basel 3 may 2013

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Basel iii Compliance Professionals Association (BiiiCPA) 1200 G Street NW Suite 800 Washington, DC

20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.com

Dear Member,

I had a difficult time in the past to explain liquidity risk management and ratios.

Now I know what to do. Problem solved!

I will use a pollution-mitigating technology, like scrubbers to explain liquidity risk.

Mr. Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System explained how:

“Suppose we have a power plant that produces energy and, as a byproduct, some pollution.

Suppose further that regulators want to reduce the pollution and have two tools at their disposal:

They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant.

In an ideal world, regulation would accomplish two objectives.

First, it would lead to an optimal level of mitigation – that is, it would induce the plant to install scrubbers up to the point where the cost of an

Basel iii Compliance Professionals Association (BiiiCPA)

www.basel-iii-association.com

http://www.basel-iii-association.com/

































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additional scrubber is equal to the marginal social benefit, in terms of reduced pollution.

And, second, it would also promote conservation:

Given that the scrubbers don’t get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive.

A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant.

In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers.

The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced.

And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level.

This latter effect is the implicit tax aspect of the mandate.

A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be.

Here, mandating the use of a fixed number of scrubbers is potentially problematic:

If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft.Basel iii Compliance Professionals Association

(BiiiCPA)www.basel-iii-association.com














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In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate bounces around a lot.

By contrast, a regulatory approach that fixes the price of pollution instead of the quantity – say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant – is more forgiving in the face of this kind of uncertainty.

This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed.

For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them.

This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers.

Scrubbers and high-quality liquid assets

What does all this imply for the design of the

LCR? Let’s work through the analogy in

detail.

The analog to the power plant’s energy output is the gross amount of liquidity services created by a bank – via its deposits, the credit lines it provides to its customers, the prime brokerage services it offers, and so forth.

The analog to the mitigation technology – the scrubbers – is the stock of HQLA that the bank holds.

And the analog to pollution is the net liquidity risk associated with the difference between these two quantities, something akin to the LCR shortfall.
















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That is, when the bank offers a lot of liquidity on demand to its customers but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the rest of the financial system.

In the case of the power plant, I argued that a regulation that calls for a fixed quantity of mitigation – that is, for a fixed number of scrubbers – is more attractive when there is little uncertainty about the cost of these scrubbers.”

Thank you Jeremy!

I have just opened my master plan. I have to learn more about scrubbers. I now see other similarities between the BIS and scrubbers. Only now I can understand the shape of the BIS building!

I think I have just found another regulatory arbitrage opportunity. A real national discretion, justified.

Scrubbers are capable of reduction efficiencies in the range of 50% to 98%. Why should the Liquidity Coverage Ratio be 100%?
















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A LCR from 50% to 98% (meaning 50,001%) is good enough!The calculations in Basel and scrubbers are also almost the same!
















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Liquidity regulation and central banking

Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System, at the “Finding the right balance” 2013 Credit Markets Symposium, sponsored by the Federal Reserve Bank of Richmond, Charlotte, North Carolina

I’d like to talk today about one important element of the international regulatory reform agenda – namely, liquidity regulation.

Liquidity regulation is a relatively new, post-crisis addition to the financial stability toolkit.

Key elements include the Liquidity Coverage Ratio (LCR), which was recently finalized by the Basel Committee on Banking Supervision, and the Net Stable Funding Ratio, which is still a work in progress.

In what follows, I will focus on the LCR.

The stated goal of the LCR is straightforward, even if some aspects of its design are less so.

In the words of the Basel Committee, “The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks.

It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario.”

In other words, each bank is required to model its total outflows over 30 days in a liquidity stress event and then to hold HQLA sufficient to accommodate those outflows.
















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This requirement is implemented with a ratio test, where modeled outflows go in the denominator and the stock of HQLA goes in the numerator; when the ratio equals or exceeds 100 percent, the requirement is satisfied.

The Basel Committee issued the first version of the LCR in December 2010.

In January of this year, the committee issued a revised final version of the LCR, following an endorsement by its governing body, the Group of Governors and Heads of Supervision (GHOS).

The revision expands the range of assets that can count as HQLA and also adjusts some of the assumptions that govern the modeling of net outflows in a stress scenario.

In addition, the committee agreed in January to a gradual phase-in of the LCR, so that it only becomes fully effective on an international basis in January 2019.

On the domestic front, the Federal Reserve expects that the U.S. banking agencies will issue a proposal later this year to implement the LCR for large U.S. banking firms.

While this progress is welcome, a number of questions remain.

First, to what extent should access to liquidity from a central bank be allowed to count toward satisfying the LCR?

In January, the GHOS noted that the interaction between the LCR and the provision of central bank facilities is critically important.

And the group instructed the Basel Committee to continue working on this issue in 2013.
















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Second, what steps should be taken to enhance the usability of the LCR buffer – that is, to encourage banks to actually draw down their HQLA buffers, as opposed to fire-selling other less liquid assets?

The GHOS has also made clear its view that, during periods of stress, it would be appropriate for banks to use their HQLA, thereby falling below the minimum.

However, creating a regime in which banks voluntarily choose to do so is not an easy task.

A number of observers have expressed the concern that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to drop below 100 percent when facing large outflows, even if regulators were to permit this temporary deviation, for fear that a decline in the ratio could be interpreted as a sign of weakness.

My aim here is to sketch a framework for thinking about these and related issues.

Among them, the interplay between the LCR and central bank liquidity provision is perhaps the most fundamental and a natural starting point for discussion.

By way of motivation, note that before the financial crisis, we had a highly developed regime of capital regulation for banks – albeit one that looks inadequate in retrospect – but we did not have formal regulatory standards for their liquidity.

The introduction of liquidity regulation after the crisis can be thought of as reflecting a desire to reduce dependence on the central bank as a lender of last resort (LOLR), based on the lessons learned over the previous several years.
















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However, to the extent that some role for the LOLR still remains, one now faces the question of how it should coexist with a regime of liquidity regulation.

To address this question, it is useful to take a step back and ask another one:

What underlying market failure is liquidity regulation intended to address, and why can’t this market failure be handled entirely by an LOLR?

I will turn to this question first.

Next, I will consider different mechanisms that could potentially achieve the goals of liquidity regulation, and how these mechanisms relate to various features of the LCR.

In so doing, I hope to illustrate why, even though liquidity regulation is a close cousin of capital regulation, it nevertheless presents a number of novel challenges for policymakers and why, as a result, we are going to have to be open to learning and adapting as we go.

The case for liquidity regulation

One of the primary economic functions of banks and other financial intermediaries, such as broker-dealers, is to provide liquidity – that is, cash on demand – in various forms to their customers.

