monday october 22, 2012 - top 10 risk management news

P a g e | 1

_____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and Compliance Professionals (IARCP)

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

Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the

week's agenda, and what is next

Dear Member, “You would not expect to put an earthquake tidy in a few minutes, would you?” Who said that? Lord Stamp told that to Keynes. Read the amazing speech given by Mervyn King, Governor of the Bank of England According to Mervyn King, the new Keynesian model omits a number of key factors. “The treatment of expectations is simplified, and neglects the possibility that expectations themselves may be a source of fluctuations, rather than simply reflecting changes elsewhere in the economy.” Grab a cup of coffee first, and read more at Number 6 below. Welcome to the Top 11 list (this week).

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

P a g e | 2



The Federal Reserve Board

Two final rules with stress testing requirements for certain bank holding companies, state member banks, and savings and loan holding companies The Federal Reserve Board on Tuesday published two final rules with stress testing requirements for certain bank holding companies, state member banks, and savings and loan holding companies.

EIOPA Work Programme 2013 EIOPA Work Programme 2013 describes the goals and deliverables for EIOPA in its third year of operation. EIOPA has decided to reshape the structure of its Work Programme, following the recommendation from the European Court of Auditors, aligning it with the tasks that the Regulation settling EIOPA assigns to the Authority.

EBA publishes follow-up review of banks’ transparency in their 2011 Pillar 3 reports

The European Banking Authority (EBA) published today a follow-up review aimed at assessing the disclosures European banks’ made in response to the Pillar 3 requirements set out in the Capital Requirements Directive (CRD).

P a g e | 3



Speech by Andrew Bailey, Managing Director, Prudential Business Unit at the Edinburgh Business School Scotland is home to a very important financial services industry for the UK and Europe and although it may at times seem like the changes taking place in regulation appear through London and Whitehall bubbles, they are clearly as relevant to you as they are to your counterparts in the City of London and Canary Wharf.

Financial Instruments and Exchange (Amendment) Act of 2012 [Briefing Materials] October 2012, Financial Services Agency, Japan

Twenty years of inflation targeting Speech given by Mervyn King, Governor of the Bank of England The Stamp Memorial Lecture, London School of Economics

P a g e | 4



Statement by the Honorable, Mr. Koriki Jojima Minister of Finance of Japan and Governor of the IMF for Japan Twenty-Sixth Meeting of the International Monetary and Financial Committee, Tokyo, Japan

Communiqué of the Twenty-Sixth Meeting of the IMFC Chaired by Mr. Tharman Shanmugaratnam, Deputy Prime Minister of Singapore and Minister for Finance

To: Banks Bank Holding Companies Federally Regulated Trust and Loan Companies Cooperative Retail Associations

Subject: New Required Interim Public Capital Disclosure Requirements related to Basel III Pillar 3

On June 26, 2012, the Basel Committee on Banking Supervision (BCBS) issued its final rules on the information banks must publicly disclose when detailing the composition of their capital.

P a g e | 5



Hearing before the Committee on Economic and Monetary Affairs of the European Parliament Introductory statement by Chair of the ESRB, Brussels

Capital and Adventure: The Auditor’s Role in the Modern Corporation James R. Doty, Chairman International Forum of Independent Audit Regulators (IFIAR) London, England

P a g e | 6



The Federal Reserve Board

Two final rules with stress testing requirements for certain bank holding companies, state member banks, and savings and loan holding companies The Federal Reserve Board on Tuesday published two final rules with stress testing requirements for certain bank holding companies, state member banks, and savings and loan holding companies. The final rules implement sections 165(i)(1) and (i)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act that require supervisory and company-run stress tests. Nonbank financial companies designated by the Financial Stability Oversight Council will also be subject to certain stress testing requirements contained in the rules. "Implementation of the Dodd-Frank stress test requirement is an important step in the Federal Reserve's efforts to promote the health of the financial sector," Governor Daniel K. Tarullo said. "Stress testing is a key tool to ensure that financial companies have enough capital to weather a severe economic downturn without posing a risk to their communities, other financial institutions, or to the general economy." The Federal Reserve will begin conducting supervisory stress tests under the final rules this fall for the 19 bank holding companies that participated in the 2009 Supervisory Capital Assessment Program and subsequent Comprehensive Capital Analysis and Reviews. The final rules also require these companies and their state-member bank subsidiaries to conduct their own Dodd-Frank company-run stress tests this fall, with the results to be publicly disclosed in March 2013.

P a g e | 7



In general, other companies subject to the Board's final rules for Dodd-Frank stress testing will be required to comply with the final rule beginning in October 2013. Companies with between $10 billion and $50 billion in total assets that begin conducting their first company-run stress test in in the fall of 2013 will not have to publicly disclose the results of that first stress test. The Board's two final rules revise portions of the Federal Reserve's notice of proposed rulemaking to implement the enhanced prudential standards and early remediation requirements established under the Dodd-Frank Act. The Board coordinated closely with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation to ensure that final stress testing rules issued by the agencies are consistent and comparable. The Board also coordinated with the Federal Insurance Office as required by the Dodd-Frank Act. The Federal Reserve will release the scenarios for this year's supervisory and company-run stress tests no later than November 15, 2012. As required by the Dodd-Frank Act, the scenarios will describe hypothetical baseline, adverse, and severely adverse conditions, with paths for key macroeconomic and financial variables. To help firms prepare to estimate their losses and revenues under the scenarios, the Federal Reserve on Tuesday released historical data for variables likely to be used in the scenarios. A revised version of these historical data, reflecting the latest information, will be published along with the scenarios.

P a g e | 8



Important Parts

FEDERAL RESERVE SYSTEM Annual Company-Run Stress Test Requirements for Banking Organizations with Total Consolidated Assets over $10 Billion Other than Covered Companies AGENCY: Board of Governors of the Federal Reserve System (Board). ACTION: Final rule. SUMMARY: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) requires the Board to issue regulations that require financial companies with total consolidated assets of more than $10 billion and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis. The Board is adopting this final rule to implement the company-run stress test requirements in section 165(i)(2) of the Dodd-Frank Act regarding company-run stress tests for bank holding companies with total consolidated assets greater than $10 billion but less than $50 billion and state member banks and savings and loan holding companies with total consolidated assets greater than $10 billon. This final rule does not apply to any banking organization with total consolidated assets of less than $10 billion. Furthermore, implementation of the stress testing requirements for bank holding companies, savings and loan holding companies, and state member banks with total consolidated assets of greater than $10 billion but less than $50 billion is delayed until September 2013. DATES: The rule is effective on November 15, 2012.

P a g e | 9



Background The Board has long held the view that a banking organization, such as a bank holding company or insured depository institution, should operate with capital levels well above its minimum regulatory capital ratios and commensurate with its risk profile. A banking organization should also have internal processes for assessing its capital adequacy that reflect a full understanding of its risks and ensure that it holds capital commensurate with those risks. Moreover, a banking organization that is subject to the Board’s advanced approaches risk-based capital requirements must satisfy specific requirements relating to their internal capital adequacy processes in order to use the advanced approaches to calculate its minimum risk-based capital requirements. Stress testing is one tool that helps both bank supervisors and a banking organization measure the sufficiency of capital available to support the banking organization’s operations throughout periods of stress. The Board and the other federal banking agencies previously have highlighted the use of stress testing as a means to better understand the range of a banking organization’s potential risk exposures. In particular, as part of its effort to stabilize the U.S. financial system during the recent financial crisis, the Board, along with other federal financial regulatory agencies and the Federal Reserve system, conducted stress tests of large, complex bank holding companies through the Supervisory Capital Assessment Program (SCAP). The SCAP was a forward-looking exercise designed to estimate revenue, losses, and capital needs under an adverse economic and financial market scenario. By looking at the broad capital needs of the financial system and the specific needs of individual companies, these stress tests provided valuable information to market participants, reduced uncertainty about

P a g e | 10



the financial condition of the participating bank holding companies under a scenario that was more adverse than that which was anticipated to occur at the time, and had an overall stabilizing effect. Building on the SCAP and other supervisory work coming out of the crisis, the Board initiated the annual Comprehensive Capital Analysis and Review (CCAR) in late 2010 to assess the capital adequacy and the internal capital planning processes of large, complex bank holding companies and to incorporate stress testing as part of the Board’s regular supervisory program for assessing capital adequacy and capital planning practices at large bank holding companies. The CCAR represents a substantial strengthening of previous approaches to assessing capital adequacy and promotes thorough and robust processes at large banking organizations for measuring capital needs and for managing and allocating capital resources. The CCAR focuses on the risk measurement and management practices supporting organizations’ capital adequacy assessments, including their ability to deliver credible inputs to their loss estimation techniques, as well as the governance processes around capital planning practices. In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Board to issue regulations that require bank holding companies with total consolidated assets of $50 billion or more (large bank holding companies) and nonbank financial companies that the Financial Stability Oversight Committee has designated to be supervised by the Board (together, covered companies) to conduct stress tests semi-annually, and requires other financial companies with total consolidated assets of more than $10 billion and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis (company-run stress tests). The Act requires that the Board issue regulations that: (i) Define the term “stress test”

P a g e | 11



(ii) Establish methodologies for the conduct of the company-run stress tests that provide for at least three different sets of conditions, including baseline, adverse, and severely adverse conditions (iii) Establish the form and content of the report that companies subject to the regulation must submit to the Board (iv) Require companies to publish a summary of the results of the required stress tests. On January 5, 2012, the Board invited public comment on a notice of proposed rulemaking (proposal or NPR) that would implement the enhanced prudential standards required to be established under section 165 of the Dodd-Frank Act and the early remediation requirements established under Section 166 of the Act, including proposed rules regarding company-run stress tests. The proposed rules would have required each bank holding company, state member bank, and savings and loan holding company with more than $10 billion in total consolidated assets to conduct an annual company-run stress test using data as of September 30 of each year and the three scenarios provided by the Board. In addition, each state member bank, bank holding company, and savings and loan holding company would be required to disclose a summary of the results of its company-run stress tests within 90 days of submitting the results to the Board. The Dodd-Frank Act mandates that the OCC and the FDIC adopt rules implementing stress testing requirements for the depository institutions that they supervise, and the OCC and FDIC invited public comment on proposed rules in January of 2012. The Board is finalizing the stress testing frameworks in two separate rules. First, the Board is issuing this final rule, which implements the company-run stress testing requirements applicable to bank holding

P a g e | 12



companies with total consolidated assets greater than $10 billion but less than $50 billion and savings and loan holding companies and state member banks with total consolidated assets greater than $10 billion. Second, the Board is concurrently issuing a final rule implementing the supervisory and semi-annual company-run stress testing requirements applicable to large bank holding companies and nonbank financial companies supervised by the Board.

Overview of Comments The Board received approximately 100 comments on its NPR on enhanced prudential standards and early remediation requirements. Approximately 40 of these comments pertained to the proposed stress testing requirements. Commenters ranged from individual banking organizations to trade and industry groups and public interest groups. In general, commenters expressed support for stress testing as a valuable tool for identifying and managing both microand macro-prudential risk. However, several commenters recommended changes to, or clarification of, certain provisions of the proposed rule, including its timeline for implementation, reporting requirements, and disclosure requirements. Commenters also urged greater interagency coordination regarding stress tests.

A. Delayed compliance date

Commenters suggested that companies with total consolidated assets less than $50 billion that have not previously been subject to stress-testing requirements need more time to develop the systems and procedures to be able to conduct company-run stress tests and to collect the information that the Board may require in connection with these tests.

P a g e | 13



In response to these comments and to reduce burden on these institutions, the final rule requires most bank holding companies, savings and loan holding companies, and state member banks to conduct their first stress test in the fall of 2013. In addition, the final rule requires bank holding companies, savings and loan holding companies, and state member banks with less than $50 billion in total consolidated assets to begin publicly disclosing their stress test results in 2015 with respect to the stress test conducted in the fall of 2014. Banking organizations that become subject to the rule’s requirements after November 15, 2012 must comply with the requirements beginning in the fall of the calendar year that follows the year the company meets the asset threshold, unless that time is extended by the Board in writing. For example, a company that becomes subject to the rule on March 31, 2013 must conduct its first stress test in the fall of 2014 and report the results in 2015.

B. Tailoring The proposed rule would have applied consistent annual company-run stress test requirements, including the compliance date and the disclosure requirements, to all banking organizations with total consolidated assets of more than $10 billion. The Board sought public comment on whether the stress testing requirements should be tailored, particularly for financial companies that are not large bank holding companies. Several commenters expressed concern that the NPR that would have applied stress testing requirements previously applicable only to large bank holding companies, such as those conducted under the CCAR, to smaller, less complex banking organizations with smaller systemic footprints.

P a g e | 14



The Board recognizes that bank holding companies, savings and loan holdings companies, and state member banks with total consolidated assets less than $50 billion are generally less complex and pose more limited risk to U.S. financial stability than larger banking organizations. As a result, the Board has modified the requirements in the final rule for these institutions, and expects to use a tailored approach in implementation. The final rule modifies the requirements for smaller banking organizations in a number of ways. First, as noted above, most banking organizations, other than state member bank subsidiaries of the large bank holding companies that participated in the SCAP, are not required to conduct their first stress test until 2013. The final rule also provides a longer period for smaller banking organizations to conduct their stress tests. Under the final rule, smaller banking organizations, other than state member bank subsidiaries of SCAP bank holding companies, are not required to report the results of the stress test until March 31. The final rule also modifies the public disclosure requirements, generally requiring less detailed disclosure for smaller banking organizations than for larger banking organizations. Separately, the Board intends to seek comment on reporting forms that smaller banking organizations would use in reporting the results of their stress tests to the Board, which are expected to be significantly more limited than the reporting forms applicable to large banking organizations. Banking organizations may be required to include additional components in their adverse and severely adverse scenarios or to use additional scenarios in their stress tests.

P a g e | 15



The Board expects to apply such additional components and additional scenarios to large, complex banking organizations. For example, the Board expects to require large banking organizations with significant trading activities to include global market shock components in their adverse and severely adverse scenarios, and may require large or complex banking organizations to use additional components in the adverse and severely adverse scenarios or to use additional scenarios that are designed to capture salient risks to specific lines of business. Finally, the Board plans to issue supervisory guidance to provide more detail describing supervisory expectation for company-run stress tests. This guidance will be tailored to banking organizations with total consolidated assets greater than $10 billion but less than $50 billion.

C. Coordination Many commenters emphasized the need for the federal banking agencies to coordinate stress testing requirements for parent holding companies and depository institution subsidiaries and more generally in regard to stress testing frameworks. Commenters recommended that the Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) coordinate in implementing the Dodd-Frank Act stress testing requirements in order to minimize regulatory burden. Commenters asked that the agencies eliminate duplicative requirements and use an interagency forum, like the Federal Financial Institutions Examination Council, to develop common forms, policies, procedures, assumptions, methodologies, and application of results. The Board has coordinated closely with the FDIC and the OCC to help to ensure that the company-run stress testing regulations are consistent and comparable across depository institutions and depository institution holding companies and to address any burden that may be associated

P a g e | 16



with having multiple entities within one organizational structure subject to stress testing requirements. The Board anticipates that it will continue to consult with the FDIC and OCC in the implementation of the final rule, and in particular, in the development of stress scenarios. The Board plans to develop scenarios each year in close consultation with the FDIC and the OCC, so that, to the greatest extent possible, a common set of scenarios can be used for the supervisory stress tests and the annual company-run stress tests across various banking entities within the same organizational structure.

D. Consolidated publication and group-wide systems and models In addition to requesting better coordination, commenters inquired as to whether a company-run stress test conducted by a parent holding company would satisfy the stress testing requirements applicable to that holding company’s subsidiary depository institutions. Commenters recommended that, in order to reduce burden, the Board develop and require the use of a single set of scenarios for a bank holding company and any depository institution subsidiary of the bank holding company, if the Board imposed separate stress testing requirements on both the bank holding company and bank. In order to reduce burden on banking organizations, the final rule provides that a subsidiary depository institution generally will disclose its stress testing results as part of the results disclosed by its bank holding company parent. Disclosure by the bank holding company of its stress test results and those of any subsidiary state member bank generally will satisfy any disclosure requirements applicable to the state member bank subsidiary. Moreover, a state member bank that is controlled by a bank holding company may rely on the systems and models of its parent bank holding

P a g e | 17



company if its systems and models fully capture the state member bank’s risks. For example, under those circumstances, the bank holding company and state member bank may use the same data collection processes and methods and models for projecting and calculating potential losses, pre-provision net revenues, provision for loan and lease losses, and pro forma capital positions over the stress testing planning horizon.

Description of the Final Rule Scope of Application The final rule applies to any bank holding company with average total consolidated assets of greater than $10 billion but less than $50 billion, and any state member bank and savings and loan holding company that have average total consolidated assets of more than $10 billion (“asset threshold”). Average total consolidated assets is based on the average of the total consolidated assets as reported on bank holding company’s or savings and loan holding company’s four most recent Consolidated Financial Statement for Bank Holding Companies (FR Y-9C) or a state member bank’s four most recent Consolidated Report of Condition and Income (Call Report). If the bank holding company, savings and loan holding company, or state member bank has not filed the FR Y-9C or Call Report, as applicable, for each of the four most recent quarters, average total consolidated assets will be based on the average of the company’s total consolidated assets, as reported on the company’s FR Y-9C or Call Report, as applicable, for the most recent quarter or consecutive quarters. In either case, average total consolidated assets are measured on the as-of date of the relevant regulatory report.

