of arrangements that approved risky strategies (which often produced unprecedented short-term profits and remuneration), was blind to the looming dangers on the balance sheet and in the global economy, and therefore failed to safeguard the FI, its customers and shareholders, and society at large. Management teams, boards of directors, regulators and supervisors, and shareholders all failed, in their respective roles, to prudently govern and oversee. On the subject of governance as it applies to FIs, much has been written and said in the past few years. Notable among these statements are the 2009 Walker report (A Review of Corporate Governance in UK Banks and other Financial Industry Entities) and the Basel Committees Principles for Enhancing Corporate Governance (2010). Many domestic regulators and stock exchanges have also weighed in with new requirements and guidelines for governance. The Group of Thirty (G30) applauds these prior initiatives and supports not only the spirit of their conclusions but also many of the detailed recommendations they contain.
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The combination of these reports, self scrutiny by the firms themselves, and pressure from regulatory overseers has already yielded substantial changes in governance practice across the financial services industry and around the globe. Why would the G30 wish to add its own voice to the body of work already available, in light of progress being made? First, no one should presume that FI governance is now fixed. It is true that boards are working harder; supervisors are asking tough questions and preparing for more intensive oversight; management has become much more attuned to risk management and to supporting the oversight responsibilities of the board; and shareholders, to some degree, are taking a deeper look into their role in promoting effective governance. Nevertheless, as this report highlights, highly functional governance systems take significant time and sustained effort to establish and hone, and the G30s input can help with that effort. Second, in a modern economy, business leadership represents a large concentration of power. The social externalities associated with the business of significant financial institutions give that power a major additional dimension and underscore the critical importance of good corporate governance of such entities. Third, we note that the prior reports and guidance almost always come from a national or regional perspective (the Basel Committee report being a notable exception), which is understandable as a practical matter, but curious given the distinctly global nature of the SIFIs, which are appropriately the focus of attention.
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Accordingly, in late spring of 2011, the G30 launched a project on the governance of major financial institutions. The project was led by a Steering Committee chaired by Roger W. Ferguson, Jr., with John G. Heimann, William R. Rhodes, and Sir David Walker as its vice-chairmen. They were supported by 11 other G30 members, who participated in an informal working group. Requests for interviews went out from the G30 to the chairs of 41 of the worlds largest, most complex financial institutions banks, insurance companies, and securities firms. In an extraordinary response, especially in light of the pressures on each of these companies, 36 institutions shared their perspectives and experiences through detailed discussions with board leaders, CEOs, and selected senior management leaders. In addition, the project team held discussions with a global cross section of FI regulators and supervisors. The majority of these interviews were conducted in person, all under the Chatham House Rule,which encourages candor. The report is the responsibility of the G30 Steering Committee and Working Group and reflects broad areas of agreement among the participating G30 members, who took part in their individual capacities. All G30 members (aside from those with current national official responsibilities) have had the opportunity to review and discuss preliminary drafts. The report does not reflect the official views of those in policy-making positions or leadership roles in the private sector.
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The report is wide-ranging in its coverage of the composition and functioning of FI boards and the roles of regulators, supervisors, and shareholders. The focus is on potentially universal core themes but acknowledges differences in customs and practice in different parts of the world. As regards approaches to total compensation, we do not address this subject in detail in this report; the G30 commends the Financial Stability Boards Principles for Sound Compensation Practices and fully supports their implementation. The G30 undertook its initiative on effective FI governance in the hope and expectation that FI board and senior management leaders could share actionable wisdom on the essence of effective governance and what it takes to build and nurture governance systems that work. We hope this report provides a measure of insight and sustenance to those with policymaking and operational responsibilities for effective governance in the worlds great financial institutions.
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Executive Summary
What is meant by governance in the context of a financial institution (FI)? Corporate governance is traditionally defined as the system by which companies are directed and controlled. The OECD Principles of Corporate Governance (2004) defines corporate governance as involving a set of relationships between a companys management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. In the case of financial institutions, chief among the other stakeholders are supervisors and regulators charged with ensuring safety, soundness, and ethical operation of the financial system for the public good. They have a major stake in, and can make an important contribution to, effective governance. Good corporate governance requires checks and balances on the power and rights accorded to shareholders, stakeholders, and society overall. Without checks, we see the behaviors that lead to disaster. But governance is not a fixed set of guidelines and procedures; rather, it is an ongoing process by which the choices and decisions of FIs are scrutinized, management and oversight are strengthened and streamlined, appropriate cultures are established and reinforced, and FI leaders are supported and assessed.
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Why governance matters