Some of this liquidity provision happens on the liability side of the balance sheet, with bank demand deposits being a leading example.

But, importantly, banks also provide liquidity via committed lines of credit.

Indeed, it is probably not a coincidence that these two products – demand deposits and credit lines – are offered under the roof of the same
















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institution; the underlying commonality is that both require an ability to accommodate unpredictable requests for cash on short notice.

A number of other financial intermediary services, such as prime brokerage, also embody a significant element of liquidity provision. Without question, these liquidity-provision services are socially valuable.

On the liability side, demand deposits and other short-term bank liabilities are safe, easy-to-value claims that are well suited for transaction purposes and hence create a flow of money-like benefits for their holders.

And loan commitments are more efficient than an arrangement in which each operating firm hedges its future uncertain needs by “pre-borrowing” and hoarding the proceeds on its own balance sheet; this latter approach does a poor job of economizing on the scarce aggregate supply of liquid assets.

At the same time, as the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk.

That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether.

And fire sales and bank failures – and the accompanying contractions in credit availability – can have spillover effects to other financial institutions and to the economy as a whole.

Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure.
















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It is this externality that creates a role for policy.

There are two broad types of policy tools available to deal with this sort of liquidity-based market failure.

The first is after-the-fact intervention, either by a deposit insurer guaranteeing some of the bank’s liabilities or by a central bank acting as an LOLR.

The second type is liquidity regulation.

As an example of the former, when the economy is in a bad state, assuming that a particular bank is not insolvent, the central bank can lend against illiquid assets that would otherwise be fire-sold, thereby damping or eliminating the run dynamics and helping reduce the incidence of bank failure.

In much of the literature on banking, such interventions are seen as theprimary method for dealing with run-like liquidity problems.

A classic statement of the central bank’s role as an LOLR is Walter Bagehot’s 1873 book Lombard Street.

More recently, the seminal theoretical treatment of this issue is by Douglas Diamond and Philip Dybvig, who show that under certain circumstances, the use of deposit insurance or an LOLR can eliminate run risk altogether, thereby increasing social welfare at zero cost.

To be clear, this work assumes that the bank in question is fundamentally solvent, meaning that while its assets may not be liquid on short notice, the long-run value of these assets is known with certainty to exceed the value of the bank’s liabilities.

One way to interpret the message of this research is that capital regulation is important to ensure solvency, but once a reliable regime of Basel iii Compliance Professionals Association















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capital regulation is in place, liquidity problems can be dealt with after the fact, via some combination of deposit insurance and use of the LOLR.

It follows that if one is going to make an argument in favor of adding preventative liquidity regulation such as the LCR on top of capital regulation, a central premise must be that the use of LOLR capacity in a crisis scenario is socially costly, so that it is an explicit objective of policy to economize on its use in such circumstances.

I think this premise is a sensible one.

A key point in this regard – and one that has been reinforced by the experience of the past several years – is that the line between illiquidity and insolvency is far blurrier in real life than it is sometimes assumed to be in theory.

Indeed, one might argue that a bank or broker dealer that experiences a liquidity crunch must have some probability of having solvency problems as well; otherwise, it is hard to see why it could not attract short-term funding from the private market.

This reasoning implies that when the central bank acts as an LOLR in a crisis, it necessarily takes on some amount of credit risk.

And if it experiences losses, these losses ultimately fall on the shoulders of taxpayers.

Moreover, the use of an LOLR to support banks when they get into trouble can lead to moral hazard problems, in the sense that banks may be less prudent ex ante.

If it were not for these costs of using LOLR capacity, the problem would be trivial, and there would be no need for liquidity regulation:
















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Assuming a well-functioning capital-regulation regime, the central bank could always avert all fire sales and bank failures ex post, simply by acting as an LOLR.

This observation carries an immediate implication:

It makes no sense to allow unpriced access to the central bank’s LOLR capacity to count toward an LCR requirement.

Again, the whole point of liquidity regulation must be either to conserve on the use of the LOLR or in the limit, to address situations where the LOLR is not available at all – as, for example, in the case ofbroker-dealers in the United States.

At the same time, it is important to draw a distinction between priced and unpriced access to the LOLR.

For example, take the case of Australia, where prudent fiscal policy has led to a relatively small stock of government debt outstanding and hence to a potential shortage of HQLA.

The Basel Committee has agreed to the use by Australia of a Committed Liquidity Facility (CLF), whereby an Australian bank can pay the Reserve Bank of Australia an upfront fee for what is effectively a loan commitment, and this loan commitment can then be counted toward its HQLA.

In contrast to free access to the LOLR, this approach is not at odds with the goals of liquidity regulation because the up-front fee is effectively a tax that serves to deter reliance on the LOLR – which, again, is precisely the ultimate goal.

I will return to the idea of a CLF shortly.
















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The design of regulation

Once it has been decided that liquidity regulation is desirable, the next question is how best to implement it.

In this context, note that the LCR has two logically distinct aspects as a regulatory tool:

It is a mitigator, in the sense that holding liquid assets leads to a better outcome if there is a bad shock; it is also an implicit tax on liquidity provision by banks, to the extent that holding liquid assets is costly.

Of course, one can say something broadly similar about capital requirements.

But the implicit tax associated with the LCR is subtler and less well understood, so I will go into some detail here.

An analogy may help to explain.

Suppose we have a power plant that produces energy and, as a byproduct, some pollution.

Suppose further that regulators want to reduce the pollution and have two tools at their disposal:

They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant.

In an ideal world, regulation would accomplish two objectives.

First, it would lead to an optimal level of mitigation – that is, it would induce the plant to install scrubbers up to the point where the cost of an additional scrubber is equal to the marginal social benefit, in terms of reduced pollution.
















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And, second, it would also promote conservation:

Given that the scrubbers don’t get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive.

A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant.

In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers.

The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced.

And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level.

This latter effect is the implicit tax aspect of the mandate.

A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be.

Here, mandating the use of a fixed number of scrubbers is potentially problematic:

If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft.

In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is

equivalent to one where the implicit tax rate bounces around a lot.
















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By contrast, a regulatory approach that fixes the price of pollution instead of the quantity – say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant – is more forgiving in the face of this kind of uncertainty.

This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed.

For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them.

This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers.

Scrubbers and high-quality liquid assets

What does all this imply for the design of the

LCR? Let’s work through the analogy in

detail.

The analog to the power plant’s energy output is the gross amount of liquidity services created by a bank – via its deposits, the credit lines it provides to its customers, the prime brokerage services it offers, and so forth.

The analog to the mitigation technology – the scrubbers – is the stock of HQLA that the bank holds.

And the analog to pollution is the net liquidity risk associated with the difference between these two quantities, something akin to the LCR shortfall.