P a g e | 18



Once a bank holding company, savings and loan holding company, or state member bank meets the asset threshold, the company will remain subject to the final rule’s requirements unless and until the total consolidated assets of the company are less than $10 billion, as reported on four consecutively filed FR Y-9C or Call Report, as applicable (measured on the as-of date of the relevant FR Y-9C or Call Report, as applicable). A bank holding company, state member bank, or savings and loan holding company that has reduced its total consolidated assets to below $10 billion will again become subject to the requirements of this rule if it meets the asset threshold again at a later date. However, if a bank holding company’s total consolidated assets equal or exceed $50 billion or a savings and loan holding company becomes designated as a nonbank financial company supervised by the Board, such companies will be required to conduct stress tests under subpart G of the Board’s Regulation YY (12 CFR Part 252 Subpart G). Such a company will be required to comply with this final rule until it is required to conduct stress tests under subpart G. The final rule does not apply to foreign banking organizations. The Board expects to issue a separate rulemaking on the application of enhanced prudential standards to foreign banking organizations. A U.S.-domiciled bank holding company subsidiary of a foreign banking organization that has total consolidated assets of $10 billion or more is subject to the requirements of this rule.

Effective Date Under the proposal, the company-run stress testing requirements applicable to bank holding companies and state member banks would have become effective upon adoption of the final rule.

P a g e | 19



A bank holding company, savings and loan holding company, or state member bank that met the rule’s asset threshold as of the adoption of the rule would have been required to immediately comply with its requirements. A bank holding company, savings and loan holding company, or state member bank that met the proposal’s asset threshold more than 90 days before September 30 of a given year would be subject to stress testing requirements beginning in that calendar year. The Board received comments with regard to the timing of the first stress test for institutions that meet the asset threshold upon the rule’s effective date and for institutions that meet the asset threshold at a later date, and has modified both aspects of the final rule.

1. First Stress Test for Bank Holding Companies and State Member Banks that Meet the Asset Threshold on or before December 31, 2012 Commenters indicated that smaller and mid-sized banking organizations need more time to develop the systems and procedures to conduct company-run stress tests and to collect the information requested by the Board in connection with these tests. In response to these comments, the Board is delaying the date that existing, smaller companies are required to conduct their first stress test, as described below.

a. Bank Holding Companies

Under the final rule, a bank holding company that meets the asset threshold on or before December 31, 2012, must conduct its first stress test beginning in the fall of 2013, unless that time is extended by the Board in writing. Such a bank holding company is not required to publicly disclose the results of its stress test until June 2015.

P a g e | 20



b. State Member Banks Under the final rule, a state member bank that meets the asset threshold on or before November 15, 2012, and is a subsidiary of a bank holding company that participated in the SCAP, or successor to such bank holding company, must comply with the requirements of this subpart beginning in the fall of 2012, unless that time is extended by the Board in writing. Any other state member bank that meets the asset threshold on or before December 31, 2012, must comply with the requirements of this subpart beginning in the fall of 2013, unless that time is extended by the Board in writing. If such a state member bank has total consolidated assets of less than $50 billion as of December 31, 2012, it is not required to publicly disclose the results of its stress test until June 2015.

2. First Stress Test for Bank Holding Companies and State Member Banks Subject to Stress Testing Requirements After December 31, 2012

Commenters similarly expressed concern that bank holding companies, state member banks, and savings and loan holding companies met the rule’s asset threshold after the effective date of the final rule would not have sufficient time to build the systems, contract with outside vendors, recruit experienced personnel, and develop stress testing models that are unique to their organization under the proposed compliance date. In addition, the Federal Advisory Council recommended that the Board phase in disclosure requirements to minimize risk, build precedent, and allow banks and supervisors to gain experience, expertise, and mutual understanding of stress testing models. In response to these comments, the Board extended the compliance date applicable to bank holding companies and state member banks that exceed the final rule’s asset threshold after December 31, 2012.

P a g e | 21



Under the final rule, these companies will be required to conduct their first stress tests beginning in the fall of the calendar year after they meet the asset threshold, unless that time is extended by the Board in writing.

3. First Stress Test for Savings and Loan Holding Companies Under the final rule, a savings and loan holding company will not be required to conduct its first stress test until after it is subject to minimum capital requirements. A savings and loan holding company that meets the asset threshold when it becomes subject to minimum capital requirements will be required to conduct this first stress test in the fall of the calendar year after it first becomes subject to capital requirements, unless the Board accelerates or extends the time in writing. A savings and loan holding company that meets the asset threshold after it becomes subject to capital requirements will be required to conduct its first stress test beginning in the fall of the calendar year after it meets the asset threshold, unless that time is extended by the Board in writing.

Annual Stress Tests Requirements Timing of Stress Testing Requirements The Board proposed the following timeline for company-run tests in the NPR. The Board would have required an as-of date of September 30 of information to be submitted to the Board. By no later than mid-November of each calendar year, the Board would provide bank holding companies, state member banks, and savings and loan holding companies with scenarios for annual stress tests. By January 5 of the following calendar year, these companies would be required to submit regulatory reports to the Board on their stress tests.

P a g e | 22



By early April of that calendar year, companies would be required to make public disclosure of results. Several commenters provided suggestions on the proposed timeline. Those comments focused on the as-of date for data to be submitted by bank holding companies, state member banks, and savings and loan holding companies, the date for submitting results to the Board, and the dates when public disclosures of stress test results are to be made. For instance, some commenters suggested that the Board should use data collected at as-of dates other than September 30, such as June 30 or December 31, and make corresponding changes to the timing of public disclosure in order to reduce burden on companies during the year-end period. One commenter suggested having a floating submission date, allowing organizations to submit their results at the point in the year when it is most convenient. Some commenters also requested that the Board release the scenarios earlier to provide banking organizations more time to prepare the required reports for the stress tests. The final rule maintains the as-of date for data for the purposes of the annual company-run stress tests so that the same set of scenarios can be used to conduct annual company-run stress tests for large bank holding companies and their subsidiary state-member banks. The Board believes, and several commenters noted, that such alignment is beneficial. Furthermore, using the same scenarios for all firms subject to stress testing requirements will decrease market confusion, minimize burden on institutions, and provide for comparability across institutions. As stated in the concurrent final rule for covered companies, it was necessary to maintain the September 30 as-of date for stress test

P a g e | 23



requirements for large bank holding companies in order to align the stress testing requirements with the capital planning requirements applicable to these institutions under section 225.8 of the Board’s Regulation Y. Commenters requested that the Board release the scenarios earlier in the annual stress test cycle to provide banking organizations more time to prepare the reports for company-run stress tests. Under the final rule, the Board will provide descriptions of the baseline, adverse, and severely adverse scenarios generally applicable to companies no later than November 15 of each year, and provide any additional components or scenarios by December 1. The Board believes that providing scenarios earlier than November could result in the scenarios being stale, particularly in a rapidly changing economic environment, and that it is important to incorporate economic or financial market data that are as current as possible while providing sufficient time for companies to incorporate the scenarios in their annual company-run stress tests. Commenters suggested that smaller banking organizations be allowed additional time to conduct their company-run stress tests in light of resource constraints faced by these institutions. In response to these comments, the Board has delayed the timing of report submission to the Board for most banking organizations. Consistent with the requirements imposed on large bank holding companies under subpart G, the final rule requires a state member bank that is controlled by a bank holding company that has average total consolidated assets of $50 billion or more and a savings and loan holding company that has average total consolidated assets of $50 billion or more to conduct its stress test and submit its results to the Board by January 5, unless that time is extended by the Board in writing.

P a g e | 24



All other bank holding companies, savings and loan holding companies, and state member banks are required to conduct their stress tests and submit the results to the Board by March 31. Commenters also noted that the proposed public disclosure deadlines would interfere with so-called “quiet periods” that some publicly traded banking organizations enforce in the lead up to earnings announcements. These quiet periods are designed to limit communications that could disseminate proprietary company information prior to earnings announcements. In light of these comments, the Board adjusted the disclosure date to avoid interfering with firms’ quiet periods. Under the final rule, a savings and loan holding company with total consolidated assets of $50 billion or more or a state member bank that is a subsidiary of a bank holding company with total consolidated assets of $50 billion or more is required to disclose the results of its stress tests between March 15 and March 31 of each year. All other banking organizations will be required to disclose their results between June 15 and June 31.

Scenarios The proposal provided that the Board would publish a minimum of three different sets of economic and financial conditions, including baseline, adverse, and severely adverse scenarios, under which the Board would conduct its annual analyses and companies would conduct their annual company-run stress tests. The Board would update, make additions to, or otherwise revise these scenarios as appropriate, and would publish any such changes to the scenarios in advance of conducting each year’s stress test.

P a g e | 25



Commenters suggested that significant changes in scenarios from year to year could cause a banking organization’s stress testing results to dramatically change. To ameliorate this volatility, commenters suggest that the federal banking agencies have a uniform approach for identifying stress scenarios or establish a “quantitative severity limit” in the final rule to ensure that scenarios do not drastically change from year to year. Commenters pointed out that consistency in annual scenario development will make comparability of stress test results between institutions and across time periods more accurate, increase market confidence in the results of stress tests, and make for more dependable capital planning by banking organizations. Commenters also requested the opportunity to provide input on the scenarios. The Board believes that it is important to have a consistent and transparent framework to support scenario design. To further this goal, the final rule clarifies the definition of “scenarios” and includes definitions of baseline, adverse, and severely adverse scenarios. In the final rule, “scenarios” are defined as those sets of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank that the Board annually determines are appropriate for use in the company-run stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios. The baseline scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank, and that reflect the consensus views of the economic and financial outlook.

P a g e | 26



The adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank that are more adverse than those associated with the baseline scenario and may include trading or other additional components. The severely adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components. In general, the baseline scenario will reflect the consensus views of the macroeconomic outlook expressed by professional forecasters, government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. The Board expects that the severely adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with the paths observed during severe post-war U.S. recessions. Each year, the Board expects to take into account of salient risks that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, and state member bank that may not be observed in a typical severe recession. The Board expects that the adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with mild to moderate recessions. The Board may vary the approach it uses for the adverse scenario each year so that the results of the scenario provide the most value to supervisors, given the current conditions of the economy and the banking industry. Some of the approaches the Board may consider using include, but are not limited to, a less severe version of the severely adverse scenario or

P a g e | 27



specifically capturing, in the adverse scenario, risks that the Board believes should be understood better or should be monitored. The scenarios will consist of a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank over the stress test planning horizon. These conditions will include projections for a range of macroeconomic and financial indicators, such as real Gross Domestic Product (GDP), the unemployment rate, equity and property prices, and various other key financial variables, and will be updated each year to reflect changes in the outlook for economic and financial conditions. The paths of these economic variables could reflect risks to the economic and financial outlook that are especially salient but were not prevalent in recessions of the past. Depending on the systemic footprint and scope of operations and activities of a company, the Board may require that company to include additional components in its adverse or severely adverse scenarios or to use additional scenarios or more complex scenarios that are designed to capture salient risks to specific lines of business. For example, the Board recognizes that certain trading positions and trading-related exposures are highly sensitive to adverse market events, potentially leading to large short-term volatility in certain companies’ earnings. To address this risk, the Board will require companies with significant trading activities to include market price and rate “shocks,” as specified by the Board, that are consistent with historical or other adverse market events. The final rule also provides that the Board may impose this trading shock on a state member bank that is subject to the Board’s market risk rule (12 CFR part 208, appendix E) and that is a subsidiary of a bank holding company subject to the trading shock under the final rule or under the

P a g e | 28



Board’s company-run stress test rule for covered companies (12 CFR 252.144(b)(2)(i)). The Board is making this modification to allow for coordination of the trading shock between a bank holding company and any state member bank subsidiary that is subject to the market risk rule. In addition, the scenarios, in some cases, may also include stress factors that may not be directly correlated to macroeconomic or financial assumptions but nevertheless can materially affect covered companies’ risks, such as factors that affect operational risks. The process by which the Board may require a company to include additional components or use additional scenarios is described under section D.2 of this preamble. Some commenters suggested that the Board adopt a tailored approach to scenarios to better capture idiosyncratic characteristics of each company. For example, commenters representing the insurance industry suggested that any stress testing regime applicable to insurance companies incorporate shocks relating to the exogenous factors that actually impact a particular company, such as a shock to the insurance company's insurance policy portfolio arising from a natural disaster, and de-emphasize shocks arising from traditional banking activities. In the Board’s view, a generally uniform set of scenarios is necessary to provide a basis for comparison across companies. However, the Board expects that each company’s stress testing practices will be tailored to its business model and lines of business, and that the company may not use all of the variables provided in the scenario, if those variables are not appropriate to the firm’s line of business, or may add additional variables, as appropriate. In addition, the Board expects banking organizations to consider other scenarios that are more idiosyncratic to their operations and associated risks, as part of their ongoing internal analyses of capital adequacy.

P a g e | 29



FEDERAL RESERVE SYSTEM

Supervisory and Company-Run Stress Test Requirements for Covered Companies AGENCY: Board of Governors of the Federal Reserve System (Board). ACTION: Final rule. SUMMARY: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) requires the Board to conduct annual stress tests of bank holding companies with total consolidated assets of $50 billion or more and nonbank financial companies the Financial Stability Oversight Council (Council) designates for supervision by the Board (nonbank covered companies, and together, with bank holding companies with total consolidated assets of $50 billion or more, covered companies) and also requires the Board to issue regulations that require covered companies to conduct stress tests semi-annually. The Board is adopting this final rule to implement the stress test requirements for covered companies established in section 165(i)(1) and (2) of the Dodd-Frank Act. This final rule does not apply to any banking organization with total consolidated assets of less than $50 billion. Furthermore, implementation of the stress testing requirements for bank holding companies that did not participate in the Supervisory Capital Assessment Program is delayed until September 2013.

DATES: The rule is effective on November 15, 2012

P a g e | 30



Background The Board has long held the view that a banking organization, such as a bank holding company or insured depository institution, should operate with capital levels well above its minimum regulatory capital ratios and commensurate with its risk profile. A banking organization should also have internal processes for assessing its capital adequacy that reflect a full understanding of its risks and ensure that it holds capital commensurate with those risks. Moreover, a banking organization that is subject to the Board’s advanced approaches risk-based capital requirements must satisfy specific requirements relating to their internal capital adequacy processes in order to use the advanced approaches to calculate its minimum risk-based capital requirements. Stress testing is one tool that helps both bank supervisors and a banking organization measure the sufficiency of capital available to support the banking organization’s operations throughout periods of stress. The Board and the other federal banking agencies previously have highlighted the use of stress testing as a means to better understand the range of a banking organization’s potential risk exposures. In particular, as part of its effort to stabilize the U.S. financial system during the recent financial crisis, the Board, along with other federal financial regulatory agencies and the Federal Reserve system, conducted stress tests of large, complex bank holding companies through the Supervisory Capital Assessment Program (SCAP). The SCAP was a forward-looking exercise designed to estimate revenue, losses, and capital needs under an adverse economic and financial market scenario. By looking at the broad capital needs of the financial system and the specific needs of individual companies, these stress tests provided valuable information to market participants, reduced uncertainty about

P a g e | 31



the financial condition of the participating bank holding companies under a scenario that was more adverse than that which was anticipated to occur at the time, and had an overall stabilizing effect. Building on the SCAP and other supervisory work coming out of the crisis, the Board initiated the annual Comprehensive Capital Analysis and Review (CCAR) in late 2010 to assess the capital adequacy and the internal capital planning processes of large, complex bank holding companies and to incorporate stress testing as part of the Board’s regular supervisory program for assessing capital adequacy and capital planning practices at large bank holding companies. The CCAR represents a substantial strengthening of previous approaches to assessing capital adequacy and promotes thorough and robust processes at large banking organizations for measuring capital needs and for managing and allocating capital resources. The CCAR focuses on the risk measurement and management practices supporting organizations’ capital adequacy assessments, including their ability to deliver credible inputs to their loss estimation techniques, as well as the governance processes around capital planning practices. On November 22, 2011, the Board issued an amendment (capital plan rule) to its Regulation Y to require all U.S bank holding companies with total consolidated assets of $50 billion or more to submit annual capital plans to the Board to allow the Board to assess whether they have robust, forward-looking capital planning processes and have sufficient capital to continue operations throughout times of economic and financial stress. In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Board to implement enhanced prudential supervisory standards, including requirements for stress tests, for covered companies to mitigate the threat to financial stability posed by these institutions. Section 165(i)(1) of the Dodd-Frank Act requires the Board to conduct an annual stress test of each covered company to evaluate whether the covered company has sufficient capital, on a total consolidated basis, to

P a g e | 32



absorb losses as a result of adverse economic conditions (supervisory stress tests). The Act requires that the supervisory stress test provide for at least three different sets of conditions—baseline, adverse, and severely adverse conditions—under which the Board would conduct its evaluation. The Act also requires the Board to publish a summary of the supervisory stress test results. In addition, section 165(i)(2) of the Dodd-Frank Act requires the Board to issue regulations that require covered companies to conduct stress tests semi-annually and require financial companies with total consolidated assets of more than $10 billion that are not covered companies and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis (collectively, company-run stress tests). The Act requires that the Board issue regulations that: (i) Define the term “stress test”; (ii) Establish methodologies for the conduct of the company-run stress tests that provide for at least three different sets of conditions, including baseline, adverse, and severely adverse conditions; (iii) Establish the form and content of the report that companies subject to the regulation must submit to the Board; and (iv) Require companies to publish a summary of the results of the required stress tests. On January 5, 2012, the Board invited public comment on a notice of proposed rulemaking (proposal or NPR) that would implement the enhanced prudential standards required to be established under section 165 of the Dodd-Frank Act and the early remediation requirements established under Section 166 of the Act, including proposed rules regarding supervisory and company-run stress tests.