The global economic crisis, with the financial services sector at its center, wreaked economic chaos and imposed enormous costs on society. The depth, breadth, speed, and impact of the crisis caught many FI management teams and boards of directors by surprise and stunned central banks, FI regulators, supervisors, and shareholders. [Note: We attempt throughout the report to distinguish the regulatory function from the supervisory function. The regulator sets the rules and regulations within which FIs are obliged to operate, while the supervisor oversees the actions of the board and management to ensure compliance with those rules and regulations. Confusion arises because both functions are often performed within the same institution (for example, the U.S. Federal Reserve and the UK Financial Services Authority).] Enormous thought and debate has gone into discovering what caused the global financial crisis and how to avoid another. In his much-quoted 2009 report on the causes of the crisis, Lord Adair Turner, chair of the UKs Financial Services Authority (FSA), cited seven proximate causes: (1) Large, global macroeconomic imbalances; (2) An increase in commercial banks involvement in risky trading activities; (3) Growth in securitized credit; (4) Increased leverage; (5) Failure of banks to manage financial risks;
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(6) Inadequate capital buffers; and (7) A misplaced reliance on complex math and credit ratings in assessing risk. A critical subtext to these seven causes is a pervasive failure of governance at all levels. More generally, most observers have agreed that a combination of light touch supervision, which relied too heavily on self-governance in financial firms, and weak corporate governance and risk management at many systemically important financial institutions (SIFIs) contributed to the 2008 meltdown in the United States. In several key markets, deregulation and market-based supervision were the political order of the day as countries vied for global capital flows, corporate headquarters, and exchange listings. Regulators also missed the potential systemic impact of entire classes of financial products, such as subprime mortgages, and in general failed to spot the large systemic risks that had been growing during the previous two decades. In this context, boards of directors failed to grasp the risks their institutions had taken on. They did not understand their vulnerability to major shocks, or they failed to act with appropriate prudence. Management, whose decisions and actions determine the organizations risk status, clearly failed to understand and control risks. In many cases, spurred on by shareholders, both management and the board focused on performance to the detriment of prudence.
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Effective governance is a necessary complement to rules-based regulation. The system needs both. Carefully crafted rules-based regulations concerning capital, liquidity, permitted business activities, and so forth are essential safeguards for the financial system, while effective governance shapes, monitors, and controls what actually happens in FIs. Ineffective governance at financial institutions was not the sole contributor to the global financial crisis, but it was often an accomplice in the context of massive macroeconomic vulnerability. Effective governance can make a significant positive difference by helping to prevent future crises or by mitigating their deleterious impact. In other words, the rewards for investment in effective governance are great.
A call to action
Each of the four participants in the governance systemboards of directors, management, supervisors, and (to an extent) long-term shareholders needs to reassess their approach to FI governance and take meaningful steps to make governance stronger. This report offers a comprehensive set of concrete insights and recommendations for what each participant needs to do to make FI governance function more effectively. The G30 is acutely aware that the agendas of FI boards and supervisors are crowded, yet we urge them to continue to give effective governance one of their highest priorities.
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. The financial sector needs better methods of assessing governance and of cultivating the behaviors and approaches that make governance systems work well. Board self-evaluation, especially when facilitated or led by an outside expert, can yield important insight, but it is sobering to consider that in 2007, most boards would likely have given themselves passing grades. . Supervisors now aspire to understand governance effectiveness and vulnerabilities, but admit to having much to learn. . Governance experts often describe what good governance looks like, but give little thought to how to measure or achieve high-performance results. Given the role that inadequate governance played in the massive failure of financial sector decision making that led to the global financial crisis, it is natural that supervisors and stock exchanges are now paying great attention to governance arrangements. This attention, as a practical matter, often focuses on explicit rules, structures, and processesbest practicesthat governance experts often believe are indicative of effective governance. Consequently, compliance with best practice guidelines has become very important to boards and to overseers charged with monitoring and encouraging good governance. The G30 hopes this report will contribute meaningfully to the body of knowledge on governance and will be a useful tool for those tasked with shaping governance systems.
The board
Boards of directors play the pivotal role in FI governance through their control of the three factors that ultimately determine the success of the FI: the choice of strategy; the assessment of risk taking; and the assurance
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that the necessary talent is in place, starting with the CEO, to implement the agreed strategy. The 20082009 financial crisis revealed that management at certain FIs, with the knowledge and approval of their boards, took decisions and actions that led to terrible outcomes for employees, customers, shareholders, and the wider economy.
What should the boards have done differently?