That is, when the bank offers a lot of liquidity on demand to its customers but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the rest of the financial system.
















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In the case of the power plant, I argued that a regulation that calls for a fixed quantity of mitigation – that is, for a fixed number of scrubbers – is more attractive when there is little uncertainty about the cost of these scrubbers.

In the context of the LCR, the cost of mitigation is the premium that the bank must pay – in the form of reduced interest income – for its stock of HQLA.

And, crucially, this HQLA premium is determined in market equilibrium and depends on the total supply of safe assets in the system, relative to the demand for those assets.

On the one hand, if safe HQLA-eligible assets are in ample supply, the premium is likely to be low and stable.

On the other hand, if HQLA-eligible assets are scarce, the premium will be both higher and more volatile over time.

This latter situation is the one facing countries like Australia, where, as I noted earlier, the stock of outstanding government securities is relatively small.

And it explains why, for such countries, having a price-based mechanism as part of their implementation of the LCR can be more appealing than pure reliance on a quantity mandate.

When one sets an up-front fee for a CLF, one effectively caps the implicit tax associated with liquidity regulation at the level of the commitment fee and tamps down the undesirable volatility that would otherwise arise from an entirely quantity-based regime.

Moreover, it bears reemphasizing that having a CLF with an up-front fee is very different from simply allowing banks to count central - bank - eligible collateral as HQLA at no charge.
















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Rather, the CLF is like the pollution tax.

For every dollar of pre-CLF shortfall – that is, for every dollar of required liquidity that a bank can’t obtain on the private market – the bank has to pay the commitment fee.

So even if there is not as much mitigation, there is still an incentive for conservation, in the sense that banks are encouraged to do less liquidity provision, all else being equal.

This would not be the case if the CLF were available at a zero

price. What about the situation in countries where safe

assets are moreplentiful?

The analysis here has a number of moving parts because in addition to the implementation of the LCR, substantial increases in demand for safe assets will arise from new margin requirements for both cleared and noncleared derivatives.

Nevertheless, given the large and growing global supply of sovereign debt securities, as well as other HQLA-eligible assets, most estimates suggest that the scarcity problem should be manageable, at least for the foreseeable future.

In particular, quantitative impact studies released by the Basel Committee estimate that the worldwide incremental demand for HQLA coming from both the implementation of the LCR and swap margin requirements might be on the order of $3 trillion.

This is a large number, but it compares with a global supply of HQLA-eligible assets of more than $40 trillion.

Moreover, the eligible collateral for swap margin is proposed to be broader than the LCR’s definition of HQLA – including, for example, certain equities and corporate bonds without any cap.
















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If one focuses just on U.S. institutions, the incremental demand number is on the order of $1 trillion, while the sum of Treasury, agency, and agency mortgage-backed securities is more than $19 trillion.

While this sort of analysis is superficially reassuring, the fact remains that the HQLA premium will depend on market-equilibrium considerations that are hard to fully fathom in advance, and that are likely to vary over time.

This uncertainty needs to be understood, and respected.

Indeed, the market-equilibrium aspect of the problem represents a crucial distinction between capital regulation and liquidity regulation, and it is one reason why the latter is particularly challenging to implement.

Although capital regulation also imposes a tax on banks – to the extent that equity is a more expensive form of finance than debt – this tax wedge is, to a first approximation, a fixed constant for a given bank, independent of the scale of overall financial intermediation activity.

If Bank A decides to issue more equity so it can expand its lending business, this need not make it more expensive for Bank B to satisfy its capital requirement.

In other words, there is no scarcity problem with respect to bank equity – both A and B can always make more.By contrast, the total supply of HQLA is closer to being fixed at any point in time.

Policy implications

What does all of this imply for policy design?

First, at a broad philosophical level, the recognition that liquidity regulation involves more uncertainty about costs than capital regulation suggests that even a policymaker with a very strict attitude toward capital
















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might find it sensible to be somewhat more moderate and flexible with respect to liquidity.

This point is reinforced by the observation that when an institution is short of capital and can’t get more on the private market, there is really no backup plan, short of resolution.

By contrast, as I mentioned earlier, when an institution is short of liquidity, policymakers do have a backup plan in the form of the LOLR facility.

One does not want to rely too much on that backup plan, but its presence should nevertheless factor into the design of liquidity regulation.

Second, in the spirit of flexibility, while a price-based mechanism such as the CLF may not be immediately necessary in countries outside of Australia and a few others, it is worth keeping an open mind about the more widespread use of CLF-like mechanisms.

If a scarcity of HQLA-eligible assets turns out to be more of a problem than we expect, something along those lines has the potential to be a useful safety valve, as it puts a cap on the cost of liquidity regulation.

Such a safety valve would have a direct economic benefit, in the sense of preventing the burden of regulation from getting unduly heavy in any one country.

Perhaps just as important, a safety valve might also help to protect the integrity of the regulation itself, by harmonizing costs across countries and thereby reducing the temptation of those most hard-hit by the rules to try to chip away at them.

Without such a safety valve, it is possible that some countries – those with relatively small supplies of domestic HQLA – will find the regulation considerably more costly than others.
















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If so, it would be natural for them to lobby to dilute the rules – for example, by arguing for an expansion in the type of assets that can count as HQLA.

Taken too far, this sort of dilution would undermine the efficacy of the regulation as both a mitigator and a tax.

In this scenario, holding the line with what amounts to a proportional tax on liquidity provision would be a better outcome.

One situation where liquid assets can become unusually scarce is during a financial crisis.

Consequently, even if CLFs were not counted toward the LCR in normal times, it might be appropriate to count them during a crisis.

Indeed, while the LCR requires banks to hold sufficient liquid assets in good times to meet their outflows in a given stress scenario, it implicitly recognizes that if things turn out even worse than that scenario, central bank liquidity support will be needed.

Allowing CLFs to count toward the LCR in such circumstances would acknowledge the importance of access to the central bank, and this access could be priced accordingly.

Finally, a price-based mechanism might also help promote a willingness of banks to draw down their supply of HQLA in a stress scenario.

As I noted at the outset, one important concern about a pure quantity - based system of regulation is that if a bank is held to an LCR standard of 100 percent in normal times, it may be reluctant to allow its ratio to fall below 100 percent when facing large outflows for fear that doing so might be seen by market participants as a sign of weakness.

By contrast, in a system with something like a CLF, a bank might in normal times meet 95 percent of its requirement by holding
















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private-market HQLA and the remaining 5 percent with committed credit lines from the central bank, so it would have an LCR of exactly 100 percent.

Then, when hit with large outflows, it could maintain its LCR at 100 percent, but do so by increasing its use of central bank credit lines to 25 percent and selling 20 percent of its other liquid assets.