P a g e | 33



Under the proposed rules, the Board would conduct an annual supervisory stress test of covered companies under three sets of scenarios, using data as of September 30 of each year as reported by covered companies, and publish a summary of the results of the supervisory stress tests in early April of the following year. In addition, the proposed rule required each covered company to conduct two company-run stress tests each year: an “annual” company-run stress test using data as-of September 30 of each year and the three scenarios provided by the Board, and an additional company-run stress test using data as of March 31 of each year and three scenarios developed by the company. The proposed rule required each covered company to publish the summary of the results of its company-run stress tests within 90 days of submitting the results to the Board. Together, the supervisory stress tests and the company-run stress tests are intended to provide supervisors with forward-looking information to help identify downside risks and the potential effect of adverse conditions on capital adequacy at covered companies. The stress tests will estimate the covered company’s net income and other factors affecting capital and how each covered company’s capital resources would be affected under the scenarios and will produce pro forma projections of capital levels and regulatory capital ratios in each quarter of the planning horizon, under each scenario. The publication of summary results from these stress tests will enhance public information about covered companies’ financial condition and the ability of those companies to absorb losses as a result of adverse economic and financial conditions. The Board will use the results of the supervisory stress tests and company-run stress tests in its supervisory evaluation of a covered company’s capital adequacy and capital planning practices.

P a g e | 34



In addition, the stress tests will also provide a means to assess capital adequacy across companies more fully and support the Board’s financial stability efforts. The Dodd-Frank Act mandates that the OCC and the FDIC adopt rules implementing stress testing requirements for the depository institutions that they supervise, and the OCC and FDIC invited public comment on proposed rules in January of 2012. The Board is finalizing the stress testing frameworks in two separate rules. First, the Board is issuing this final rule, which implements the supervisory and company-run stress testing requirements for covered companies (final rule). Second, the Board is concurrently issuing a final rule implementing annual company-run stress test requirements for bank holding companies, savings and loan holding companies, and state member banks with consolidated assets greater than $10 billion that are not otherwise covered by this rule. The Board is issuing this final rule implementing the stress testing requirements in advance of the other enhanced prudential standards and early remediation requirements in order to address the timing of when the stress testing requirements will apply to various banking organizations and to require large bank holding companies to publicly disclose the results of their company-run stress tests conducted in the fall of 2012.

Description of the Final Rule Scope of Application This final rule applies to any bank holding company (other than a foreign banking organization) that has $50 billion or more in average total consolidated assets and to any nonbank financial company that the

P a g e | 35



Council has determined under section 113 of the Dodd-Frank Act must be supervised by the Board and for which such determination is in effect. Average total consolidated assets for bank holding companies is based on the average of the total consolidated assets as reported on the bank holding company’s four most recent Consolidated Financial Statement for Bank Holding Companies (FR Y–9C). If the bank holding company has not filed the FR Y-9C for each of the four most recent consecutive quarters, average total consolidated assets will be based the average of the company’s total consolidated assets, as reported on the company’s FR Y–9C, for the most recent quarter or consecutive quarters. In either case, average total consolidated assets are measured on the as-of date of the relevant regulatory report. Once the average total consolidated assets of a bank holding company exceed $50 billion, the company will remain subject to the final rule’s requirements unless and until the total consolidated assets of the company are less than $50 billion, as reported on four FR Y-9C reports consecutively filed. Average total consolidated assets are measured on the as-of date of the FR Y-9C. The final rule does not apply to foreign banking organizations. The Board expects to issue for public comment a separate rulemaking on the application of enhanced prudential standards and early remediation requirements established under the Dodd-Frank Act, including enhanced capital and stress testing requirements, to foreign banking organizations at a later date. AU.S.-domiciled bank holding company subsidiary of a foreign banking organization that has total consolidated assets of $50 billion or more is subject to the requirements of this final rule

P a g e | 36



Scenarios The proposal provided that the Board would publish a minimum of three different sets of economic and financial conditions, including baseline, adverse, and severely adverse scenarios, under which the Board would conduct its annual analyses and companies would conduct their annual company-run stress tests. The Board would update, make additions to, or otherwise revise these scenarios as appropriate, and would publish any such changes to the scenarios in advance of conducting each year’s stress test. Commenters suggested that significant changes in scenarios from year to year could cause a banking organization’s stress testing results to dramatically change. To ameliorate this volatility, commenters suggest that the federal banking agencies have a uniform approach for identifying stress scenarios or establish a “quantitative severity limit” in the final rule to ensure that scenarios do not drastically change from year to year. Commenters pointed out that consistency in annual scenario development will make comparability of stress test results between institutions and across time periods more accurate, increase market confidence in the results of stress tests, and make for more dependable capital planning by banking organizations. Commenters also requested the opportunity to provide input on the scenarios. The Board believes that it is important to have a consistent and transparent framework to support scenario design. To further this goal, the final rule clarifies the definition of “scenarios” and includes definitions of baseline, adverse, and severely adverse scenarios.

P a g e | 37



Scenarios are defined as those sets of conditions that affect the U.S. economy or the financial condition of a covered company that the Board, or with respect to the mid-cycle stress test, the covered company, annually determines are appropriate for use in the company-run stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios. The baseline scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company and that reflect the consensus views of the economic and financial outlook. The adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company that are more adverse than those associated with the baseline scenario and may include trading or other additional components. The severely adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components. In general, the baseline scenario will reflect the consensus views of the macroeconomic outlook expressed by professional forecasters, government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. The Board expects that the severely adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with the paths observed during severe post-war U.S. recessions. Each year the Board expects to take into account of salient risks that affect the U.S. economy or the financial condition of a covered company that may not be observed in a typical severe recession. The Board expects that the adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with mild to moderate recessions.

P a g e | 38



The Board may vary the approach it uses for the adverse scenario each year so that the results of the scenario provide the most value to supervisors, given the current conditions of the economy and the banking industry. Some of the approaches the Board may consider using include, but are not limited to, a less severe version of the severely adverse scenario or specifically capturing, in the adverse scenario, risks that the Board believes should be understood better or should be monitored. The scenarios will consist of a set of conditions that affect the U.S. economy or the financial condition of a covered company over the stress test planning horizon. These conditions will include projections for a range of macroeconomic and financial indicators, such as real Gross Domestic Product (GDP), the unemployment rate, equity and property prices, and various other key financial variables, and will be updated each year to reflect changes in the outlook for economic and financial conditions. The paths of these economic variables could reflect risks to the economic and financial outlook that are especially salient but were not prevalent in recessions of the past. Depending on the systemic footprint and scope of operations and activities of a company, the Board may use, and require that company to use, additional components in the adverse and severely adverse scenarios or additional or more complex scenarios that are designed to capture salient risks to specific lines of business. For example, the Board recognizes that certain trading positions and trading-related exposures are highly sensitive to adverse market events, potentially leading to large short-term volatility in covered companies’ earnings. To address this risk, the Board may require covered companies with significant trading activities to include market price and rate “shocks” in

P a g e | 39



their adverse and severely adverse scenarios as specified by the Board, that are consistent with historical or other adverse market events. In addition, the scenarios, in some cases, may also include stress factors that may not be directly correlated to macroeconomic or financial assumptions but nevertheless can materially affect covered companies’ risks, such as factors that affect operational risks. The process by which the Board may require a covered company to include additional components in its adverse and severely adverse scenarios or to use additional scenarios is described under section III.E.2 of this Supplementary Information. The Board plans to publish for comment a policy statement that describes its framework for developing scenarios. Some commenters suggested that the Board adopt a tailored approach to scenarios to better capture idiosyncratic characteristics of each company. For example, commenters representing the insurance industry suggested that any stress testing regime applicable to insurance companies incorporate shocks relating to the exogenous factors that actually impact a particular company, such as a shock to the insurance company's insurance policy portfolio arising from a natural disaster, and de-emphasize shocks arising from traditional banking activities. In the Board’s view, a generally uniform set of scenarios is necessary to provide a basis for comparison across companies. However, the Board expects that each company’s stress testing practices will be tailored to its business model and lines of business, and that the company may not use all of the variables provided in the scenario, if those variables are not appropriate to the firm’s line of business, or may add additional variables, as appropriate. In addition, the Board expects banking organizations to consider other scenarios that are more idiosyncratic to their operations and associated risks as part of their ongoing internal analyses of capital adequacy and

P a g e | 40



include company-specific vulnerabilities in their scenarios when complying with the Board’s requirements for mid-cycle company-run stress test.

P a g e | 41



EIOPA Work Programme 2013 EIOPA Work Programme 2013 describes the goals and deliverables for EIOPA in its third year of operation. EIOPA has decided to reshape the structure of its Work Programme, following the recommendation from the European Court of Auditors, aligning it with the tasks that the Regulation settling EIOPA assigns to the Authority. Such change in structure has not affected the highly ambitious programme presented for 2013, nor the high quality internal standards that inform and guide all EIOPA deliverables. The content of this Work Programme is driven by EIOPA role towards Supervisory and Regulatory Convergence, the core importance that Consumers have in EIOPA strategy and Mission, and the active role in the field of Financial Stability and Crisis Management. Relevant projects such as Solvency II will be reshaped, with a clear shift from regulation to supervision. Other areas of work, in particular in the field of pensions, will demand significant efforts from EIOPA in terms of sound and quality deliverables to the European Commission in the frame of their projected enhancement of pensions regulation. Supervisory tasks, and their convergence, rank high among EIOPA priorities. Concrete deliverables such as a supervisory handbook, an internal models support expert unit, or an enhancement of the role and scope of the colleges of supervisors will be provided during 2013.

P a g e | 42



External relations, within Europe and outside, will continue playing a significant role in EIOPA deliverables. EIOPA places great value on the formal opinions, and other contributions, made by its two stakeholder groups for insurance and for occupational pensions. In addition to its sectoral work, EIOPA’s Chair will take the Chairmanship of the Joint Committee of ESAs. All these developments will entail a further growth of the organisation, in terms of budget and resources. Staff number, if the Budgetary Authority agrees to the request of EIOPA, will grow up to 112, to achieve the objectives and deliverables set in this Work Programme. Priorities still have to be made with regards to EIOPA mandate, as the Authority will only reach its anticipated size in 2020. For 2013, according to EIOPA proposal, the budget will grow from 15.6 to 20 million Euro, with a share of 40% from the Commission and 60% from its Members. If at the end of the budgetary process EIOPA’s budget would not reach the aforementioned figure, the Work Programme would be reprioritized and some of the deliverables today incorporated would have to be postponed. These deliverables are marked green in Annex I of the Work Programme. The language versions of the document’s main part will be made available at a later stage.

Insurance The European insurance market is the largest in the world.

P a g e | 43



Given its importance there will be substantial benefits from the introduction under Solvency II of a Europe-wide harmonised framework which provides the right incentives for insurers to better understand, measure and manage their risks. EIOPA has already achieved a great deal in the preparation for Solvency II. EIOPA is currently consulting on the technical standards and guidelines in order to complete the legislative framework for Solvency II. Its last quantitative impact study (QIS5) of the impact of Solvency II was the most ambitious and comprehensive impact study ever carried out in the financial sector, involving more than 2,500 insurance companies. It has provided technical contributions during the political discussions on key aspects of Solvency II such as long term guarantees and reporting. It is already carrying out assessments of whether third countries’ insurance frameworks are equivalent to those of the EU’s. In 2013 EIOPA will finalise the standards and guidelines which insurance undertakings require as part of the Solvency II framework. These will comprise the 53 standards and guidelines mandated by legislation and on its own initiative a guideline on external scrutiny or audit for the purposes of Solvency II publicly disclosed information. The standards and guidelines will cover the solvency capital requirements, own funds, internal models, group supervision, supervisory transparency and accountability, reporting and disclosure, valuation, the valuation of assets and liabilities other than technical provisions, and governance. In 2013 EIOPA will also continue to identify, scope and implement the operational tasks required of it under Solvency II. This includes the following

P a g e | 44



- Publishing a list of authorised firms,

- Collecting and publishing a report about the use of capital add-ons

and the extent to which they are consistently applied across member states

- Deriving and publishing the risk free rate.

- Mapping the ratings of External Credit Assessment Institutions.

- Publishing lists of typologies of regional governments and local

authorities, exposures to whom are to be treated as exposures to the central government.

- Specifying adjustments to be made for currencies pegged to the euro.

- Choosing the equity index for the equity dampening mechanism

- Determining, at the request of national supervisory authorities or on

its own initiative, the existence of an exceptional fall in financial markets for the application of the extension of the SCR recovery period

- Reporting to the European Parliament on the functioning of

supervisory colleges and the appointment of the group supervisor. These specific operational tasks are accompanied by generic tasks which have been given to EIOPA as part of the new supervisory structure. This includes the power for binding mediation, further work on equivalence assessments, and membership of colleges of supervisors. EIOPA will consider what should be the configuration of working groups and other mechanisms to deliver this next phase of insurance regulation. On its own initiative EIOPA will also deliver the following during 2013:

P a g e | 45



- Start working on best practices with respect to aspects of the Supervisory Review Process for supervisors as a practical step to contributing to a common supervisory culture among supervisors

- Develop a centre of expertise on the use of internal models under

Solvency II - Collect data in EIOPA for further use for the purposes of financial

stability and micro-prudential analysis, as part of implementing EIOPA’s database strategy EIOPA will continue in 2013 to build links between the Solvency II framework and other areas.

It will complete the current assessments of equivalence of third countries and begin to assess the impact on consumer choice of the solvency II framework. EIOPA’s plans are naturally dependent on political and other developments, especially with respect to the quantitative supervisory framework. EIOPA will also enter a process of maintenance of its standards and guidelines; this maintenance includes: - The revision of standards and guidelines already published.

- The potential drafting of additional guidelines and recommendations,

following the further needs which might be identified through communication with stakeholders and National Supervisory Authorities.

Colleges Colleges of Supervisors (Colleges) are considered efficient and effective tools used in supervision of financial institutions, and they are essential instruments to enhance mutual understanding among supervisors and convergence of supervisory practices, with tangible benefits to undertakings, supervisors and policyholders.

P a g e | 46



The overall strategic target of EIOPA’s college work is to build the position of the EEA supervisory community towards the cross border operating insurance groups for the benefit of both group and solo supervision. The focus is on combining and leveraging the knowledge and forces of the National Supervisory Authorities in the EEA to form a strong and equal supervisory body to effectively deal with centrally organized and managed undertakings. According to EIOPA Regulation, day to day supervision as well as the set up and organisation of the Colleges is the responsibility of the National Supervisory Authorities. EIOPA as a member of Colleges promotes communication, cooperation, consistency, quality and efficiency in Colleges and provides oversight. EIOPA established in 2011 and reinforced in 2012 a highly qualified College Team and each staff member has a portfolio comprising several Colleges. This allows EIOPA to cover all 93 colleges currently active in Europe, targeting physical participation in at least 70 colleges of supervisors during 2013. EIOPA expects that the added value brought by EIOPA into the Colleges and activities of the Colleges will have improved considerably in 2012 and in 2013 the participation of EIOPA Staff in the Colleges can be consolidated. When monitoring the functioning of Colleges, the result will form the basis of EIOPA’s Action Plan for Colleges 2013 and include measurable, realistic, and at the same time ambitious goals. As for the 2012 Action Plan, the performance of individual colleges on the agreed deliverables will be made public. In 2013 EIOPA will:

P a g e | 47



- Promote specifically the finalisation of the preparation of the Colleges for Solvency II, e.g. coordination agreements are expected to be agreed by year-end 2013 by all Colleges - EIOPA staff will continue as a Member in the Colleges to advise

Group Supervisors and Colleges on the possibilities to improve the functioning of their College. Practical solutions and examples of supervisory practices will be collected

- Develop best practices on specific topics with a particular focus on delegation of tasks amongst supervisors - To promote a common understanding of the group’s risk profile

within Colleges, EIOPA will prepare for a data collection and analysis system for peer comparisons as a support function to Colleges

P a g e | 48



EBA publishes follow-up review of banks’ transparency in their 2011 Pillar 3 reports

The European Banking Authority (EBA) published today a follow-up review aimed at assessing the disclosures European banks’ made in response to the Pillar 3 requirements set out in the Capital Requirements Directive (CRD). Overall, the EBA welcomes efforts made by banks to improve their disclosure practices and to comply with the new requirements introduced with CRD 3. Nevertheless, the report notes that there is still room for improvements in Banks’ Pillar 3 disclosures, and the EBA intends to continue to press for such improvements.

Main findings

Weaknesses remain in the areas of banks disclosures of credit risk – on Internal Ratings Based approaches (IRB) and securitisation activities – and market risk.

The introduction of new disclosure requirements in CRD 3 in particular in the areas of securitisation and market risk may explain some of the weaknesses identified.

But the EBA has also noted that weaknesses already identified in its previous assessments remain and calls for further action.

Beyond assessing compliance with CRD disclosures requirements, the EBA has also performed an analysis of banks’ Basel III implementation disclosures, in particular as regards the impact on own funds, and of the 2011 EBA Capital Exercise related disclosures.

Information provided by credit institutions in these two areas were found to be of varying quality.

P a g e | 49



In all disclosure areas, the EBA has identified some best practices which credit institutions are encouraged to follow, in order to enhance the general quality of Pillar 3 information.

With a view of both facilitating compliance with the requirements as well as enhancing the quality and comparability of disclosures, the EBA will this year supplement information on best practices with further explanations on the objective and content of the disclosure requirements, which banks are also encouraged to consider while preparing their Pillar 3 disclosures.

Some improvements in the quality of disclosures were noted in the area of remuneration and own funds.

On the latter, credit institutions provided appropriate details of capital items and a meaningful breakdown of deductions.

With regards to the timing, formats or verification of disclosures, no significant changes have been made in banks’ practices of reporting Pillar 3 information.