To answer that question, it is helpful to consider the mandate of boards. Boards control the three key factors that ultimately determine the success of an FI: 1. The choice of business model (strategy) 2. The risk profile, and 3. The choice of CEOand by extension the quality of the top-management team. Boards that permit their time and attention to be diverted disproportionately into compliance and advisory activities at the expense of strategy, risk, and talent issues are making a critical mistake. Above all else, boards must take every step possible to protect against potentially fatal risks. FI boards in every country must take a long-term view that encourages long-term value creation in the shareholders interests, elevates prudence without diminishing the importance of innovation, reduces short-term self-interest as a motivator, brings into the foreground the firms dependence on its pool of talent, and demands the firm play a palpably positive role in society. The importance of mature, open leadership by a skillful board chair cannot be overemphasized.
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Effective chairs capitalize on the wisdom and advice of board members and management leaders and on the boards interactions with supervisors and shareholders, individually and collectively. Good chairs respect each of these vital constituents, preside, encourage debate, and do not manage toward a predetermined outcome.
Risk governance
Those accountable for key risk policies in FIs, on the board and within management, have to be sufficiently empowered to put the brakes on the firms risk taking, but they also play a critical role in enabling the firm to conduct well-measured, profitable risk-taking activities that support the firms long-term sustainable success. In the financial services sector more than in other industries, risk governance is of paramount importance to the stability and profitability of the enterprise. Without an ability to properly understand, measure, manage, price, and mitigate risk, FIs are destined to underperform or fail. Effective risk governance requires a dedicated set of risk leaders in the boardroom and executive suite, as well as robust and appropriate risk frameworks, systems, and processes. The history of financial crises, including the 20082009 crisis, is littered with firms that collapsed or were taken to the brink by a failure of risk governance. The most recent financial crisis demonstrated the inability of many FIs to accurately gauge, understand, and manage their risks. Firms greatly understated their inherent risks, particularly correlations across their businesses, and were woefully unprepared for the exogenous risks that unfolded during the crisis and afterward.
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Management
Management needs to play a continuous proactive role in the overall governance process, upward to the board and downward through the organization. The vast majority of governance and control processes are embedded in the organizational fabric, which is woven and maintained by management. The board is dependent on management for information and for translating sometimes highly technical information into issues and choices requiring business judgment. Governance cannot be effective without major continuing input from management in identifying the big issues and presenting them for discussion with the board. Management needs to strengthen the fabric of checks and balances in the organization. It must deepen its respect for the vital roles of the board and supervisors and help them to do their jobs well. It must reinforce the values that drive good behavior through the organization and build a culture that respects risk while encouraging innovation.
Supervisors
Supervisors that more fully comprehend FI strategies, risk appetite and profile, culture, and governance effectiveness will be better able to make the key judgments their mandate requires. Supervisors have legally defined responsibilities relating to risk control; fraud control; and conformance to laws, regulations, and standards of
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conduct. Supervisors now seek a deeper and more nuanced understanding of how the board works, how key decisions are reached, and the nature of the debate around them, all of which reveal much about the firms governance. Most FI boards applaud this expansion in the supervisors focus from control process details to include a broader grasp of issues and context. To be effective, however, this expansion requires regular interaction among senior people in supervisory agencies and boards and board members. Supervisors need to broaden their perspectives to include FI strategy, people, and culture. They should focus their discussions with senior management and the board on the real issuesthrough both formal and informal communications. But they must also maintain their independence and accept that they will at best have an incomplete picture. Similarly, supervisors must not try to do the boards job or so overwhelm the board and management that they cannot guide the FI. Supervisors have a unique perspective on emerging systemic, macroprudential risks and can compare and contrast one FI with others. This is vital information to develop and share. Unfortunately, in the policy-making debate, the qualitative aspect of supervision is sometimes overshadowed by quantitative, rules-based regulatory requirements.
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Clearly, new capital, liquidity, and related standards are essential to a more stable global financial architecture, but enhanced oversight of the performance and decision-making processes of major FIs is also essential.
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The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.
Basel III Speakers Bureau