This scenario would be the sort of liquid-asset drawdown that one would ideally like to see in a stress situation.

Moreover, the central bank could encourage this drawdown by varying the pricing of its credit lines – specifically, by reducing the price of the lines in the midst of a liquidity crisis.

Such an approach would amount to taxing liquidity provision more in good times than in bad, which has a stabilizing macroprudential effect.

This example also suggests a design that may have appeal in jurisdictions where there is a relatively abundant supply of HQLA-eligible assets.

One can imagine calibrating the pricing of the CLF so as to ensure that lines provided by central banks make up only a minimal fraction of banks’ required HQLA in normal times – apart, perhaps, from the occasional adjustment period after an individual bank is hit with an idiosyncratic liquidity shortfall.

At the same time, in a stress scenario, when liquidity is scarce and there is upward pressure on the HQLA premium, the pricing of the CLF could be adjusted so as to relieve this pressure and promote usability of the HQLA buffer.

Such an approach would respect the policy objective of reducing expected reliance on the LOLR while at the same time allowing for a safety valve in a period of stress.Basel iii Compliance Professionals Association















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The limit case of this approach is one where the CLF counts toward the LCR only in a crisis.

Conclusion

By way of conclusion, let me just restate that liquidity regulation has a key role to play in improving financial stability.

However, we should avoid thinking about it in isolation; rather, we can best understand it as part of a larger toolkit that also includes capital regulation and, importantly, the central bank’s LOLR function.

Therefore, proper design and implementation of liquidity regulations such as the LCR should take account of these interdependencies.

In particular, policymakers should aim to strike a balance between reducing reliance on the LOLR on the one hand and moderating the costs created by liquidity shortages on the other hand – especially those shortages that crop up in times of severe market strain.

And, as always, we should be prepared to learn from experience as we go.
















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Basel I I I Capital: A Well-Intended I llusion Thomas M. Hoenig

Vice Chairman, Federal Deposit Insurance CorporationInternational Association of Deposit Insurers 2013 Research Conference, Basel, Switzerland

Introduction

Aristotle is credited with being the first philosopher to systematically study logical fallacies, which he defined as arguments that appear valid but, in fact, are not.

I call them well-intended illusions.

One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength.

For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized.

The reality is that each dollar of their total assets is funded with far less equity capital, leaving open the matter of how well capitalized they might be.

Here’s how the illusion is created.

Basel's Tier 1 capital measure is a bank's ratio of Tier 1 capital to risk-weighted assets.
















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Each category of bank assets is weighed by the supervisory authority on a complicated scale of probabilities and models that assign a relative risk of loss to each group, including off balance sheet items.

Assets deemed low risk are reported at lower amounts on the balance sheet.

The lower the risk, the lower the amount reported on the balance sheet for capital purposes and the higher the calculated Tier 1 ratio.

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights.

The objective is to maximize a firm's return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management.

This creates the illusion that banking organizations have adequate capital to absorb unexpected losses.

For the largest global financial companies, risk-weighted assets are approximately one-half of total assets.

This "leveraging up" has served world economies poorly.

In contrast, supervisors and financial firms can choose to rely on the tangible leverage ratio to judge the overall adequacy of capital for the enterprise.

This ratio compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets.Basel iii Compliance Professionals Association















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In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes. Using this leverage ratio as our guide, we find for the largest banking organizations that each dollar of assets has only 4 to 6 cents funded with tangible equity capital, a far smaller buffer than asserted under the Basel standards.

Comparing Measures

Table 1 reports the Basel Tier 1 risk-weighted capital ratio and theleverage ratio for different classes of banking firms.
















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Column 4 shows Tier 1 capital ratios ranging between 12 and 15 percent for the largest global firms, giving the impression that these banks are highly capitalized.

However, it is hard to be certain of that by looking at this ratio sincerisk-weighted assets are so much less than total assets.

In contrast, Column 6 shows U.S. firms' average leverage ratio to be 6 percent using generally accepted accounting standards (GAAP), and Column 8 shows their average ratio to be 3.9 percent using international accounting standards (IFRS), which places more of these firms' derivatives onto the balance sheet than does GAAP.

The bottom portion of Table 1 shows the degree of leverage among different size groups of banking firms, which is striking as well.

The Tier 1 capital measure suggests that all size groups of banks hold comparable capital levels, while the leverage ratio reports a different outcome.
















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For example, the leverage ratio for most banking groups not considered systemically important averages near 8 percent or higher.

Under GAAP accounting standards, the difference in this ratio between the largest banking organizations and the smaller firms is 175-250 basis points.

Under IFRS standards, the difference is as much as 400-475 basis points.

The largest firms, which most affect the economy, hold the least amount of capital in the industry.

While this shows them to be more fragile, it also identifies just how significant a competitive advantage these lower capital levels provide the largest firms.

These comparisons illustrate how easily the Basel capital standard can confuse and misinform the public rather than meaningfully report a banking company’s relative financial strength.

Recent history shows also just how damaging this can be to the industry and the economy.

In 2007, for example, the 10 largest and most complex U.S. banking firms reported Tier 1 capital ratios that, on average, exceeded 7 percent ofrisk-weighted assets.

Regulators deemed these largest to be well capitalized.

This risk-weighted capital measure, however, mapped into an average leverage ratio of just 2.8 percent.

We learned all too late that having less than 3 cents of tangible capital for every dollar of assets on the balance sheet is not enough to absorb even the smallest of financial losses, and certainly not a major shock.
















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With the crisis, the illusion of adequate capital was discovered, after having misled shareholders, regulators, and taxpayers.

There are other, more recent, examples of how this arcane measure can be manipulated to give the illusion of strength even when a firm incurs losses.

For example, in the fourth quarter of 2012, Deutsche Bank reported a loss of 2.5 billion EUR.

That same quarter, its Tier 1 risk-based capital ratio increased from 14.2 percent to 15.1 percent due, in part, to “model and process enhancements” that resulted in a decline in risk-weighted assets, which now amount to just 16.6 percent of total assets.

On Feb. 1, SNS Reaal, the fourth largest Dutch bank with $5 billion in assets, was nationalized by the Dutch government.

Just seven months earlier, on June 30, 2012, SNS reported a Tier 1 risk-based capital ratio of 12.2 percent.

However, the firm reported a Tier 1 leverage ratio based upon international accounting standards of only 1.47 percent.

This leverage ratio was much more indicative of the SNS’s poor financial position.

The Basel I I I proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis.

It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals.Basel iii Compliance Professionals Association















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Misallocating Resources and Creating Asset Imbalances

An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market's collective daily judgment about the relative risk of assets.

It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes.

The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets.

The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy.