However, information was generally published nearer to the reporting date of banks’ annual accounts and annual report but the EBA will still push for publication of these reports at the same time to allow investors to have the complete set of publicly available information at once.

Next steps

Based on the findings and content of this report, the EBA, throughout 2012 and in 2013, plans to implement a strategy for enhanced transparency and to that end will

i) Keep on identifying best practices of public disclosures in the publications as well as the CRD requirements for which compliance has to be improved and

ii) Will work on these improvements, including in the area of comparability of disclosures. In this respect, the EBA will consult and engage with the industry and users where it is needed.

P a g e | 50



Background

The analysis, carried out in 2012 and covering a sample of nineteen European banks, focussed mainly on those areas where the need for improvement had already been identified in previous assessments as well as on areas where new disclosure requirements have been introduced with CRD3.

The conclusions of this review will serve as essential input for defining and developing the EBA’s strategy in enhancing the area of transparency.

The European Banking Authority was established by Regulation (EC) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010.

The EBA has officially come into being as of 1 January 2011 and has taken over all existing and ongoing tasks and responsibilities from the Committee of European Banking Supervisors (CEBS).

The EBA acts as a hub and spoke network of EU and national bodies safeguarding public values such as the stability of the financial system, the transparency of markets and financial products and the protection of depositors and investors.

Executive summary One of the EBA’s regular tasks is to assess Pillar 3 reports of European banks / credit institutions1 and monitor their compliance with the requirements of the Capital Requirements Directive (CRD).

This analysis continues from Pillar 3 assessments that have been carried out annually since 2008.

It focuses particularly on areas where the need for improvement was already identified in previous assessments.

It also covers areas where new disclosure requirements entered into force in 2011.

P a g e | 51



The current analysis was carried out in 2012 and covers the 2011 Pillar 3 reports of nineteen European banks.

No significant changes in banks’ practices were noted this year in the practical aspects of the publication of Pillar 3 information (e.g. timing, formats or verification of disclosures), although the EBA noted that banks have generally published their Pillar 3 information nearer to the reporting date of their annual accounts and publication of their annual reports.

The EBA would prefer the Pillar 3 information to be published at the same time as these annual reports and accounts, and expects the situation to improve as a result of compliance with the new Capital Requirements Regulation (CRR).

As far as remuneration disclosures are concerned, if these are not actually included in the Pillar 3 reports or annual reports, the EBA would also prefer them to be published at the same time and provide cross-references between the reports.

This would then ensure that Pillar 3 report users (investors and other users) have timely access to the complete set of publicly available information that is essential for assessing credit institutions’ risk profiles.

Disclosures on own funds were generally assessed as comprehensive, with credit institutions providing details of capital items and a meaningful breakdown of deductions.

Cases of non-compliance were mostly related to disclosures on the grandfathering of instruments, qualitative details about the capital instruments or breakdowns of capital items.

The EBA also believes that comparability of disclosures on own-funds will be significantly improved by the implementation of the CRR and of the related EBA‘s implementing technical standards on own funds disclosures, which will provide common definitions and templates for disclosures.

However, the analysis of information on credit risk – Internal Ratings Based (IRB) approach and securitisation risk – revealed certain weaknesses as well as the need for improvements and more explanation on the rationale for and the expected content of disclosure requirements.

P a g e | 52



In particular, credit institutions are expected to increase the back-testing disclosures.

Half of the banks in the sample failed to comply with the relevant CRD requirement, and many of the banks provided confusing information about the assumptions underlying internally developed models.

In this context, the EBA also notes that to allow meaningful and reliable conclusions to be drawn on the functioning of the model, disclosures of a comparison between expected losses against actual losses should be provided for a period of at least three years - a best practice that is not followed by the majority of the banks.

As far as securitisation risk is concerned, the small number of disclosures assessed as adequate was mainly due to the introduction of new qualitative and quantitative disclosures requirements with the implementation of CRD III.

Significant improvement is therefore needed for new disclosures on risk management and exposures in the trading book or related to special purpose entities (SPEs).

However, there were also failures to comply with disclosure requirements which were related to pre-CRD III requirements.

Market risk was another area where many new disclosure requirements were introduced and here the analysis also identified certain areas where significant improvements were needed.

These included disclosures on back-testing of internal models, stress testing, valuation models, adequate breakdown of market risk capital requirements, stressed VaR measure, the new incremental risk charge as well as the comprehensive risk measure.

On the other hand, significant improvements were noted in the area of remuneration disclosures with a total of 57% of the banks in the sample assessed as providing adequate disclosures or disclosures that captured the spirit of the CRD requirements.

In all these disclosure areas, the EBA identified some best practices which credit institutions are encouraged to follow to enhance the quality of Pillar 3 information.

P a g e | 53



In addition to the assessment results and detailed findings as set forth in this report, there are two other sections.

The EBA decided to add further analysis that was not limited to a compliance exercise, but touched upon disclosure related issues, outside the Pillar 3 framework.

The EBA therefore carried out a thematic study reviewing and comparing Basel III implementation disclosures, focusing on information provided by banks about the resulting impact on own funds, and on disclosures for the EBA 2011 capital exercise.

It was found that all credit institutions provided some disclosures, but the content and presentation of these greatly varied.

Some institutions only disclosed qualitative elements while others supplemented these qualitative disclosures with some quantitative data.

Data were however not comparable, due to differences in terms of granularity and of hypotheses used to estimate the impacts of regulatory changes on own-funds.

As last year, the EBA noticed that one of the main challenges of Pillar 3 information, regardless the requirements considered, was comparability of disclosures between credit institutions.

The EBA still believes greater comparability or some standardisation would enhance the benefits of Pillar 3 information for users, including the ESAs and the ESRB.

The conclusions of the report are the result of productive discussions between the National Supervisory Authorities and the EBA, informed by inputs from preparers and users of Pillar 3 disclosures.

These conclusions have highlighted topics where further discussions should be encouraged between those preparing and those using of Pillar 3 information and the NSAs/EBA to enhance of quality of disclosures in these areas.

The EBA will use these conclusions as a basis for initiating discussions and also as essential input for defining and developing its strategy in enhancing the area of transparency.

P a g e | 54



Indeed, as a result to the findings from this report, the EBA will in 2012 and 2013 :

- Keep on identifying best practices of public disclosures in the publications

- Keep on identifying the CRD requirements for which compliance has to be improved and those that should be improved, and work on these improvements, including in the area of comparability

- Consult and work with industry and users to improve transparency in areas where it is needed

P a g e | 55



Speech by Andrew Bailey, Managing Director, Prudential Business Unit at the Edinburgh Business School It is a great pleasure to be in Edinburgh again and to have the opportunity to set out progress on the reform of financial regulation as we approach the formal introduction of the new arrangements. Scotland is home to a very important financial services industry for the UK and Europe and although it may at times seem like the changes taking place in regulation appear through London and Whitehall bubbles, they are clearly as relevant to you as they are to your counterparts in the City of London and Canary Wharf.

All of us witnessed the costs associated with the failures of banks. We have learnt the lessons of that experience and that is why the reforms we are making to the way we regulate will affect us all and will create a system that is safer and stronger for every part of the UK. One thing I should emphasise is that this is a reform of the whole of financial regulation. I say that because it is easy to conclude from observation of the issues we face as regulators, and the public debate, that we are just dealing with reforming the regulation of banks. That is not the case, and what we are doing is not about dragging the rest of the financial services industry into reform to solve a problem that is in essence only about the banks. We have to design a system that works effectively for all sectors of the industry. On that theme, I would like to start by reflecting for a few moments on the lessons of history.

P a g e | 56



My main theme is that I think integrated regulation – by which I mean regulation which combines Prudential and Conduct of Business in one regulatory body with single teams of supervisors covering both – has not worked as effectively as it would need to do, for reasons that are deep-seated in the structure. I think there are a number of closely related reasons for this. First, on a rather practical point, I think it is hard for a single organisation to balance, particularly during a period of crisis, a wide range of very demanding issues which are individually rightly of great concern to the public and can come from anywhere in a landscape of around 25,000 authorised firms. Second, I think the evidence suggests that, over the last 15 years, there have been periods when either conduct or prudential supervision has been more in the ascendancy to the detriment of the other. In the years leading up to the start of the crisis there was a dearth of prudential supervision, but I am quite prepared to acknowledge that there have been periods where the opposite has been true. My point here is that I don’t think the system of integrated regulation demonstrated the ability to deliver a stable equilibrium of conduct and prudential supervision. Third, there is something of an inbuilt tendency within integrated regulation to play down the active debate of issues where conduct and prudential regulators find themselves with potentially conflicting objectives. Of course, it can be said that the ‘twin peaks’ approach that we are introducing could lead to endless debate and no outcomes. My own view is that that is not correct, and that the benefits of clarity in defining the objectives of the PRA and the new Conduct Authority, the FCA, will dominate any other consequences.

P a g e | 57



There are several important reasons why reform of financial regulation will, in my view, be an important step forward, starting with establishing very clear public policy objectives for financial regulation to which we, as the regulators, are fully committed. For both banks and insurance companies, the PRA will have the objective of promoting the safety and soundness of firms. Consistent with this objective, it will focus on the potential harm that firms can cause to the stability of the financial system in the UK. We define a stable financial system as one that is resilient in providing the critical financial services that the economy needs. And this supply of services is a necessary condition for a healthy and successful economy, as demonstrated by the costs imposed by the financial crisis on the public and society at large. For insurance companies, the PRA will have the second objective of contributing to securing an appropriate degree of protection for those policyholders. Why do we need a second objective for insurance? For me, it rightly emphasises that in taking out some forms of insurance policies, the public can become locked into very long-term contracts, much longer often than is the case in banking with deposit contracts. Bearing this in mind, the public interest I think justifies a second objective for insurance, which is more directly targeted at the situation of individual policyholders. In contrast as bank deposits are redeemable on demand at par value, and as banks lend the deposits at longer maturities, so they are inherently fragile and vulnerable to contagion, so protecting the system protects depositors. There are a number of important points in this description of the PRA’s objectives.

P a g e | 58



First, the emphasis on economic well-being as an ultimate goal aligns the supervision of banks and insurers more closely to the field of macroeconomic policy. This is in line with the definition of ‘financial stability’ as the continuity of supply of critical financial services which are important to the functioning of the economy. Three services stand out here: the provision of payment services including access to funds; credit extension; and, risk transfer. This definition is critical to clarifying the public interest-objective in a stable financial system, and that this public interest can diverge from the private interest of a firm in profit maximisation without reference to the public interest. One of the biggest lessons I take from the financial crisis is the need to ensure that the boards and management of firms appreciate and act consistent with the public interest. To achieve this end, we need a much better definition of the ‘public interest’, which will come from the legislation. The second important point regarding the meaning of the PRA’s objectives is that it will not be the PRA’s role to ensure that no firm fails. Rather, the PRA will seek to ensure that any firm it regulates that does fail should do so in a way that avoids significant disruption to the supply of critical financial services. Nevertheless, failure is not without cost and there is inherent uncertainty about whether a firm can fail without damaging the financial system and the supply of critical services. Consequently, the PRA will expect a given level of resilience to failure from all firms.

P a g e | 59



Now, I recognise that we have a lot to do still on resolution planning to be comfortable about our objective of avoiding a ‘no failure’ regime. For large banks, we are making progress on resolution planning, and this world is different to five years ago, but we are not there yet by any means. I have a background in resolving banks, and I regard having the capacity to resolve failed large banks – including the largest – as the Holy Grail of resolution. Unlike the legendary Holy Grail, I think there is a good reason to believe that the objective of being able to resolve large banks that fail can be within our grasp. But the challenge of resolving PRA-regulated firms goes beyond banks. Insurers raise exactly the same issue of continuity of provision of critical financial services. Moreover, in a line of business such as with-profits life, the business model involves pooling many vintages of long-term contracts in a single fund for the benefit of policyholders. A typical resolution involves run-off over a long period, which remains a sensible approach. But the public policy interest is reasonably directed towards ensuring a process of resolution, which is fair to those various vintages and more broadly which allows more rapid payout to policyholders, since the current arrangements can involve long delays and pressure for policyholders to accept lower payouts in return for greater speed. This is a different, but nonetheless important, public policy interest in orderly resolution. I am very clear that when firms mess up, they should be allowed to fail, and by doing so they are putting at risk the money of their shareholders and if necessary after that, those who provide debt funding according to levels of seniority.

P a g e | 60



But I am also very clear that really achieving the objective of avoiding a no failure regime requires a fundamental change of mindset both inside the PRA and in society more broadly. Fear of failure is an important conditioner of behaviour in a financial regulator, and achieving a change on this front depends on establishing a wide acceptance of our approach that orderly failure that does not compromise our public policy objectives is an acceptable outcome. To be clear, we should be criticised where failure compromises those objectives and we could have taken steps to avoid it, and we will be required to report on such failures. But if failure is orderly, and does not compromise our public policy objectives, the responsibility should rest with the board and management for failing to serve the private interest of their shareholders and creditors. Last on the theme of failure, having firms that are either too big or too important to fail is bad for competition in the industries that we regulate. An industry where exit is too difficult is one where entry is likewise inhibited. Put simply, if we don’t know how to deal with a failed firm, we will inevitably set a higher barrier to entry. This is what we see in the banking industry. Embedding resolution into the public policy objectives of financial regulation matters for two reasons relevant to competition: first, because, to repeat, exit enables entry; and, second, because if, as we will, we require new entrants to satisfy us on their resolvability in order to be authorised, we can lower the barriers and costs of opening for business. We have already started to put this new approach into operation. Resolution of failed firms consistent with the public policy objectives is one key plank of the new approach to financial regulation.

P a g e | 61



Another key plank concerns the macro-prudential approach to regulation. The legislation will establish the Financial Policy Committee (FPC), charged with the primary objective of identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. In June, the Chancellor announced that the government would amend the Bill to give the FPC a secondary objective so that subject to being content on the first objective, it should support the economic policy of the government, including its objectives for growth and employment. Currently, the FPC is acting in an interim capacity to undertake, as far as possible, the future statutory FPC’s macro-prudential role. Macro-prudential regulation is focused on protecting the financial system as a whole. In a very ‘big picture’ sense, there is nothing new about this activity. The problems of the last five years have emphasised the close links between the health and behaviour of banks and the condition of the economy. This is a lesson of history, and one that should not have been forgotten. But, forgotten it was. At present the FPC is pursuing two important objectives: seeking to increase the resilience of the UK banking system, including to the threats emanating from the euro areas; and, subject to being content with the path towards greater resilience, supporting the creation of credit in the UK economy. I am in no doubt that if banks take reasonable steps to enhance their resilience, they will be better placed to sustain the availability of credit to the economy by lowering their cost of funding and reducing their vulnerability to unanticipated events.

P a g e | 62



Macro-prudential regulation takes a system-wide view of the risks we face and the buffers of capital and liquidity that banks should hold against possible stress events. This is very clearly the resilience objective for the system, to which the FPC attaches great weight. Banks in the UK have made substantial progress over the last four years in building that resilience, from of course a very low base. We believe that there is further to go on capital, and the FPC has set this position out, but in doing so we should not forget the distance that has been travelled. We should also remember that more capital cannot be conjured from thin air, particularly as there are at present quite severe constraints around the rate of return earned by banks due to low interest margins and redress for past misdeeds on conduct issues. Credit growth in the UK economy continues to be weak. The latest Bank of England credit conditions survey indicates early signs of an increase in the amount of mortgage lending available to households, though much less evidence of a change in credit conditions for businesses. But it is very early days for the recently announced policy measures – in particular the Funding for Lending Scheme – which are intended to have a positive impact on domestic credit conditions. So, we can see a picture of gradually improving resilience in the banking system but with further to go, but also credit growth which remains weak. In that context, and recognising the balance of objectives within macro-prudential policy, the FSA has taken a number of steps. We have allowed banks to reduce the capital buffers they hold over the minimum requirements in line with new lending to the UK economy.

P a g e | 63



Our view here is that a reduction in the risk arising from this new lending caused by an improvement in credit conditions should offset the risk from lowering capital buffers. If such extra lending boosts economic growth, it will enhance resilience in the financial system. Likewise, we have altered our guidance to banks on the liquid asset buffers that they need to maintain. This reflects the Bank of England’s stance on the potential access of banks to liquidity from the Bank, and a wider desire to reduce the incentives for banks to hold excessive liquid asset buffers for precautionary reasons. This, too, we hope will support credit availability. It is too soon to assess the impact of all these changes on the resilience of the financial system and on credit creation. We will monitor the results of these actions very carefully, and we will be prepared to amend our judgements in the light of experience. The key point here is that we are applying judgement to our decisions on regulation and within a framework that quite explicitly defines and seeks to balance our objectives of resilience, the primary objective, and, subject to that primary objective, supporting credit conditions and economic activity. To be clear, in this world of judgement-based regulation, we will not get all the calls correct, not least because the future is uncertain. But, I am a lot more comfortable that we have a framework in which we can apply judgement more consistently and be held to account for those judgements in a more open way.

P a g e | 64



There is one further element to the package of reforms, namely the measures proposed by the Commission chaired by Sir John Vickers, which the government intends to place into legislation in the near future. I fully support the Vickers proposals. The key plank of this is to ring-fence commercial from investment banking and, in doing so, define the scope of commercial banking that can be inside the ring-fence. This will be a major structural change for the banking system, and will have important implications for us as regulators. There are two key points for me in the Vickers reforms. First, in the last ten years or more, the nature of investment banking has changed to include a much larger element of proprietary position taking. The incentives and risks of this activity are quite different from commercial banking, and I do not believe that the two should be mixed in the same legal entity. Regulators around the world have struggled to regulate this mixture, and will continue to do so even though we have raised the cost of doing investment banking business through changes to the regulatory regime. Second, in a world where we will not accept banks being too big or complicated to fail, it is sensible to be able to resolve commercial and investment banks separately, and to achieve this we need the ring-fence approach. This will support the continuity of provision of financial services. In conclusion, we have a very big programme of reforms under way, with the central objective that we must not let a financial crisis of this scale happen again. The reform programme is founded on very clear public policy objectives.