The Basel iii Compliance Professionals Association (BiiiCPA) has established the Basel III Speakers Bureau for firms and organizations that want to access the Basel iii expertise of Certified Basel iii Professionals (CBiiiPros). The BiiiCPA will be the liaison between our certified professionals and these organizations, at no cost. We strongly believe that this can be a great opportunity for both, our certified professionals and the organizers. To learn more: www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html
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Certified Basel iii Professional (CBiiiPro) Distance Learning and Online Certification Program
The all-inclusive cost is $297 What is included in this price:
A. The official presentations we use in our instructor-led classes (1426 slides)

You can find the course synopsis at: www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Pr ofessional.html
B. Up to 3 Online Exams
There is only one exam you need to pass, in order to become a Certified Basel iii Professional (CBiiiPro). If you fail, you must study again the official presentations, but you do not need to spend money to try again. Up to 3 exams are included in the price. To learn more you may visit: www.basel-iii-association.com/Questions_About_The_Certification_An d_The_Exams_1.pdf www.basel-iii-association.com/Certification_Steps_CBiiiPro.pdf
C. Personalized Certificate printed in full color.

Processing, printing and posting to your office or home. To become a Certified Basel iii Professional (CBiiiPro) you must follow the steps described at: www.basel-iii-association.com/Basel_III_Distance_Learning_Online_C ertification.html
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Basel 3 News November 2012

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Basel iii Compliance Professionals Association (BiiiCPA)

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

II. The principles

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Higher loss absorbency

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Higher loss absorbency

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Mario Draghi: Opening statement at Deutscher Bundestag

Financial markets and the disruptions of monetary policy transmission

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Restoring the proper transmission of monetary policy

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

The consequences of the ECBs actions

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Andreas Dombret: As goes Ireland, so goes Europe?

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

2. The origins of the crisis

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

3. The way forward

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Other Balance Sheet and Liquidity Metrics

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Managements Discussion and Analysis

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Internal Capital Adequacy Assessment Process

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Progress note on the Global LEI Initiative

Charter for the Regulatory Oversight Committee (ROC):

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Location and legal form of the global LEI foundation:

Board of Directors of the LEI foundation:

Operational Solutions Demonstration Day:

Business Processes and Use Cases:

Number allocation scheme for the global LEI system:

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Ownership and hierarchy data:

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

2. Objectives and process

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

3. Scope and other considerations Scope of the recommendations in this report