It is no coincidence, for example, that after a Basel standard assigned only a 7 percent risk weight on triple A, collateralized debt obligations and similar low risk weights on assets within a firm's trading book, resources shifted to these activities.

Over time, financial groups dramatically leveraged these assets onto their balance sheets even as the risks to that asset class increased exponentially.

Similarly, assigning zero weights to sovereign debt encouraged banking firms to invest more heavily in these assets, simultaneously discounting the real risk they presented and playing an important role in increasing it.

In placing a lower risk weight on select assets, less capital was allocated to fund them and to absorb unexpected loss for these banks, undermining their solvency.
















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A More Realistic Capital Standard Is Required

Taxpayers are the ultimate backstop to the safety net and have real money at stake.

In choosing which capital measure is most useful, it is fair to ask the following questions:

- Does the Basel Tier 1 ratio or the tangible leverage ratio best indicate the capital strength of the firm?

- Which one is most clearly understood?

- Which one best enables comparison of capital across institutions?

-Which one offers the most confidence that it cannot be easily

gamed? Charts 1 through 4 compare the relationship of the

tangible leverage andBasel Tier 1 capital ratios to various market measures for the largest firms.
















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These measures include: the price-to-book ratio, estimated default frequency, credit default swap spreads, and market value of equity.

In each instance, the correlation of the tangible leverage ratio to these variables is higher than for the risk-weighted capital ratio.

While such findings are not conclusive, they suggest strongly that investors, when deciding where to place their money, rely upon the information provided by the leverage ratio.

We would do well to do the same.
















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Despite all of the advancements made over the years in risk measurement and modeling, it is impossible to predict the future or to reliably anticipate how and to what degree risks will change.

Capital standards should serve to cushion against the unexpected, not to divine eventualities.

All of the Basel capital accords, including the proposed Basel I I I , look backward and then attempt to assign risk weights into the future.

It doesn't work.

In contrast, the tangible leverage ratio provides a simpler, more direct insight into the amount of loss-absorbing capital that is available to a firm.

A leverage ratio as I ’ve defined it explicitly excludes intangible items that cannot absorb losses in a crisis.

Also, using IFRS accounting rules, off-balance sheet derivatives are brought onto the balance sheet, providing further insight into a firm's leverage.

Thus, the tangible leverage ratio is simpler to compute and more easily understood by bank managers, directors, and the public.

Importantly also, it is more likely to be consistently enforced by bank supervisors.

A more difficult challenge may be to determine an appropriate minimum leverage ratio.

Chart 5 provides a history of bank leverage over the past 150 years for theU.S. banking system and gives initial insight into this question.
















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It shows that the equity capital to assets ratio for the industry prior to the founding of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corporation in 1933 ranged between 13 and 16 percent, regardless of bank size.

Without any internationally dictated standard or any arcane weighting process, markets required what today seems like relatively high capital levels.

In addition, there is an increasing body of research (Admati and Hellwig; Haldane; Miles, Yang, and Marcheggiano) that suggests that leverage ratios should be much higher than they currently are and that Basel I I I’s proposed 3 percent figure adds little security to the system.

Finally, and importantly, some form of risk-weighted capital measure could be useful as a backstop, or check, against which to judge the adequacy of the leverage ratio for individual banks.

If a bank meets the minimum leverage ratio but has concentrated assets in areas that risk models suggest increase the overall vulnerability of the balance sheet, the bank could be required to increase its tangible capital levels.

Such a system provides the most comprehensive measure of capital adequacy both in a broad context of all assets and according to a bank's allocation of assets along a defined risk profile.

Tangible Leverage Ratio and the Myth of Unintended Consequences

Concerns are often raised within the financial industry and elsewhere that requiring the largest and most complex firms to hold higher levels of capital as defined using a tangible leverage ratio would have serious adverse effects on the industry and broader economy.Basel iii Compliance Professionals Association















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It has been suggested, for example, that requiring more capital for these largest banks would raise their relative cost of capital and make them less competitive.

Similarly, there is concern that failing to assign risk weights to the different categories of assets would encourage firms to allocate funds to the highest risk assets to achieve targeted returns to equity.

These issues have been well addressed by Anat Admati and Martin Hellwig in their recently published book, The Bankers’ New Clothes.

The required ROE and the ability to attract capital are determined by a host of factors beyond the level of equity capital.

These include a firm’s business model, its risk-adjusted returns, the benefits of services and investments, and the undistorted, ornon-subsidized, costs of capital.

A level of capital that lowers risk may very well attract investors drawn to the more reliable returns.

Table 1 shows many of the banks with stronger leverage ratios also have stock prices trading at a higher premium to book value than the largest firms that are less well-capitalized.

There also is a concern that requiring a stronger, simpler leverage ratio would cause managers to place more risk on their balance sheet.

While possible, the argument is unconvincing.

With more capital at risk and without regulatory weighting schemes affecting choice, managers will allocate capital in line with market risk and returns.

Furthermore, risk-weighted measures and strong bank supervision can be available as a back-up system to monitor such activity.
















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Moreover, given the experience of the recent crisis and the on-going efforts to manage reported risk assets down, no matter the risk, it rings hollow to suggest that having a higher equity buffer for the same amount of total assets makes the financial system less safe.

In addition, there is a concern that demanding more equity capital and reducing leverage among the largest firms would inhibit the growth of credit and the economy.

This statement has an implied presumption that the Basel weighting scheme is more growth friendly than a simpler, stronger leverage ratio.

However, having a sufficient capital buffer allows banks to absorb unexpected losses.

This serves to moderate the business cycle and the decline in lending that otherwise occurs during contractions.

If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets.

Basel systematically encourages investments in sectors pre-assigned lower weights -- for example, mortgages, sovereign debt, and derivatives-- and discourages loans to assets assigned higher weights -- commercial and industrial loans.

We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.

If risk weights could be assigned that anticipate and calibrate risks with perfect foresight, adjusted on a daily basis, then perhaps risk-weighted capital standards would be the preferred method for determining how to deploy capital.
















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However, they cannot.

To believe they can is a fallacy that puts the entire economic system at risk.

Changing the Debate

The tangible leverage ratio is a superior alternative to risk-weighting schemes that have proven to be an illusion of precision and insufficient in defining adequate capital.

The effect of relying on such measures has been to weaken the financial system and misallocate resources.

The leverage ratio deserves serious consideration as the principal tool in judging the capital strength of financial firms.

The Basel discussion would be well served to focus on the appropriate levels of tangible capital for banking firms to hold and the right transition period to achieve these levels.

Finally, we should not accept even comforting errors of logic which suggest that Basel I I I requirements will create stronger capital than those of Basel I I , which failed.