P a g e | 65



We are absolutely committed to the reform programme and knitting together the various parts. We expect financial institutions to abide by the spirit of it too. There are big changes in what we are doing, and it is an exciting time to be putting these changes into effect. We will get a much clearer focus from splitting prudential and conduct regulation for banks and insurers, from introducing macro-prudential regulation to help to protect the financial system as a whole, and from focusing our regulation on applying judgement in a transparent way. Firms that mess up should, and will, be allowed to fail, but it must not be at the cost of damaging the financial system and economy. Ringfencing commercial and investment banking will help to achieve that objective. And, out of these reforms I hope we can encourage a banking system that is more open to competition and serves the public more effectively and, more broadly, a financial system that delivers the public policy objective of financial stability. Thank you.

P a g e | 66



Financial Instruments and Exchange (Amendment) Act of 2012 [Briefing Materials] October 2012, Financial Services Agency, Japan

P a g e | 67



P a g e | 68



P a g e | 69



P a g e | 70



Twenty years of inflation targeting Speech given by Mervyn King, Governor of the Bank of England The Stamp Memorial Lecture, London School of Economics

Introduction I am delighted to be back at the School to deliver the Stamp Memorial Lecture. Lord Stamp was eminent in the worlds of both academic and public life. Among other achievements, he was an alumnus and a governor of the School, and a Director of the Bank of England. Following his untimely death, in an air raid in 1941, he was succeeded at the Bank by John Maynard Keynes. Keynes and Stamp often broadcast live discussions on the BBC which were published a week later in The Listener. Their conversations during the 1930s, at the height of the Great Depression, are eerily reminiscent of the enormous challenges we face today, as you can see from the following exchange in 1930: KEYNES: Is not the mere existence of general unemployment for any length of time an absurdity, a confession of failure, and a hopeless and inexcusable breakdown of the economic machine? STAMP: Your language is rather violent. You would not expect to put an earthquake tidy in a few minutes, would you? I object to the view that it is

P a g e | 71



a confession of failure if you cannot put a complicated machine right all at once. KEYNES: In my opinion the return to the gold standard in the way we did it set our currency system an almost impossible task ... If prices outside this country had been going up since 1925 that would have done something to balance the effect on this country of the return to the gold standard. STAMP: Hush, Maynard; I cannot bear it. Remember, I am a Director of the Bank of England. In some respects our experience today is no different: putting right our economic machine is proving a slow and difficult task. But in the 1920s the Government made the task substantially harder by reinstating the gold standard at a rate that left sterling overvalued. Today, monetary policy is part of the solution, not part of the problem. That is thanks, in large part, to the monetary framework we have had in place since 1992. Twenty years ago today, on 9 October 1992, the newspapers reported that for the first time monetary policy in Britain would be based on an explicit target for inflation. Three weeks earlier, sterling had been forced out of the European Exchange Rate Mechanism (ERM). A new framework for monetary policy was needed. After keen debates within the Treasury and the Bank of England, the answer emerged – the inflation target. The essence of this new approach was the combination of a numerical target for inflation in the medium term and the flexibility to respond to shocks to the economy in the short run – and so the framework became

P a g e | 72



known as flexible inflation targeting. It is time to reflect on twenty years’ experience of inflation targeting; fifteen years of stability and five years of turbulence – the Great Stability and the Great Recession, shown in Table 1 and Charts 1-3.

P a g e | 73



Over that period, monetary policy around the world has changed radically. Inflation targeting has spread to more than 30 countries. And the results in terms of low and stable inflation have been impressive. There have been pronounced reductions in the mean, variance and persistence of inflation in Britain and elsewhere. During the past twenty years, annual consumer price inflation in this country has averaged 2.1%, remarkably close to the 2% target and well below the averages of over 12% a year in the 1970s and nearly 6% a year in the 1980s. But did we pay too high a price for this achievement in lowering inflation?

P a g e | 74



After fifteen years of apparent success, the past five years of financial crisis and turmoil in the world economy have raised serious questions about the adequacy of inflation targeting. We don’t have to look far to see that the costs of financial instability are huge. In Britain, total output is today some 15% below an extrapolation of its pre-crisis trend, and that gap is likely to persist for some time yet. In the light of such costs, should monetary policy go beyond targeting price stability and also target financial stability? And should the present financial crisis lead us to question the intellectual basis of monetary policy as practised in most of the industrialised world today? Those questions are the subject of tonight’s lecture.

The story of inflation targeting But let us start at the beginning. Shortly after the adoption of inflation targeting, my predecessor but one, Lord Kingsdown (Robin Leigh-Pemberton as he then was), gave an important speech at the London School of Economics – indeed in this room – entitled “The Case for Price Stability”. I remember it vividly – for I had been involved in drafting it. It was an exciting time; we were reconstructing British monetary policy after the trauma of forced exit from the ERM. In those days, of course, the Chancellor set monetary policy and the Bank of England played only a behind the scenes role. But the role of the Bank was about to change – first with the Inflation Report in February 1993, which gave the Bank its own public voice, and then with independence for the Bank and the creation of the Monetary Policy Committee (MPC) in 1997.

P a g e | 75



The inflation target was born out of the experience that high and variable inflation was very costly to reduce and that only a policy based on domestic considerations would be credible. The objective of monetary policy in the medium term would unambiguously be price stability. As the then Chancellor of the Exchequer, Norman Lamont, put it “we wish to reduce inflation to the point where expected changes in the average price level are small enough and gradual enough that they do not materially affect business and household financial plans”. The idea that there is a long-run trade-off between price stability and employment had long since been abandoned. That intellectual revolution, associated with the names of Friedman, Phelps and Lucas, had stood the test of time and formed the foundations of inflation targeting. The initial reception of the inflation target among economists and commentators alike was distinctly mixed. As the Financial Times put it in a leader published twenty years ago today, “the Chancellor's speech was as economically thin as it was politically disappointing”. The critics argued that the new framework was inadequate to control inflation. They were to be proved wrong. Over the previous twenty years inflation had been the single biggest problem facing the UK economy, peaking at 27% a year in 1975. Over the subsequent twenty years, inflation, as I mentioned earlier, would average only 2.1%.

P a g e | 76



From the outset, inflation targeting was conceived as a means by which central banks could improve the credibility and predictability of monetary policy. The overriding concern was not to eliminate fluctuations in consumer price inflation from year to year, but to reduce the degree of uncertainty over the price level in the long run because it is from that unpredictability that the real costs of inflation stem. The improvement in credibility of policy is shown by the fact that whereas in 1992 expected inflation, as measured by the difference between yields on conventional and index-linked gilts, was close to 6%, today the same measure is around 2½ %. Predictability of the price level is greater because over a long period inflation has on average been close to the target. Even if inflation deviates from target – as will often be the case – it is expected to return to target, and so inflation expectations are anchored. That is why since 2007 the UK has been able to absorb the largest depreciation of sterling since the Second World War, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3.2% over the past five years and without dislodging long-term inflation expectations. So the framework has been tested and has proved its worth. But the current crisis has demonstrated vividly that price stability is not sufficient for economic stability more generally. Low and stable inflation did not prevent a banking crisis. Did the single-minded pursuit of consumer price stability allow a disaster to unfold?

P a g e | 77



Would it have been better to accept sustained periods of below or above target inflation in order to prevent the build up of imbalances in the financial system? Is there, in other words, sometimes a trade-off between price stability and financial stability?

The intellectual foundations of monetary policy The experience of the past five years suggests that we reassess the intellectual framework underpinning monetary policy. The emergence of inflation targeting, and the successful results in the form of the Great Stability, coincided with the development of the so-called New Keynesian consensus on macroeconomic theory. This framework offered a theoretical foundation for flexible inflation targeting. Central to the New Keynesian view is the assumption that some prices are “sticky” and adjust slowly. That assumption has two implications. First, high inflation produces inefficient changes in relative prices. As a result, there is a cost to inflation. Second, when central banks change nominal interest rates they also affect real interest rates, and so encourage households and businesses to switch expenditure from today to tomorrow or, as in present circumstances, the other way round. In this way, central banks can, in the model at least, offset shocks to aggregate demand. But there are shocks to supply as well as demand.

P a g e | 78



External cost shocks sometimes drive inflation away from the target, as we saw in recent years with rises in world energy and food prices. Because other prices are “sticky”, attempts to keep inflation at target all the time would result in inefficient fluctuations in output. There is, therefore, a trade-off between stabilising inflation and stabilising output. Following a cost shock, it is sensible to bring inflation back to target gradually. In this, by now conventional, framework, the proper objective of monetary policy is to minimise the variability of inflation around the target rate and the variability of output (or employment) around a sustainable path consistent with stable inflation. Such an objective means that the central bank is effectively choosing a trade-off between the volatility of inflation and the volatility of output. This is sometimes described as choosing a point on the Taylor frontier showing, as in Chart 4, the combinations of lowest volatility of inflation for a given volatility of output.

P a g e | 79



That optimal choice leads to a policy reaction function describing how the central bank responds to shocks hitting the economy. The success of the New Keynesian framework was that it showed how the long run objective of price stability could be implemented by an appropriate central bank policy reaction function. It stressed the importance of expectations and credibility, to which too little attention had been paid during the inflationary episodes of the 1970s and 1980s. But inevitably, as with all models, the basic New Keynesian model omits a number of key factors. The treatment of expectations is simplified, and neglects the possibility that expectations themselves may be a source of fluctuations, rather than simply reflecting changes elsewhere in the economy. Sentiment can vary, misperceptions occur, and people can change the heuristics they use to cope with a complex world.

P a g e | 80



And it lacks an account of financial intermediation, so money, credit and banking play no meaningful role. Those omissions obviously limit the ability of the model to help us understand the trade-offs between monetary policy and financial stability. Although there is a, by now extensive, literature on financial frictions, including attempts to incorporate them in New Keynesian models, it turns out that such extensions make little difference to the propagation of shocks, to optimal policy, or to the quantitative conclusion that overwhelmingly the most important objective remains inflation stabilisation. There is no doubt that financial frictions such as asymmetric information, credit constraints, and costly monitoring of borrowers, to name but a few, are an important part of the story of how crises happen and why they impact on output. But those models do not provide a convincing account of the gradual build-up of debt, leverage and fragility that characterises the run-up to financial crises. Existing models, then, do not tell us why stability today may come at the expense of instability tomorrow. Perhaps we should heed the advice of Ricardo Caballero, who has written that “macroeconomic research has been in ‘fine-tuning’ mode within the local maximum of the dynamic stochastic general equilibrium world, when we should be in ‘broad-exploration’ mode”. So let me now move into broad exploration mode and give three examples in which a trade-off between monetary and financial stability might arise, and which could in theory justify a policy of aiming off the inflation target in order to reduce the risk of future financial instability, before I turn to whether such a policy would have been appropriate before the crisis.

P a g e | 81



The first is where misperceptions about future incomes persist and are embodied in key prices, such as the exchange rate and long-term interest rates. Households, businesses, and banks can all make big mistakes when forming judgements about the future, and make spending decisions today which they will come to regret when their true lifetime budget constraints are revealed. There is no mechanism for ensuring that misperceptions about the sustainable level of spending are corrected quickly. It may take many years before those beliefs are invalidated by experience. So an equilibrium pattern of spending and saving can emerge that is stable temporarily but not sustainable indefinitely. And misaligned prices may reinforce mistaken beliefs if people are using market prices to extract signals about future incomes and consumption opportunities. Evidence of the persistence of misperceptions can be seen in the imbalances in the world, and especially the European, economies. I do not mean to imply that when economic agents make these mistakes they are behaving irrationally. Rather that in a world of intrinsic uncertainty it is far from obvious how to make decisions. The assumption of rational expectations is very helpful for economists when trying to understand the implications of their own models – it is a discipline to prevent the drawing of arbitrary conclusions. In practice, however, households are on their own in a highly uncertain and complex world where they are learning from experience.

P a g e | 82



When it comes to decisions about how much to spend and how much to save, expectations of future incomes are crucial. In the absence of a complete set of markets for future consumption goods – and labour – there is no mechanism to ensure that decisions today, and so the implied plans for tomorrow, will be consistent with the possibilities available in the future. If revisions to expectations of future incomes are uncorrelated across households, then aggregate spending will be relatively stable. The problem comes when many households have similarly over-optimistic views about the future. Aggregate spending and borrowing can then be unsustainably high and lead to an inevitable correction at an unpredictable date when reality dawns. Financial markets both reflect and propagate that common degree of optimism. Sentiment and animal spirits can change very quickly. Examples include the extrapolation of past growth rates of incomes or asset prices into the future when in fact they reflect an adjustment of the level of income or asset price to a new equilibrium. At the time, the MPC argued that the rise in the ratio of house prices to incomes in the years leading up to 2007 reflected a fall in long-term real interest rates – in other words, an adjustment to a new equilibrium house price to income ratio. But if households extrapolated past increases in house prices into the future, then they may have mistakenly inferred that future incomes too would be higher, and so spending and borrowing more than could be sustained.

P a g e | 83



Similar arguments could be made about the reaction of businesses and households to the rise in the sterling effective exchange rate in the late 1990s, and I shall return to this later. Since long-term interest rates in financial markets are, if anything, even lower today the question of sustainability has not yet been resolved. Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults. Keynesian policies to smooth the path of adjustment by supporting aggregate demand can help in the short run, but their effectiveness is limited by the fact that a significant adjustment to spending – from consumption to investment – is required. If policymakers can, first, identify misperceptions, and, second, correct them by changes in monetary policy – both highly uncertain empirically – then there is indeed a trade-off between hitting the inflation target and reducing the chance of a financial crisis down the road. But are central banks less prone to misperceptions than others? My second example concerns what Masaaki Shirakawa, Governor of the Bank of Japan calls the ‘cycle of confidence’. He argues that success breeds confidence, and eventually over-confidence and complacency, leading to collapse. Such ideas are closely associated with the work of Hyman Minsky and others.

P a g e | 84



Minsky set out a ‘financial instability hypothesis’ in which a period of stability encourages exuberance in credit markets and subsequent instability. Perhaps the experience of unprecedented stability in the UK and world economies before the crisis dulled the senses and bred complacency about future risks. I talked about this when I christened the period leading up to 2003 the nice (non-inflationary consistently expansionary) decade. The point of that speech was that the following decade was unlikely to be as nice. And, of course, it wasn’t. But the point didn’t get home, and the financial system became more and more fragile as the leverage of our banking system rose to unprecedented levels. The experience of continuing stability may have sowed the seeds of its own destruction. That idea has been explored recently in an interesting new book by Nassim Taleb. He argues that the opposite of fragility is not resilience or robustness, but “antifragility”, that is a state in which people or institutions thrive on volatility, shocks to the system and risk. We go to the gym to stress our muscles in order to strengthen them; occasional seismic activity may prevent a more damaging earthquake. Frequent exposure to shocks and surprises may improve the way people learn about and manage risks. In a complex world, we are “better at doing than we are at thinking”, in Taleb’s words.

P a g e | 85



Unless we train and practice at coping with bad outcomes we may fail to respond in the right way to adverse shocks when they come. “Antifragility” does not imply that it might be desirable to engineer small recessions in order to head off a deep depression. We know far too little about the economy to attempt any such strategy, and in a world of intrinsic uncertainty we rely on heuristics – simplified rules of thumb – to guide our behaviour. But it offers a warning of the dangers of believing that the role of monetary policy is to offset all shocks. Rather than pretend that we can forecast the future, a more intelligent response is to reinforce the resilience of those parts of the financial system that we cannot permit to fail and encourage entry and exit in a free market in other parts. It is clear that we need to understand more about how stability affects risk-taking, leverage, and the ‘cycle of confidence’. My third example relates to the so-called ‘risk taking’ channel of monetary policy. Short-term policy rates, especially when they are, as now, exceptionally low, may encourage investors to take on more risk than they would otherwise wish as they ‘search for yield’. Financial institutions with long-term commitments (pension funds and insurance companies, for example) need to match the yield they promised on their liabilities, with the yield on their assets. When interest rates are high, they can invest in safe assets to generate the necessary revenue. When interest rates are low, however, they are forced to invest in riskier assets to continue to meet their target nominal rate of return.

P a g e | 86



That tends to push down risk premia and lower the price of borrowing. Other investors too find it difficult to accept that in a world of low nominal and real interest rates equilibrium rates of return will not meet their previous expectations. If these mechanisms are important, the financial cycle may be heavily influenced by monetary policy, especially when interest rates are low. That also creates the possibility of a trade-off between monetary and financial stability. All three examples suggest that the conventional analysis of the trade-off between the volatility of inflation and the volatility of output is likely to be far too optimistic. Does this add up to a case for ‘leaning against the wind’ of rising asset prices rather than waiting to ‘mop’ up after the bust? Certainly we have seen that monetary policy cannot fully offset the effects of financial crises for two reasons. First, crises may impact output before the response of monetary policy is felt. Second, crises typically reduce potential supply growth, for example by disrupting the supply of credit to productive firms. A failure to take financial instability into account creates an unduly optimistic view of where the Taylor frontier lies, especially when it is based on data drawn from a period of stability. Relative to a Taylor frontier that reflects only aggregate demand and cost shocks, the addition of financial instability shocks generates what I call the Minsky-Taylor frontier, shown in Chart 5.