Instead, past industry performance and mounting academic and other evidence suggest that we would be best served to focus on a strong leverage ratio standard in judging a firm and the industry's financial strength.

No bank capital program is perfect.

Our responsibility as regulators and deposit insurers is to choose the best available measure that will contribute to financial stability.
















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Note:

Thomas M. Hoenig was confirmed by the Senate as Vice Chairman of the Federal Deposit Insurance Corporation on Nov. 15, 2012.

He joined the FDIC on April 16, 2012, as a member of the FDIC Board of Directors for a six-year term.

He is a member of the executive board of the International Association of Deposit Insurers.

Prior to serving on the FDIC board, Mr. Hoenig was the President of the Federal Reserve Bank of Kansas City and a member of the Federal Reserve System's Federal Open Market Committee from 1991 to 2011. Mr. Hoenig was with the Federal Reserve for 38 years, beginning as an economist and then as a senior officer in banking supervision during theU.S. banking crisis of the 1980s.

In 1986, he led the Kansas City Federal Reserve Bank's Division of Bank Supervision and Structure, directing the oversight of more than 1,000 banks and bank holding companies with assets ranging from less than$100 million to $20 billion.

He became President of the Kansas City Federal Reserve Bank on October 1, 1991.

Mr. Hoenig is a native of Fort Madison, Iowa. He received a doctorate in economics from Iowa State University.
















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“A comfortable position for German banks”

The Bundesbank currently sees no signs whatsoever of a credit shortage or a tightening of lending standards in Germany.

“German banks are in a pretty comfortable position at the moment.

By and large, neither their liquidity nor their capital situation are causing them any problems,” Deputy President Sabine Lautenschläger said earlier this week at the Internationaler Club Frankfurter Wirtschaftjournalisten (International club of Frankfurt-based business journalists).

What is more, banks were benefiting from their strong industrial and SME customer base.

“German banks further improved their resilience in 2012,” Ms Lautenschläger explained, referring to the results of the Basel I I I impact study published some time ago.

This study looked at how the sample of banks would have fared if Basel I I I had already been fully phased in as at the cut-off date.

The impact study reveals that the capital shortfall of the eight large German banks has decreased by €15 billion, or 30%, as compared with the last cut-off date.

Another gratifying outcome of the study is that, on average, the 33 participating German institutions already meet the future minimum ratio of 4.5% for core tier 1 capital.

Sabine Lautenschläger commented that this trend had continued “with the same intensity” in the second half of 2012, with banks raising capital in the tens of billions.
















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Challenges facing banks in the future

The ability of banks to carry on generating sufficient income on a higher cost base was a key factor in deciding whether their business models were sustainable over the long run, Ms Lautenschläger explained.

Persistently low interest rates and the fierce competition among banks were dragging on earnings.

“The weak earnings trend will present a major challenge for banks and supervisors alike,” the Deputy President added.

Ms Lautenschläger struck a positive tone over the scheduled global implementation of Basel I I I and said she expected the other major financial centres to follow suit.

“Only then will Basel I I I be able to fulfil its protective function and provide a suitable response to the 2008 financial crisis.”

Appropriate supervision and resolution mechanisms for banks with an international focus necessitated greater coordination and improved cooperation.

Special arrangements at the national level would be a breeding ground for risks to financial stability, Ms Lautenschläger remarked.

Banking union – questions still unanswered

Sabine Lautenschläger said that many questions still remained unanswered over the establishment of the single European supervisory mechanism.

Most notably, a clear set of rules governing the cooperation between national supervisors and the ECB would have to be drawn up.
















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Developing a common approach to supervision, building up appropriate reporting procedures and recruiting staff were tasks that would certainly keep supervisors busy over the next few months.

But, Ms Lautenschläger added, there was one thing that supervisors could not change, that being the legal basis.

A legal framework for bank supervisors that allowed monetary policy to be strictly segregated from supervisory duties was something that only EU governments and parliaments could create.

“This is a process that will probably take years. But I believe the effort will be worthwhile,” she told journalists.

Ms Lautenschläger also spoke out in favour of a single European resolution mechanism.

It did not make sense to oversee banks at the European level while leaving their resolution to national authorities.

A single resolution mechanism should allow a large bank to be restructured and resolved without seriously jeopardising financial stability, she added.

At the same time, it had to be guaranteed that any resulting losses would be fairly distributed according to source and responsibility.

“If investors receive a premium for risk, they should also be prepared to bear the risk itself.

Taxpayers should be left out of the equation altogether, where possible.”

Legacy risks should not be redistributed

Legacy risks – that is, financial risks that arose at national banks on the watch of national supervisors – should, however, be borne by those
















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responsible for them and not be mutualised, Ms Lautenschläger pointed out.

And there was also the question of whether the losses resulting from future risks should be shouldered solely at the European level. After all, banks’ balance sheets also reflected a large number of national factors such as taxes or economic policy measures.

“As long as economic and fiscal policies are not coordinated, it might make sense for liability risks to be divided between the national and European levels,” she concluded.
















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Remarks by the Superintendent Julie Dickson,Office of the Superintendent of Financial Institutions Canada (OSFI)to the 2013 Financial Services Invitational Forum, Cambridge, Ontario

Introduction

OSFI recently released its Plan and Priorities for 2013-2016, and tonight I am going to highlight and discuss a few of our key priorities and why we chose them: specifically our focus on the increased threat of cyber attacks; low interest rates (including real estate lending); and governance and risk appetite.

Cyber security

At OSFI, cyber risk has become one of our top concerns.

A growing number of North American banks have been hit with denial of service attacks, in some cases causing websites to go down, thereby creating problems for customers trying to do everyday transactions.

Denial of service attacks are costly to defend against and a form of harassment and inconvenience.

But more importantly, they can be a prelude to more serious types of cyber attacks.

Our concern is growing due to the rapid evolution of cyber attacks in terms of frequency, fire power and targets.

This drives home the need for all financial institutions to focus on this threat.
















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At OSFI, we have significantly increased our supervisory resources in the Op-risk area, and have launched a number of initiatives, such as conducting in-depth reviews of institutions’ current cyber protection practices.

There are many stakeholders involved in this effort and a clear focus on this issue by all will serve us well.

Low interest rates

When low interest rates first appeared, the impact was most noticeable on pension plans and insurance companies.

But a sustained low interest rate environment (especially combined with a flat yield curve) affects the banking sector as well.

Banks lose flexibility to adjust the customer deposit rate down, hence introducing a deposit rate floor.

Net interest margins are squeezed, negatively affecting revenues.

Combined with tepid economic growth, reduced demand for loans is further affecting banks.

This environment can provide incentives for banks to grow their earnings asset base by trying to gain market share (a zero sum game), increase fee income activities, reduce expenses, enter new markets, and increase the proportion of higher-yielding assets (both in the lending and investment portfolios).