P a g e | 87



This reflects the influence of misperceptions, financial cycles and the search for yield. On the Minsky-Taylor curve, for a given degree of inflation variability, output is more volatile in the long run than on the simple Taylor curve. Ignoring financial instability might mean choosing a policy reaction function that is believed to imply a trade-off at point O in Chart 5. In fact, the true trade-off is given by point P. Once that is understood then the optimal policy reaction function might well change and correspond to a trade-off at point Q. The examples I have given suggest the possibility that there is a trade-off between meeting the inflation target in the short run and reducing the risk of a financial crisis in the long run. To shed light on whether that possibility warrants a change to the way we implement inflation targeting, I want now to conduct a counter-factual thought experiment and ask whether monetary policy before 2007 might have moderated the crisis if it had not simply pursued a target for inflation.

P a g e | 88



A Counter-Factual Monetary Policy 1997-2007 I want to ask whether, with the benefit of hindsight, monetary policy should have been set differently during the period of the so-called Great Stability. Should interest rates have been higher during that period in order to mitigate some of the growth of credit, rise in asset prices, and increase in the leverage of the banking system? Many commentators today seem to think that the answer is clearly yes – though I seem to remember that fewer said so at the time – and most of the pressure on the MPC, both from without and within, was for lower rather than higher levels of Bank Rate. Before trying to answer the question, let me remind you of two key facts about the Great Stability. First, the growth rate of GDP over the period prior to the onset of the crisis in 2007 was 2.9%, very close to its previous long-run average of 2.8% (see Table 2).

P a g e | 89



Second, the policy rate set by the MPC was higher than that in any other G7 country for almost the whole of the ten years prior to the crisis (see Chart 6).

But if the rate of growth was sustainable, its pattern was not. In the late 1990s, there had been a substantial, and not entirely explicable, rise in sterling of around 25% against most other currencies, leading to the emergence of imbalances in the UK economy. These took the form of a shift in the composition of output away from manufacturing and towards services, and a shift in demand away from exports towards domestic demand. National saving fell to unsustainably low levels. In the early years of the MPC there was an intense debate about these imbalances, and how they should affect monetary policy. In a speech in April 2000, I argued that “it is important not to let domestic demand grow too rapidly for too long. The longer the correction is left, the sharper the required adjustment will be”.

P a g e | 90



The question was how much to stimulate domestic demand, at the cost of exacerbating the imbalances, in order to compensate for weak external demand, and the minutes of the MPC in 2001 and 2002 explicitly discussed the case for accepting inflation below target over the two-year horizon. The Committee rejected the case, and during that period most of the dissenting votes on the MPC were for lower rates (see Table 3). The dilemma, and the MPC’s resolution of it, was summed up by my predecessor Eddie George in 2002 when he said “So in effect we have taken the view that unbalanced growth in our present situation is better than no growth – or as some commentators have put it, a two-speed economy is better than a no-speed economy.” Was that the right choice? As in some other industrialised countries, asset prices, including house prices, had been pushed up by falls in long-term real interest rates (see Chart 7).

P a g e | 91



Since those long rates were set in world capital markets by the interaction between the demand for investment and the (very large) supply of saving, only a strategy of persistently higher interest rates at home than overseas – which to some extent we did follow – would have prevented a significant rise in asset prices, thus reducing some of the upward pressure on credit growth. Such a strategy might have brought some benefits for financial stability. It is possible that without rising asset prices we might have kept expectations of future incomes on a more modest path that did not later require a correction. Higher rates and the resulting recession and unemployment might have reminded firms, households and financial markets that the economy was not guaranteed to experience continual steady growth, and thereby have disrupted the dynamic I described earlier in which stability leads to overconfidence and eventual instability – by stressing the economy in order to promote its “antifragility”, in Taleb’s phrase. And higher domestic interest rates might have alleviated some of the ‘search for yield’ that probably followed a period of low rates. But leverage and the growth rate of credit may be relatively insensitive to interest rates, especially once a self-reinforcing cycle of optimism and credit expansion is underway. And this financial crisis was a global one; the United Kingdom could not alone have stopped it happening. We would still have suffered greatly from the very sudden and sharp fall in world output and trade in 2008-09. We might still have experienced a banking crisis and a domestic ‘credit crunch’ because, as my colleague Ben Broadbent has described, lending to the UK real economy contributed only a small share of the rise in leverage of the largest UK banks which reflected more an expansion of lending within the financial sector and overseas (see Table 4).

P a g e | 92



Three quarters of UK banks’ losses to date have been on their foreign assets. The search for yield that prompted excessive risk-taking was the result of low long-term interest rates around the world, not simply rates in the UK. So what would have happened had we adopted the counter-factual policy of higher levels of Bank rate? Of course, it is impossible to know with certainty. And much depends on what would have happened to the exchange rate. On the MPC, two views were discussed. One was that by setting interest rates at a much higher level, so dampening domestic demand and output growth, expectations of the long-run exchange rate consistent with a sustainable path of domestic demand might be dislodged and ‘jolted’ down to a lower equilibrium level – from A to B in Chart 8.

P a g e | 93



Certainly, there seemed good reason at the time to imagine that slower growth at home might mean that hot money would return to countries experiencing stronger growth. As a result, the current exchange rate would have fallen from O to P in Chart 8 and then been expected to follow the path PB consistent with uncovered interest rate parity. The result would have been higher external demand to offset weaker domestic demand. After a time, we might have attained ‘one-speed’ growth, so avoiding the unpalatable choice between ‘two-speed’ and no growth. The other view was that higher interest rates would not have altered the expected long-run equilibrium value of sterling, but would have led to an immediate upwards jump in the exchange rate, as the greater interest rate differential with other countries would have shifted up the uncovered interest rate parity path from OA to QA in Chart 8. That would have meant even weaker external demand, and a more depressed domestic economy.

P a g e | 94



Higher interest rates would have moderated domestic credit growth and asset prices, but only at the expense of slower output growth, rising unemployment and a prolonged undershoot of the inflation target. Everything would have hinged on the success of the strategy in bringing down the expected equilibrium level of sterling in the long run to avoid a further rise in sterling in the short run and a damaging recession. At best, persistently higher interest rates would have implied an initial slowing of growth, a deliberate attempt to weaken sterling, and an under-shooting of the inflation for a period. At worst, we would have seen the exchange rate appreciate further. The decade would have been characterised by rising unemployment and very low inflation. To have deviated from our statutory remit in a direction that would have imposed real costs to output and employment would have been a big gamble. But the costs of the ensuing crisis have been so great that we cannot stop there and say that nothing could have been done. Was there a better alternative to a strategy of higher interest rates? The natural first line of defence against financial crises is macro-prudential policy. In principle, such policies can shift the Minsky-Taylor curve closer to the original Taylor curve. With hindsight, before 2007 there should have been a cap on the leverage of banks (see Chart 9).

P a g e | 95



And the cap should have tightened as asset prices increased and the likely exposure to losses increased. That is why we now have a macro-prudential policy regime in the UK. It will be overseen by the Bank of England’s Financial Policy Committee, which will have the power to direct, and make recommendations to, regulators about capital and leverage in the UK financial system. In my judgement, the big challenge to monetary policy before the crisis was a serious mis-pricing in long-term interest and exchange rates, and the imbalances that resulted. Much of this was outside the control of UK policy-makers and reflected developments in the world economy.

P a g e | 96



It is arguable, though not certain, that in the absence of a macro-prudential regime or tighter fiscal policy, persistently higher interest rates might have been a second-best strategy. It would, though, have been a big gamble. As the Chairman of the Federal Reserve, Ben Bernanke has remarked, “the issue is not whether central bankers should ignore possible financial imbalances – they should not – but, rather, what is ‘the right tool for the job’ to respond to such imbalances”. So it is vital that macro-prudential tools and micro-prudential regulation are part of the armoury of a central bank to mitigate, if not prevent, the build up of excessive leverage and risk-taking in the banking and wider financial sector. From next year, the Bank of England will have those responsibilities, and the new Financial Policy Committee is already up and running. But macro-prudential tools deal with symptoms rather than the underlying problems of misperceptions and mispricing. Although we think the new tools given to the Bank would have helped to alleviate the last crisis, it would be optimistic to rely solely on such tools to prevent all future crises. It would be sensible to recognize that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises. Monetary policy cannot just ‘mop up’ after a crisis. Risks must be dealt with beforehand. I do not see this as inconsistent with inflation targeting because it is the stability of inflation over long periods, not year to year changes, which is crucial to economic success.

P a g e | 97



The key principles underlying flexible inflation targeting are credibility, predictability and transparency of decision-taking, and they will remain the cornerstone of successful monetary policy in the future.

Conclusions Governor Leigh Pemberton’s 1992 lecture concluded with a message for the LSE: “in a world of price stability you might not think of inviting the Governor of the Bank of England to address you”. Had price stability guaranteed financial stability, and had I achieved my long-held ambition of being boring, that might have been true. Unfortunately, it is not how things have worked out! What I have tried to show tonight is that the case for price stability is as strong today as it was twenty years ago – both in theory and in practice. The clarity and simplicity of the inflation target helps to anchor inflation expectations on the target. We forget the lessons of the 1970s and 1980s at our peril. In the end, the essence of central banking is to maintain confidence in, and the value of, paper money. It is far too soon to bury inflation targeting. Together with central bank independence, it played a key role inbringing price stability to the UK. As the Times reported 20 years ago, “the pound's firmer tone, and softer German money market rates, could tempt the Chancellor to shave half a point off base rates to coincide with the Prime Minister's speech at Brighton today”. The party conference season is no longer a time for speculation about changes in interest rates.

P a g e | 98



No doubt we shall learn a great deal about the appropriate allocation of responsibilities to monetary policy, on the one hand, and macro-prudential policy, on the other, over the next twenty years. But we should not throw out the baby with the bathwater. Low and stable inflation is a pre-requisite for economic success. Much of what I have said is, I hope, a call to arms for economists, and especially younger economists, to rethink the foundations of our macroeconomic theories. Not to abandon rigorous modelling – after all, in the words of last year’s Nobel Prize winner Tom Sargent “it takes a model to beat a model” – but to recognize that in our present models the way we think of human behaviour in the face of irreducible uncertainty is seriously incomplete. Ideas matter far more than is usually recognised in the public discussion of monetary policy which concentrates too much on personalities. Keynes and Stamp both knew that. In February 1929, Josiah Stamp went to Paris as a member of the Young Committee to assess whether the reparations debts run up by Germany could be repaid – the similarities with the present situation in Europe are too poignant to dwell on. In a letter to Keynes, Stamp compared these international meetings to a conjuror trying to pull a rabbit out of the hat: “It is still a madhouse, in a way – but all are mad in a very genteel way, the main occupation being elaborate proofs, from different angles, of sanity. One half sit round a hat saying with Coué reiteration: there is a rabbit – there is. The other half try to make a noise like a succulent lettuce.

P a g e | 99



There is a general conviction that the more eminent the conjurors convened, the more certainty is there of the existence of the rabbit”. The only escape from madness is the power of ideas. Today, we understand less than we would wish about how the economy works. The challenge of trying to understand more, and of developing those new ideas, belongs to you – the next generation of students and academics at the LSE and elsewhere. Go to it!

P a g e | 100



Statement by the Honorable, Mr. Koriki Jojima Minister of Finance of Japan and Governor of the IMF for Japan Twenty-Sixth Meeting of the International Monetary and Financial Committee, Tokyo, Japan, October 13, 2012

I. OPENING REMARKS AS THE HOST OF THE MEETINGS IN TOKYO We are delighted to host the IMF/World Bank Annual Meetings and IMFC meeting here in Tokyo for the first time in 48 years.’

II. THE JAPANESE AND GLOBAL ECONOMIES The Japanese Economy In response to the devastating damage caused by the Great East Japan Earthquake, the Government of Japan, in July last year, designated the five years through fiscal 2015 as a “Concentrated Reconstruction Period.” Japan will implement budgetary measures for reconstruction worth a total of 19 trillion yen, equivalent to 4 percent of GDP, over this five year period. The government has already carried out post-earthquake restoration and reconstruction projects worth a total of approximately 17 trillion yen (equivalent to 3.6 percent of GDP), as included in three supplementary budgets for fiscal 2011, as well as the annual budget for fiscal 2012. Supported by such reconstruction-related demand, domestic demand in Japan has stayed firm on the whole.

P a g e | 101



Japan’s GDP recorded an annualized growth rate of 5.3 percent in the first quarter of this year and an annualized growth rate of 0.7 percent in the second quarter on a quarter-on-quarter basis. If downside risks subside, including the instability of the financial market and global economic slowdown due to the European sovereign debt crisis, we expect that Japan’s GDP will grow about 2 percent in fiscal 2012. In the medium term, the government will strive to invigorate the Japanese economy by implementing the Comprehensive Strategy for the Rebirth of Japan, which includes measures to strengthen the growth potential in such fields as energy and environment, health and agriculture, forestry and fisheries.

Japan’s Fiscal Consolidation Now, I would like to explain Japan’s efforts toward fiscal consolidation since this spring. In March this year, the government submitted a bill for the Comprehensive Reform of the Tax System, which is intended to simultaneously achieve fiscal consolidation and secure a stable source of revenue for enhancing and stabilizing the social security system in order to deal with an aging society coupled with a declining birth rate. This bill was enacted in August this year. Under the new law, the consumption tax rate is supposed to be raised from the current 5 percent to 10 percent in two phases by October 2015. Japan expects to achieve the goal of halving the ratio of the primary budget deficits of the national and local governments to GDP by fiscal 2015 in accordance with the commitment made at the G20 Summit in Toronto. This will be accomplished by steadily implementing the new law and by undertaking both revenue- and expenditure-side measures, as prescribed

P a g e | 102



by the Medium-term Fiscal Framework, which was revised in August this year. This will be a significant first step toward future fiscal consolidation. However, Japan recognizes that, as the IMF has pointed out, it is necessary to make further efforts to bring the primary balance for the national and local governments into surplus by fiscal 2020. Therefore, Japan is resolved to continue to steadily implement measures to achieve fiscal consolidation.

The Global Economy The global economy is showing growing signs of a slowdown on the whole. While we must keep a careful watch on the risk of the U.S. fiscal cliff, the greatest cause for concern is the debt and financial-sector problems in Europe. The negative spillover effects of such problems are starting to spread beyond Europe. In order to prevent a further economic downturn, it is essential to quickly take measures to resolve the European sovereign debt crisis. As for the European situation, it is first and foremost important for Europe itself to take responsibility for doing its utmost. Europe needs to quickly implement all of the measures that have been agreed upon and announced to date. In early September, the Outright Monetary Transactions program, a new bond purchases program, intended to ensure the effectiveness of monetary policy, was introduced.

P a g e | 103



In mid-September, the European Commission’s draft plan for a mechanism of unified banking supervision was announced. The European Stability Mechanism has just been launched on October 8. We welcome such positive developments. Japan is ready to make contributions as necessary while keeping watch on these European efforts.

III. EXPECTATIONS FOR THE IMF Next, I would like to explain Japan’s expectations for the IMF.

Establishment of a Global Financial Safety Net Amid the continuing uncertainty over the global economy and the financial market, the IMF has an increasingly important role to play in ensuring stable growth of the global economy in the future. First of all, providing a global financial safety net is one of the important roles of the IMF. In this respect, Japan has taken initiative to announce its intention to provide a new line of credit of US$60 billion for the enhancement of IMF resources, and has called for other countries to follow suit. We are pleased that as a result of such Japanese leadership, an agreement was reached on an increase of more than US$450 billion in IMF resources at the G-20 Summit in Los Cabos in June this year.

Cooperation between Regional Financial Safety Nets and the IMF To complement global institutions such as the IMF, Japan has been pouring efforts into enhancing regional financial safety nets in Asia.

P a g e | 104



Regarding the Chiang Mai Initiative Multilateralization (CMIM), which has been promoted under the framework of ASEAN+3, it was agreed at the ASEAN+3 Finance Ministers’ and Central Bank Governors’ Meeting in May this year that the total size of the CMIM would be doubled from US$ 120 billion to 240 billion. It was also agreed that a crisis prevention facility would be introduced. The strengthening of regional financial cooperation will provide a greater sense of regional ownership regarding crisis prevention and resolution efforts and will enhance global financial safety nets by complementing global institutions such as the IMF. In addition, ASEAN+3 is striving not only to enhance the CMIM but also to strengthen the organization of AMRO (ASEAN+3 Macroeconomic Research Office), which is the macroeconomic surveillance unit of this region. Japan is hoping that cooperation between AMRO and the IMF will deepen in fields of activity such as economic surveillance

Enhancement of the IMF Governance Providing policy advice based on high-quality surveillance is also an important role of the IMF. To perform that role in an effective manner, it is important for the IMF to secure member countries’ trust. To that end, it is necessary to ensure that each member country’s voice and quota share better reflect the member’s relative position in the world economy. Regarding the IMF quota and governance reform that was agreed upon in December 2010, the goal was to put the amended Articles of Agreement into effect before this Annual Meeting. To our great regret, however, only countries which together hold 68 percent of the voting power have accepted the amendment so far.

P a g e | 105



We hope that the countries that have not yet completed the necessary domestic procedures for the amendment will speed up the process. Increasing the IMF’s staff diversity is also important so as to enhance the Fund’s legitimacy, effectiveness, and credibility. Japan is ready to make as much contribution to the Fund in terms of human resources as it does in terms of financial resources.