Products and businesses that are over-reliant on low financing costs tend to grow.

And borrowers are strongly incented to increase leverage.
















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For all these reasons we are very focused on how banks are reacting to current conditions.

We are also cognizant that the longer the low interest rate environment persists, the more interest rate risk can be built up.

No one can predict when, or how fast, rates will start to climb (or indeed, whether they will fall further).

Yet dependence on low interest rates can become significant, meaning that transition to higher rates could be very painful.

The real estate lending market has been a big area of focus for OSFI, because of the significant incentives for consumers to borrow and for banks to maintain revenues, the size of mortgage lending portfolios, the concerns about some markets being overvalued, and the possibility that customers’ debt serviceability could be masked by low interest rates.

Our work has involved major reviews of bank lending portfolios, which was one factor leading to the issuance of Guideline B-20.

Guideline B-20 includes a set of best practices for prudent residential mortgage lending, in all economic conditions.

Our guideline, as well as the steps taken by the Minister of Finance to place restrictions on mortgage insurance, have led to some welcome changes in the market: slower growth in household credit, and a more balanced picture overall.

We are watching this very closely, and it is too early to say whether the job in this area is done.

One other area where risks can hide is in the models that are used by some banks to determine the amount of capital they have to hold for mortgage loans.
















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Accordingly, OSFI has been increasing scrutiny in this area.

Investors are also focused on this, and a number of them have asked questions about the calculation of risk weights, given the limited amount of information that the banks publicly disclose in this regard.

In Canada, the average model risk weights calculated by banks for uninsured mortgages are in the mid-teens.

The lack of information available on risk weights is something we are hoping to address.

There will be enhanced disclosure by domestic systemically important banks in the coming year, pursuant to recommendations from the Enhanced Disclosure Task Force, which was created at the request of the Financial Stability Board.

Some other countries are experiencing frothy real estate markets and have introduced floors on risk weights — sometimes around 15 per cent.

Given that in Canada the uninsured mortgages would tend to be of higher quality than the average loan portfolio in other countries (because uninsured loans in Canada have maximum loan-to-value ratios of 80 per cent), we are generally comfortable with the capital being held by banks using models.

OSFI is also aware that floors can become safe harbours and lead banks and supervisors to pay less attention to the ―appropriate‖ risk weight, especially when it should be well above the floor for a particular bank.

Thus, our focus will continue to be on scrutinizing models currently in use.
















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Risk appetite

OSFI introduced a new corporate governance guideline in 2012, and in 2013 we will be looking at how well it is being implemented, with a particular focus on risk appetite.

It is at times like these when a regulator gets a good feel for whether a bank really has a solid risk appetite framework.

What I mean is that institutions are being incented to move further along the risk curve due to more gradual economic growth, and cooling in the mortgage market.

Now is when products can be developed to appeal to yield-conscious investors.

Now is when conditions might also make the environment look safer than it is — volatility indicators have generally been at very low levels, similar to those just before the 2008 financial crisis.

Now is when low interest rates and the psychology around them – i.e. that there is little risk, along with the misconception that rates cannot go back up in rapid fashion – can lead both borrowers and lenders to overlook certain risks.

And the relative current calm in Europe — despite the flare-up in Cyprus in March — can cause some to become complacent about the risks and the challenges that lie ahead.

Indeed, prudent global bank supervisors are testing the impact of a rapid increase in rates (while rates could go down even further, there is not a lot more room to move in that direction).

Bank supervisors are testing the impact of a rapid rise in rates, not because people think this will happen; rather, it is because of the need to be prepared for all contingencies.
















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Such testing also forces supervisors to think about the reasons for any such scenarios:

If rates rise as growth resumes, the outcome is usually better than if rates rise due to a sudden aversion to risk or serious concern about the future – which could be manifested as an increase in global risk premiums.

An institution’s risk appetite framework should enable its board and management to determine just how much risk an institution is willing to tolerate — not only in terms of the business they put on their books, but also in terms of their tolerance for getting close to any regulatory requirements or limits, and even their tolerance for behaviours that can lead to big losses, such as ill-equipped risk management groups and failure to impose an effective ―three lines of defense‖ model.

In the ―three lines of defense model management is the first line of defense, the various controls and oversight functions (such as risk management) are the second line of defense, and internal audit is the third line of defense.

The natural genetics of a bank are sometimes to give the business lines considerable leeway and to see risk management and internal audit as standing in the way of progress.

This ―wiring reflects the fact that the business is where the money is made – at least in the short term.

A bank cannot consistently make money without regard for sound risk management.

So, structures and processes need to be built as a counterbalance, and to reinforce a broader and longer perspective.

Risk appetite statements are part of the new suite of tools to aid in ensuring that the bank management and the board have a 100 per cent
















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agreement on the balance of power in the institution and the overall risk stance.

Risk appetite statements will be particularly powerful in the future as banks experience unexpected losses and surprises.

The tool should help ensure that management is held accountable and that boards have played their role in having set out clear expectations and accountabilities.

Conclusion

OSFI’s plan and priorities attempt to convey the most important issues as we see them, and indicate where significant time will be spent by bank supervisors.

The effects of low interest rates have set in motion sector-shaping forces to which we must pay attention.

Cyber risk is another issue: Left unchecked, it could seriously impact banking operations.

Effective governance and risk appetite statements will help banks determine acceptable and unacceptable risk exposures and to build systems and processes to keep them on track, so that Canadians can continue to enjoy a safe and sound financial system.

Thank you.
















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Dear Member,

Life is becoming more complex for risk managers. We must have a “forward-looking perspective”, remember?

We have all these new laws and regulations …… but we also have rules, proposals and reports to consider.

Have you ever discovered the common elements of the various initiatives, including the Volcker rule in the United States, the proposals of the Vickers Commission for the United Kingdom, the Liikanen Report to the European Commission?

Leonardo Gambacorta and Adrian van Rixtel from the Monetary and Economic Department of the BIS will help us today to see the common elements and the differences!

This is a great analysis! We read:

The Volcker rule is narrow in scope but otherwise quite strict.

It is narrow in that it seeks to carve out only proprietary trading while allowing market-making activities on behalf of customers.

Moreover, it has several exemptions, including for transactions in specific instruments, such as US Treasury and agency securities.It is strict in that it forbids the coexistence of such trading activities and other banking activities in different subsidiaries within the same group.

It similarly prevents investments in, and sponsorship of, entities that could expose institutions to equivalent risks, such as hedge funds and private equity funds.

That said, it imposes very few additional restrictions on the transactions of banking organisations with other financial firms more generally (eg such as through constraints on lending or funding among them).
