Quota Review With regard to the ongoing quota review, Japan, once again, would like to stress the importance of giving appropriate consideration to member countries’ past records of financial contributions. Needless to say, quotas constitute the basis of IMF resources, and yet we must not make light of the fact that the IMF’s main activities in recent years, such as addressing the global financial crisis, supporting low-income countries and providing technical assistance, could not have been conducted without voluntary financial contributions made by member countries. In light of this reality and in order to increase the incentive for member countries to make voluntary contributions and secure stable financial resources for the IMF, voluntary financial contributions by member countries should be appropriately reflected in the current quota review. It should include financial contributions to the New Arrangements to Borrow (NAB), bilateral loans, interest subsidies and loans for concessional finance for low-income countries, and technical assistance. Some argue that if consideration is given to the past records of financial contributions, the quota shares of emerging and developing countries would be unduly lowered. However, Japan believes that it is possible to take into consideration both the past records of financial contributions and the quota shares of emerging and developing countries.

P a g e | 106



Of course, it is also important to appropriately protect the voices of least developed countries.

Support for Low-Income Countries Finally, we must not forget the importance of supporting low-income countries in Africa and other regions. In this respect, the IMF has an important role to play. The IMF has been providing concessional loans to low-income countries through the Poverty Reduction and Growth Trust (PRGT). Japan has also consistently assisted the IMF’s support for low-income countries by making contributions such as the provision of loans and interest subsidies. In response to the global financial crisis that broke out in 2008, we agreed in 2009 to increase the PRGT’s resources to enhance support for low-income countries. Based on this agreement, in May this year, Japan expressed an intention to contribute its share of the windfall profits from the IMF gold sales to the PRGT’s interest subsidies. We welcome the progress made now that the number of commitments by member countries has reached the necessary level. Even if the windfall profits from the IMF gold sales mentioned above are transferred to be used as interest subsidies based on the 2009 agreement, a further expansion of the interest subsidy account will be necessary in order to fully satisfy the needs for support for low income countries in and beyond 2015. Japan is ready to further contribute to interest subsidies for PRGT on condition that member countries act in concert based on the new agreement reached by the IMF Executive Board

P a g e | 107



Communiqué of the Twenty-Sixth Meeting of the IMFC Chaired by Mr. Tharman Shanmugaratnam, Deputy Prime Minister of Singapore and Minister for Finance Global growth has decelerated and substantial uncertainties and downside risks remain.

Key policy steps have been announced, but effective and timely implementation is critical to rebuild confidence.

We need to act decisively to break negative feedback loops and restore the global economy to a path of strong, sustainable and balanced growth. Advanced economies should deliver the necessary structural reforms and implement credible fiscal plans.

Emerging market economies should preserve or use policy flexibility as appropriate to facilitate a response to adverse shocks and support growth.

Advanced economies

There is a need to secure a sustained recovery from the crisis.

Further monetary easing has created more accommodative financial conditions.

The implementation of credible medium-term fiscal consolidation plans remains critical in many advanced economies.

Fiscal policy should be appropriately calibrated to be as growth-friendly as possible. In the euro area, significant progress has been made.

The ECB’s decision on Outright Monetary Transactions and the launch of the European Stability Mechanism are welcome.

But further steps are necessary.

P a g e | 108



We look forward to timely implementation of an effective banking and a stronger fiscal union to strengthen the monetary union’s resilience, and structural reforms to boost growth and employment at the national level.

In the United States, resolving the fiscal cliff, raising the debt ceiling, and making progress toward a comprehensive plan to ensure fiscal sustainability are essential.

In Japan, securing funding for this year’s budget and further progress in medium-term fiscal consolidation are needed.

Emerging market and developing countries

Activity is slowing in emerging market and developing economies, reflecting weaker external and domestic demand and, in some cases, policy tightening to address inflationary pressures.

Risks are compounded for some countries by falling prices for non-food commodities and upward price pressures on some food items.

These economies will need to ensure flexibility in policy implementation to support growth, consistent with global rebalancing.

The potential impact from large and volatile cross-border capital flows should be closely monitored.

The Fund has increased its support for Arab countries in transition and continues to work with these authorities as they develop home-grown national reform strategies to deliver inclusive growth and jobs.

We call on the international community to provide broader support for this region.

We welcome the increased engagement of the IMF with small states and look forward to further work in this area.

Low-income countries

While growth remains buoyant in most low-income countries, fiscal and reserve positions have weakened and buffers need to be restored.

P a g e | 109



In the near term, the Fund is adequately resourced to provide additional financial support to low-income countries, should the need arise.

We welcome the IMF Executive Board’s decision on the use of US$2.7 billion in remaining windfall gold sales profits as part of a strategy to ensure the long-term sustainability of the Fund’s concessional financing facilities.

This comes on top of the receipt of the assurances needed for the use of US$1.1 billion in resources linked to gold sales profits to bolster PRGT resources in the near term.

We call on members to expedite the unlocking of this financing.

Global Policy Agenda

We welcome the directions set forth in the Managing Director’s Global Policy Agenda and share its emphasis on the need to address the current crisis and build a strong foundation for future growth.

Policies for jobs and growth, debt sustainability, repair of financial systems, and reducing global imbalances are key priorities.

We will review progress on implementing these measures at our next meeting.

We are committed to strengthening domestic sources of growth in surplus economies, boosting national savings while enhancing export competitiveness in deficit countries, and fostering greater exchange rate flexibility, where appropriate.

We reaffirm our commitment to avoid any form of trade and investment protectionism.

Surveillance

We welcome the strengthening of the IMF’s surveillance framework through the adoption of a new Integrated Surveillance Decision, a Financial Surveillance Strategy as well as the launch of a pilot External Sector Report.

P a g e | 110



These initiatives will bring together bilateral and multilateral perspectives in the Fund’s policy advice and support better assessment of global and country-level risks and spillovers to economic and financial stability.

We look forward to the evenhanded and effective implementation of the strengthened surveillance framework and will assess progress at the next Annual Meetings.

Resources

Members have significantly augmented Fund resources.

Pledges have been received from more members since April to increase the borrowed resources available to the Fund by US$461 billion.

We welcome the signing of the first batch of bilateral borrowing agreements and encourage the conclusion of the remaining borrowing agreements soon.

2010 Quota and Governance Reforms

We have made considerable progress in ratifying the 2010 quota and governance reforms.

Most of the conditions required for the entry into force of the reforms have been achieved.

We reaffirm the urgency of making these important reforms effective and call on members who have yet to complete the necessary steps to do so.

Quota Formula Review

The comprehensive review of the quota formula is well underway.

The key issues and differences have been clearly identified.

We call on the membership to develop the consensus needed through further engagement of the IMF Executive Board, with input from the IMFC Deputies after their meeting in December, to complete the review by January 2013.

P a g e | 111



We reaffirm our commitment to conclude the Fifteenth General Review of Quotas by January 2014.

IMFC meeting

We would like to express our gratitude to the government of Japan for hosting these meetings.

The next IMFC meeting will be held in Washington D.C. on April 19-20, 2013

P a g e | 112



To: Banks Bank Holding Companies Federally Regulated Trust and Loan Companies Cooperative Retail Associations

Subject: New Required Interim Public Capital Disclosure Requirements related to Basel III Pillar 3

On June 26, 2012, the Basel Committee on Banking Supervision (BCBS) issued its final rules on the information banks must publicly disclose when detailing the composition of their capital. Entitled, Composition of capital disclosure requirements – Rules text (the BCBS Disclosure Rules), the publication sets out a framework to ensure that the components of banks’ capital bases are publicly disclosed in standardised formats across and within jurisdictions for banks subject to Basel III, which in Canada includes all banks, bank holding companies, federally regulated trust and loan companies, and cooperative retail associations (collectively institutions) regardless of size or public listings. As noted in the BCBS Disclosure Rules, “During the financial crisis, many market participants and supervisors attempted to undertake detailed assessments of the capital positions of banks and comparisons of their capital positions on a cross jurisdictional basis. The level of detail in the disclosure and the lack of consistency in the way that it was reported typically made this task difficult and often made it impossible to do with any accuracy. It is often suggested that lack of clarity on the quality of capital contributed to uncertainty during the financial crisis.” Accordingly, the new public capital disclosure requirements are intended to improve both the transparency and comparability of institutions’ capital positions.

P a g e | 113



This letter provides clarification on the implementation of the BCBS Disclosure Rules for all institutions for Q1-2013 and Q2-2013 (the “Interim Period”) and builds on OSFI’s November 2007 Advisory on Pillar 3 Disclosure Requirements.

1) Scope of Application Given that all institutions are required to implement the Basel III framework, the new composition of capital disclosure requirements also apply to all institutions. For greater certainty, these public disclosures are required, regardless of the size of the institution and whether the institution is publicly listed (i.e., public disclosure is required for wholly-owned institutions, foreign bank subsidiaries and all other institutions that might not be publicly listed). Exemption from disclosures applies to institutions that continue to meet the exemption criteria outlined in Part 1 of OSFI’s November 2007 Advisory on Pillar 3 Disclosure Requirements.

2) Interim period – Q1 2013 and Q2 2013

To facilitate comparability and to provide financial statements users with Basel III information in the interim period, OSFI requires institutions to make modified minimum composition of capital disclosures for Q1 2013 and Q2 2013 (the “Interim Period”) as described below. Institutions can disclose additional information at their discretion.

3) Disclosures, Common Template relating to the components of regulatory capital OSFI Modified Transitional Template The Transitional Template, described in Section 5 and illustrated in Annex 4 of the BCBS Disclosure Rules, is a modified version of the Post

P a g e | 114



January 1, 2018 Template that discloses the components of capital that are benefiting from transitioning. During the Interim Period, OSFI requires institutions to disclose a modified version of the BCBS Transitional Template. This “OSFI Modified Transitional Template”, appended to this letter, discloses regulatory adjustments from Common Equity Tier 1 (CET1), Additional Tier 1, and Tier 2 capital on a condensed basis, rather than individually as prescribed under the BCBS Transitional Template. Further, the OSFI Modified Transitional Template omits certain line items prescribed under the BCBS Transitional Template relating to the amount of CET1 applicable to the various capital buffers as well as details relating to the applicable caps on the inclusion of provisions in Tier 2 and the amounts below thresholds for deduction. The OSFI Modified Transitional Template also requires institutions to disclose their capital ratios on an all-in basis. Other Pillar 3 disclosures during the Interim Period During the Interim Period, OSFI expects institutions to continue to comply with the original Pillar 3 requirements (including Table 2 (Capital Structure) qualitative disclosures) along with the Pillar 3 enhancements and revisions, and the enhanced remuneration requirements. Issues of non-compliance will continue to be addressed on a case-by-case basis through bilateral discussions with institutions.

4) Location While the BCBS Disclosure Rules mandate that certain, rather than all, of the disclosures should be publicly available on institutions’ websites, OSFI continues to encourage institutions to make all Pillar 3 disclosures available on their public websites in a central location so as to enhance transparency and comparability.

P a g e | 115



5) Post Interim period – Q3 2013 and after OSFI expects all institutions to fully implement the BCBS Disclosure Rules starting in Q3 2013 (i.e., July 31, 2013 for institutions with October 31st year ends and September 30, 2013 for institutions December 31st year ends). OSFI will issue separate guidance on these requirements in due course. Mark Zelmer

Assistant Superintendent, Regulation

P a g e | 116



Hearing before the Committee on Economic and Monetary Affairs of the European Parliament Introductory statement by , Chair of the ESRB, Brussels Dear Madam Chair, Dear Honourable Members, I am very pleased to appear before this Committee today to inform you about the activities of the European Systemic Risk Board (ESRB). As you know, the ESRB complements the know-how of central banks, national supervisors and the three European Supervisory Authorities by delivering what has come to be called a macro-prudential perspective. What this means is the capacity to analyse risks across market segments, to address vulnerabilities – which currently lie mainly in the banking sector – and to examine medium-term risks in the financial system as a whole. Based on such analysis, combined with proposals for remedial action by way of warnings or recommendations, the ESRB will help to protect Europe’s economy from fragility in the financial system. An important step in the ESRB’s work was the publication of the first risk dashboard on 20 September 2012. The dashboard was requested by this Parliament in the legislative process establishing the ESRB.

P a g e | 117



It consists of a set of quantitative and qualitative indicators aimed at identifying and measuring systemic risk. The risk dashboard has been produced in cooperation with the European Central Bank (ECB) and the three European Supervisory Authorities (ESAs). It is one of the inputs considered by the ESRB’s General Board in its discussions of risks and vulnerabilities in the financial system. The dashboard, which will be updated quarterly, looks at six different categories of risks, sectorally and across the financial landscape. It should be considered an information tool that orients further analysis on systemic risk, rather than a fully-fledged early warning system. The General Board has decided to publish the dashboard and its underlying data on the ESRB’s website.

Risks in the banking sector

Let me turn to the current situation.

The European economy and financial system continue to face challenging times – and it is vital always to be mindful of systemic risks.

But there are also reasons to be confident, provided that policy-makers continue to implement agreed measures with determination.

These measures include macroeconomic and structural reforms to ensure competitiveness and sustainable public finances.

They include continued financial reform to ensure a resilient and well-functioning financial system.

And they include further development of Europe’s institutional framework.

From a macro-prudential perspective, there are three main possible risks.

P a g e | 118



First, the risk of setbacks in the implementation of agreed measures.

Second, the risk of downside macroeconomic news with implications for banks’ asset quality, profitability and funding.

And third, the risk that feedback loops between these two factors may affect the supply of credit, which in turn will affect the real economy.

Revitalising the supply of credit is crucial for the recovery.

Notwithstanding some reductions in market tensions, financial activity remains impaired in various parts of the system.

At this time, the role of macro-prudential policy is primarily to restore trust in the financial sector.

To rebuild investors’ confidence in banks, it is necessary to reassure them about asset quality.

There are a number of options that authorities can consider. One is enhanced disclosure, for example, on the level of provisioning.

A second option is supervisory assessments of asset quality, possibly including peer reviews by supervisors and third party assessments and a third option, where necessary, is the setting up of separate entities to deal with low quality assets.

Important work is already being done by the European Banking Authority (EBA), assessing forbearance in the banking sector, promoting coordinated reviews of asset quality and harmonising definitions of key variables – such as non-performing loans.

The ESRB plans to make further proposals for macro-prudential policy, particularly on vulnerabilities linked to bank funding.

In light of the impairment of some credit and interbank markets, the ESRB, together with the EBA, is reviewing asset encumbrance and complex funding instruments such as synthetic exchange-traded funds and liquidity swaps.

P a g e | 119



The aim is to identify sources of systemic risk and policy actions to mitigate them.

I intend to present the results of this process at the next hearing in the first half of 2013.

Risks in financial markets

The ESRB’s examination of the financial system extends well beyond the banking sector.

Today, I would like to focus in particular on developments in the field of central counterparties (CCPs) and over-the-counter (OTC) markets. I will outline the analytical work done by the ESRB and the policy advice it has given.

The implementation of the G20 commitment to central clearing for all standardised OTC derivatives has important consequences for the EU financial system.

The ESRB started to assess the systemic implications of the more prominent role for CCPs that they will become a crucial node within the financial system.

Macro-prudential examination of CCPs relates, in particular, to the pro-cyclicality of margining and haircutting practices. Such practices have an important bearing on financial conditions in the economy.

While the more prominent role for CCPs reduces counterparty risk, it inevitably implies an increase in concentration risk.

Therefore, the ESRB issued advice to the European Securities and Markets Authority (ESMA) on two aspects regarding the systemic resilience of CCPs.

On collateral, the ESRB advised the ESMA to increase the systemic resilience of CCPs by better defining the type of eligible collateral and the conditions under which commercial bank guarantees may be accepted as collateral by CCPs.

P a g e | 120



The ESRB also advised that risks related to cross-collateralisation should be adequately taken into account.

On clearing among non-financial corporations operating in derivative markets, the ESRB advised the ESMA to restrict the possibilities for such corporations to settle outside CCPs, so as to reduce counterparty risk.

Regrettably from a macro-prudential viewpoint, there is a risk that the systemic vulnerabilities identified by the ESRB will remain at least partly unaddressed.

This is due to an interpretation of the EMIR legislation that has made it difficult to translate fully the ESRB’s advice into technical standards.

On OTC markets more broadly, the ESRB is examining potential risks stemming from market practices that have become very common in the so-called ‘shadow banking’ sector.

For example, collateral pledged by a client may be re-used by a lender for own borrowing needs.

This pattern, which is called re-hypothecation, may be repeated several times for the same collateral.

It can therefore create a contagion chain in case any party fails to deliver.

In other cases, when collateral for securities lending transactions is represented by cash, that cash may re-invested by the lender.

In case such re-investment takes place in a risky asset or for a longer maturity, there are risks of so-called reuse of cash collateral in securities financing transactions.

Macro-prudential policies in the EU Banking union and the role of the ESRB

The ESRB has also reviewed the current plans on the banking union and welcomes the European Commission’s proposal.

P a g e | 121



Board members consider that the macro-prudential benefits of the Single Supervisory Mechanism (SSM) would be enhanced if an adequate resolution regime for banks were implemented without substantial delay.

The Commission’s initiatives for establishing a ‘single resolution mechanism to resolve banks and to coordinate the application of resolution tools to banks under the banking union’ are to be encouraged.

The ESRB is reflecting on the implications of the proposed SSM for its own work.

The Commission’s proposal directly affects macro-prudential policy and its implementation – suggesting for the ECB exclusive competence within the euro area ‘to set counter-cyclical buffer rates and any other measures aimed at addressing systemic or macro-prudential risks in the cases specifically set out in Union acts’.

The ESRB has repeatedly stressed that macro-prudential policies should be sufficiently flexible to prevent the build-up of systemic risks.

Policy-makers should be encouraged to mitigate emerging risks as soon as they are identified, rather than fostering a bias towards inaction.

Flexibility can be balanced by members’ coordination to safeguard against potential negative externalities or unintended consequences.

The ESRB is working on a general framework for the coordination of macro-prudential policies in the EU. First results can be expected in the coming year.

Meanwhile, a review of the mission and organisation of the ESRB itself will take place in 2013.

Three members of the ESRB Steering Committee – Stefan Ingves, Chair of the Advisory Technical Committee, André Sapir, Chair of the Advisory Scientific Committee, and Vítor Constâncio, Vice-President of the ECB – will examine the functioning of the ESRB, including in light of the forthcoming banking union.

P a g e | 122



Follow-up on ESRB recommendations

The ESRB is also working on first implementation of the ‘act or explain’ mechanism set out in the ESRB Regulation to ensure that addressees respond properly to ESRB recommendations.

The first set of deadlines for replies to the ESRB recommendations issued in 2011 expired in June 2012.

The current review suggests that the ‘act or explain’ mechanism has functioned smoothly.

At the same time, more work lies ahead to enhance our assessment framework.

The ESRB Secretariat has contacted relevant European and international institutions – such as the Commission, the IMF, the OECD, the FSB and the Bank for International Settlements – to learn from their experience.

Conclusions

In concluding, I would like to emphasise that there is substantial progress in the understanding of systemic risks and the design of macro-prudential policies in the EU.

This would not have been possible without the active involvement and dedication of all ESRB member institutions and committees.

On the occasion of the rotation of the Chair of the Advisory Scientific Committee, I would like to thank in particular its first Chair, Martin Hellwig, and to wish all the best to the new Chair, André Sapir.

I understand that you will have the opportunity to exchange views with the Chair and Vice-Chairs of the Committee very soon. Thank you very much for your attention. I am now at your disposal for questions.

P a g e | 123



Capital and Adventure: The Auditor’s Role in the Modern Corporation James R. Doty, Chairman International Forum of Independent Audit Regulators (IFIAR) London, England It is a genuine honor to be with you today. I want to thank Stephen Haddrill, Paul George, the U.K. delegation and the many members of the Financial Reporting Council for hosting this twelfth congregation of what is now 43 national audit regulators hailing from Europe, the Americas, Asia, Africa and the Middle East. In addition, Paul, you have my gratitude and admiration for your leadership these last two years as Chairman of IFIAR. In addition, on behalf of my fellow board members who have joined me here — Lew Ferguson, Vice Chair of IFIAR, and Steve Harris, who chairs IFIAR's Investor Working Group — I want to thank you, Stephen and Paul, for the extraordinary partnership we have enjoyed since our first meeting. Together, in our joint inspections and our work on audit reform, we have advanced the interest of the public in global cooperation to improve the rigor of audits and cast new light into the interstices of regulatory gaps that attract fraud and self-dealing. It is appropriate now to say that the remainder of my remarks today are my own and should not be attributed to the PCAOB as a whole or any other members or staff. We meet in London on this occasion, not only because the FRC is a great host. As in so many other examples in history, London is a place where journeys begin.

P a g e | 124



I began a personal journey of my own, about one hundred kilometers from here, at Merton College at Oxford, where I read modern history. Under the tutelage of the late John Morris Roberts, I awoke to the value of debate in critical thought and analysis. Some of you may remember his BBC series on Western history. He was also a prolific writer. He introduced me to a generation of historians deeply rooted in the practical details of the past — As a Briggs, Richard Cobb, and others. They saw the big ideas that lurked in the everyday patterns of contemporary life, and drew out those grand themes to guide us forward — a difficult task. As John said, "It will always remain true that the closer we get to our own times, the harder it is to see what is the history that really matters." John remained a lifelong friend until his death in 2003. But after my two years at Oxford, I returned to the United States to study law and specialize in corporate and securities law.

I. The History of the Corporate Form is a Story of Irrepressible Innovation to Suit the Needs and Opportunities of Investors. But Oxford was hard to shake off. My history lessons traveled with me. One of the grand themes was an understanding of the fact that the corporate paradigm is not immutable. It lurches forward, toward a transient solution for a moment's purpose. As the moment passes, we change it to suit the next. The modern corporation spawned from the quite basic and ancient commercial need to amass large sums to finance high-risk trading expeditions across oceans. Many such voyages, as you know, were financed by the various European

P a g e | 125



states.

A. Merchant Adventurers Pooled Resources to Capitalize on State Monopolies. Others were financed privately, by merchant adventurers or what were known as "regulated companies" that had been granted a royal or Parliamentary charter to monopolize trade. In the 14th century, England began exporting manufactured goods to Prussia, the Netherlands, and Scandinavia. Many think of globalization as a 20th century phenomenon. But as European nations transformed from agricultural economies to mercantile and manufacturing activities, private international trade burgeoned. Thus, centuries ago, in Britain, long-distance trade became more significant economically than domestic trade. The records of early regulated companies show that they were audited. And that those audits were generally conducted by a committee of directors or participants in the company.

B. Joint Stock Companies Allowed Passive Investors to Participate in Voyages and Other Ventures. Fast forward: in the 16th century, a new corporate form emerges to conduct overseas trade — joint stock companies. This was the precursor to the modern-day public company. In regulated companies, all members enjoyed and participated in the monopoly together, but each supplied his own ships and inventory to the venture. In joint stock companies, officers are appointed to trade on behalf of the

P a g e | 126



members, some of whom, to a greater and greater extent as the centuries passed, are passive investors. Over time, investors find means to transfer shares of joint stock companies. Again, these joint stock companies were audited by committees of shareholders. The use of auditors was also prevalent in early America. For example, the Massachusetts Bay Company was a joint stock company chartered in 1629. Responding to an early liquidity crisis, it used an audit committee of "eight Adventurers" to "clear up the confused state of [its] accounts" after ship purchases depleted the Puritans' initial funds.

C. 19th Century European Legislation Provided for Limited Liability Partnerships, Incorporation Outside of Crown Monopolies and Transfer of Shares, and Use of Professional Auditors. Fast forward again, and we find other countries also develop sophisticated forms for group enterprise. Notably, Napoleon's 1807 Code introduced a significant innovation by allowing limited liability partnerships. Half a century later, the UK Parliament allowed private incorporation of joint stock companies by registration — that is, without the need for a royal or Parliamentary charter — through the Joint Stock Companies Act of 1844 and the Companies Clauses Consolidation Act of 1845. These laws provided for incorporators to appoint auditors to prepare a report for the annual general meeting of shareholders, which in those days was a meaningful part of corporate governance.

P a g e | 127



Consistent with the prior 600 years of practice, they envisioned the appointment of auditors from among the body of shareholders. They required that "every auditor shall have at least one share in the undertaking; and he shall not hold any office in the company, nor be in any other manner interested in its concerns, except as a shareholder." Moreover, I note that the 1845 Act also required rotation of auditors, such that one member was required to go out of office after the first ordinary meeting each year, with eligibility to rotate back on the committee upon re-election. Of relevance to our endeavors, the legislation also, for the first time, acknowledged the right of the auditing committee to employ accountants or other persons as they deemed appropriate, at company expense. Enter the professional auditing assistant, who became a popular resource nearly overnight. These two developments — administratively-organized joint stock companies and professional experts in auditing who could vouch for agents' management of corporate funds — ushered in yet more innovations as the 19th century closed: the floating of new securities and the advent of securities markets organized for the purpose of trading shares. Thus came the earliest of the large U.S. corporations — the Baltimore & Ohio Railroad — in the early 1820s, capitalized by Baltimore merchants eager to exploit the new technology of drawing carriages by horse over railed-roads even before steam power was fully established. What made railroads modern businesses was the scope of their operations and the size of their capital requirements, which were far in excess of contemporary, owner-operated enterprises whose financing needs were seasonal and generally limited to loans. Like its corporate forbearers, the B&O Railroad used a committee of the merchant investors to audit the financial records on a regular basis. An

P a g e | 128



annual report to investors was also required under the corporate charter.

D. The 20th Century Heralded Public Securities Markets, Multi-National Corporations, and New Audit Challenges. On this groundwork, the 20th Century continued to build massive companies on a scale that could not have been imagined as that century began, including companies that were truly international, with operations in multiple countries. All the corporate building blocks developed over centuries were required: skilled managers, limited liability for large populations of investors, freedom from political direction or intervention, effective engineering works and techniques scaled large for efficient production, and the means to keep the cost of finance to a minimum. Unlike the shareholders of the past, the growing class of public investors had no realistic ability to participate in or even monitor the use of funds. As my friend Bernard Black, a prominent U.S. securities law professor, wrote — Creating strong public securities markets is hard. That securities markets exist at all is magical, in a way. Investors pay enormous amounts of money to strangers for completely intangible rights, whose value depends entirely on the quality of information that the investors receive and on the sellers' honesty. Professional auditors were key to helping investors separate the credible managers from the charlatans. By building confidence, auditors would reduce financing costs, and contributed to an efficient allocation of capital to fuel economic growth. Unlike the auditors of old, modern auditors are not shareholders. They do not examine accounts to determine their own shares and profits. Rather, their independence derives from disinterest in the company's performance — both in appearance and in fact.

P a g e | 129



Historians remind us that each generation — managers, auditors, audit regulators — we are all in a sense custodians of and fiduciaries for the best ideas the past has given us. It is our job to figure out (as Edmund Burke thought) what absolutely must be kept, and what absolutely must be discarded, to preserve the former. (Here, I paraphrase, with your permission.) I will turn back to a caution learned from professional historians. As my Oxford tutor John Roberts advised, "In deciding how to set out the story, the most dangerous, trap, potentially, [is] that of familiarity." Since the financial reporting debacles at the turn of our 21st century, we audit regulators have had the opportunity to examine in depth the effectiveness of this external audit model for public companies. I feel confident in saying that our work and collective findings demonstrate the need for rigorous, skeptical auditing to sustain wide-scale investment by diverse public investors. Time and time again, we see evidence that auditing makes a difference. But we also see, as we each deepen our understanding of the various firms that intermediate our capital markets, that the competitive markets present challenges for auditors who are trained for technical excellence but are subject to pressures to compromise audit quality.

II. The Investing Public Values Audits. In this regard, there appears to be a certain current of malaise about the auditing profession that I believe, based upon deeper examination, is misplaced. It focuses on the opinion of some that the audit is a low-value, compliance activity, made further unpleasant by the burdens of

P a g e | 130



regulation and enhanced oversight. It suggests that those attitudes and burdens may repel bright minds from the profession and leave us with shrunken public markets. The argument proves too much. We know audits are relevant, indeed critical to further economic development. It is the fact that they are so critical that, I believe, is pushing auditors to change, that is, to deepen their commitment to the investing public. Some see venture capital and private equity as a trend that will sweep us up. They are a throwback to earlier times — co-adventurers who can fit together within the walls of a coffee house, counting house, or modern conference room to negotiate shares and profits. They are a partial solution to the problem of agency costs. But I see them as just an eddy. We will yet see more innovation of the public company. Fourteenth century consumers desired fine English wools, and English merchants found a way to satisfy. Twenty-first century consumers from Delphi to Delhi crave the latest smartphone, and MNCs find a way to dazzle and deliver. The individual investors of today seek value and return as restlessly as the sponsors of early voyages of discovery. Unlike past generations, investors now have you promoting their interests. Each of you, through IFIAR and in your home country, are engaged in intellectual inquiry about ways to improve the reliability of audits for the investing public. Commissioner Michel Barnier and Director-General Jonathan Faull of the

P a g e | 131



European Commission have initiated, in concert with the EU's 27 member states, a reexamination of the audit and its role in investor protection. Leaders of the profession exhibit willingness to embark on initiatives such as the International Audit and Assurance Standard's Board's proposal to meet investor needs with an expanded auditor's report. I believe your interest has accelerated this process. I applaud IFIAR members for the various, creative initiatives you have tabled at home and at past IFIAR meetings.

III. Public Investors Require New Safeguards of Auditor Independence and Stronger Ties Among Regulators to Eliminate Gaps in Auditor Oversight. Investors have charged us to find ways to make the work of the auditor more useful to investors and to improve audit quality. This is the organizing question for IFIAR's agenda of meetings this week. For my contribution to the week's debates, I would encourage you to devote attention to two themes to enhance investor protection: (1) the lode star of auditor independence, and (2) the benefits of deepening cooperation between and among us.

A. Auditor Independence First, on auditor independence: We need to find appropriate structures to reinforce auditor independence. In the U.S., we are in the middle of a series of high-level public discussions on ways to enhance auditor independence, including possibly through mandatory term limits.

P a g e | 132



Could term limits release auditors from the natural incentive to do what they think may be necessary to foster and maintain long client relationships? And under what combination of circumstances? Would knowing that another auditor will follow cause the first to stand firmer? What length of term would encourage an audit firm to plan and make appropriate investments of staff and other resources but at the same time discourage commitment to the client's success, about which the auditor should be neutral? We have received constructive suggestions about both the merits of different approaches, as well as ways to minimize potential disruptions. Would grace periods for extenuating circumstances be appropriate? Say when there has already been a change in a key participant in financial reporting? The CEO, the CFO, the internal auditor. Or a key corporate event? A restatement, a merger, a material weakness in internal control. Is the appropriate balance a disclosure approach, such as "tender or explain," or "if you retain you must explain"? These are all ideas put forth in our public meetings. And how does all of this implicate audit committees and other governance constructs? In addition, the IAASB and the PCAOB are both actively engaged in considering ways to enhance the auditor's report, to make it more relevant and useful for investors. I believe appropriate innovations in this regard could also re-orient auditors to see public investors as their client. Therefore, I see in this project independence-related benefits and seminal implications for governance and the corporate paradigm.

P a g e | 133



B. Close Cooperation Among National Regulators Better Protects Investors Everywhere The second area I encourage you to consider is how to deepen our regulatory coordination, which I believe has delivered important investor protections already. Many investors in the modern, multi-national corporation do not fully appreciate the fact that most multi-national audits are conducted by a consortium of affiliated firms. It is an easy fact to miss, given that it is not explained in the standard auditor's report. When one is aware, though, it is equally easy to see there are hand-off risks. At the PCAOB, we have seen first hand the benefits of evaluating the various pieces of audits performed by different registered firms in multiple jurisdictions. Our inspectors often see more than the principal auditor — or signing firm — does. In many cases principal auditors rely on high-level reports from subsidiary auditors. They often don't review the work papers of the other subsidiary auditors, and their own work papers don't necessarily reveal deficiencies that may exist in the work of other auditors — or even simply the principal auditor's understanding of the work of other auditors. When our inspectors have looked directly at the work of subsidiary auditors, many times they have found problems. These findings demonstrate why it's so important that we look at the parts of the audit performed by the principal auditor as well as the auditor of a subsidiary, wherever they are located. We are all aware of notorious examples of frauds directed by corporate headquarters but perpetrated in remote locations, beyond the expected gaze of auditors and regulators.

P a g e | 134



If we each looked only at one side of the communication between affiliated firms, we would, collectively, miss these audit errors, despite our significant, but isolated, efforts. I can say this based on our experience now that, in recent years, we have been able to inspect firms that participate in audits of U.S. public companies but are based outside the U.S. It is an amazing feat of regulatory cooperation that, in the last few years, we have found ways to work together, to inspect the various members of the global networks of audit firms, on behalf of investors in all of our markets. Working side-by-side with many of you, we have been able to gain insights about cross-border audits that neither of us would have learned separately. Therefore, let me conclude with this note of urgency for continuing and deepening our regulatory cooperation. I know that some had envisioned that after an initial period of trust-building, we would each go back to our national borders. I know that coordinated inspections are attended by complicated logistics and issues of resource allocation. The more the PCAOB works with another regulator, the more we learn about how to reduce the logistical complexities and make our work together as meaningful as possible. But now that we have found that working together is effective — that it does lead to identification of audit failures we otherwise would miss — why would we turn back ? Public expectations for regulatory cooperation will likely increase, not abate. How could we turn back? * * *

P a g e | 135



History is made by people confronting emerging challenges with new ideas. As I said at the outset, the corporate paradigm is not immutable. Nor are the investor protections that attend it. We may pause to take a bearing. But we do not set anchor. The past yet urges us forward. It is a journey I hope we will continue together.

P a g e | 136



Certified Risk and Compliance Management Professional (CRCMP) distance learning and online certification program. Companies like IBM, Accenture etc. consider the CRCMP a preferred certificate. You may find more if you search (CRCMP preferred certificate) using any search engine.

The all-inclusive cost is $297. What is included in the price: A. The official presentations we use in our instructor-led classes (3285 slides) The 2309 slides are needed for the exam, as all the questions are based on these slides. The remaining 976 slides are for reference. You can find the course synopsis at: www.risk-compliance-association.com/Certified_Risk_Compliance_Training.htm B. Up to 3 Online Exams You have to pass one exam. If you fail, you must study the official presentations and try again, but you do not need to spend money. Up to 3 exams are included in the price. To learn more you may visit: www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf C. Personalized Certificate printed in full color Processing, printing, packing and posting to your office or home.

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

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

http://www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf

http://www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf

P a g e | 137



D. The Dodd Frank Act and the new Risk Management Standards (976 slides, included in the 3285 slides) The US Dodd-Frank Wall Street Reform and Consumer Protection Act is the most significant piece of legislation concerning the financial services industry in about 80 years. What does it mean for risk and compliance management professionals? It means new challenges, new jobs, new careers, and new opportunities. The bill establishes new risk management and corporate governance principles, sets up an early warning system to protect the economy from future threats, and brings more transparency and accountability. It also amends important sections of the Sarbanes Oxley Act. For example, it significantly expands whistleblower protections under the Sarbanes Oxley Act and creates additional anti-retaliation requirements. You will find more information at: www.risk-compliance-association.com/Distance_Learning_and_Certification.htm

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

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

monday october 22, 2012 - top 10 risk management news

Education

int association of risk

statemember banks

certain bank holdingcompanies

state member banks

banks transparencyin

information banks

certain stress testingre

nonbank financial companies