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BiiiCPA)

However, it is worth remembering that the current US legislation does constrain the activities of depository institutions.

The Liikanen Report proposals are somewhat broader in scope but less strict.

They are broader because they seek to carve out both proprietary trading and market-making, without drawing a distinction between the two.

They are less strict because they allow these activities to coexist with other banking business within the same group as long as these are carried out in separate subsidiaries.

The proposals limit contagion within the group by requiring, in particular, that the subsidiaries be self-sufficient in terms of capital and liquidity and that transactions between the legal entities take place on market terms.

Just like the Volcker rule, the proposals do not envisage significant restrictions between the protected banking unit and other financial firms, except that they require the separation of exposures to entities such as hedge funds and special investment vehicles (SIVs) in the trading entity.

The Vickers Commission proposals are even broader in scope but have a more articulated approach to strictness.

BIS Working Papers, No 412 Structural bank regulation initiatives: approaches and implications

Leonardo Gambacorta and Adrian van Rixtel, Monetary and Economic Department

Basel iii Compliance Professionals Association (















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Introduction

In response to the global financial crisis, several advanced economies have either adopted or are considering structural bank regulation measures.

The common element of the various initiatives, including the “Volcker rule” in the United States, the proposals of the Vickers Commission for the United Kingdom, the Liikanen Report to the European Commission and draft legislation in France and Germany, is a mandatory separation of commercial banking from certain securities markets activities.

The proposals mark a paradigm shift.

Since the 1970s, in parallel with the deregulation of financial markets, restrictions on banks’ business lines have been relaxed.

There was a broad consensus that banks which offer a full range of financial services can provide the largest economic benefits in a rapidly growing global economy.

Diversification of business lines, innovations in risk management, market based pricing of risks and market discipline were seen as effective safeguards against financial risks associated with the rapid expansion of large universal banks.

The financial crisis has triggered a reassessment of the economic costs and benefits of universal banks’ involvement in proprietary trading and other securities markets activities.

With hindsight, many large universal banks shifted too many resources to trading books, supported by cheap funding.

The complexity of many banks weakened market discipline, while their interconnectedness increased systemic risk, contributing to contagion within and across firms.Basel iii Compliance Professionals Association















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While the crisis has shown the need to strengthen market-based pricing of risk and market discipline, the heavy burden of bank losses imposed on taxpayers has raised questions about the separation of certain banking activities.

The proposed changes do not go as far as the previous strict separation of commercial from investment banking that existed in some jurisdictions, such as the United States.

But for many countries, notably a number of continental European ones, restrictions on universal banking would be new.

A number of questions arise.

How effective can these measures be in improving financial system soundness?

What can their impact be on banks’ profitability and business models, both nationally and internationally?

This paper explores these issues.

Section 2 considers in more detail the rationale behind the measures as well as their similarities and differences.

Section 3 provides a basis for evaluating their effectiveness in promoting financial stability.

Section 4 discusses their implications for banks’ business models and profitability.

The last section concludes.
















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2. The initiatives: basic rationale and features

The basic rationale for the structural measures is to insulate certain types of financial activities regarded as especially important for the real economy, or significant on consumer/depositor protection grounds, from the risks that emanate from potentially riskier but less important activities.

The line is generally drawn somewhere between “commercial” and “investment” banking businesses, restricting the universal banking model.

Such a separation can, in principle, help in several ways.

First, and most directly, it can shield the institutions carrying out the protected activities from losses incurred elsewhere.

Second, it can prevent any subsidies that support the protected activities (eg central bank lending facilities and deposit guarantee schemes) from lowering the cost of risk-taking and encouraging moral hazard in other business lines.

Third, it can reduce the complexity and possibly size of banking organisations, making them easier to manage, more transparent to outside stakeholders and easier to resolve; this in turn could improve risk management, contain moral hazard and strengthen market discipline.

Fourth, it can prevent the aggressive risk culture of the riskier activities from infecting that of more traditional banking business, thus reducing the scope for conflicts of interest.

In addition, some observers have noted that smaller institutions would reduce the risk of regulatory capture.

All these mechanisms would also help to limit taxpayers’ exposure to financial sector losses.
















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Beyond this basic similarity, structural reform initiatives differ in scope (where they draw the separation line) and strictness (how thick that line is);

The Volcker rule is narrow in scope but otherwise quite strict.

It is narrow in that it seeks to carve out only proprietary trading while allowing market-making activities on behalf of customers.

Moreover, it has several exemptions, including for transactions in specific instruments, such as US Treasury and agency securities.

It is strict in that it forbids the coexistence of such trading activities and other banking activities in different subsidiaries within the same group.

It similarly prevents investments in, and sponsorship of, entities that could expose institutions to equivalent risks, such as hedge funds and private equity funds.

That said, it imposes very few additional restrictions on the transactions of banking organisations with other financial firms more generally (eg such as through constraints on lending or funding among them).

However, it is worth remembering that the current US legislation does constrain the activities of depository institutions.

The Liikanen Report proposals are somewhat broader in scope but less strict.

They are broader because they seek to carve out both proprietary trading and market-making, without drawing a distinction between the two.

They are less strict because they allow these activities to coexist with other banking business within the same group as long as these are carried out in separate subsidiaries.
















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The proposals limit contagion within the group by requiring, in particular, that the subsidiaries be self-sufficient in terms of capital and liquidity and that transactions between the legal entities take place on market terms.

Just like the Volcker rule, the proposals do not envisage significant restrictions between the protected banking unit and other financial firms, except that they require the separation of exposures to entities such as hedge funds and special investment vehicles (SIVs) in the trading entity.

The Vickers Commission proposals are even broader in scope but have a more articulated approach to strictness.

They are broader in that they exclude a larger set of banking business from the protected entity, including also securities underwriting and secondary market purchases of loans and other financial instruments.

A very narrow set of retail banking business must be within the protected entity (retail deposit-taking, overdrafts to individuals and loans to small and medium-sized enterprises (SMEs)); and another set may be conducted within it (eg some other forms of retail and corporate banking, including ancillary operations to hedge risks to support them).

The approach to strictness is more articulated because it involves both intragroup and inter-firm restrictions (the “ring fence”).

As in the Liikanen Report, protected activities can coexist with others in separate subsidiaries within the same group but subject to intragroup constraints that are somewhat tighter, including on the size of the linkages.

Moreover, a series of restrictions limit the extent to which the banking unit within the ring fence can interact with other financial sector firms.

An in-depth exploration of the economic underpinnings of the reforms is provided in Vickers (2012).
















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Recent French and German reform proposals can be seen as adaptations of the Liikanen proposal.

The new French banking law proposal adopts the subsidiarisation model, but allows the deposit-taking institution to carry out more activities, including market-making within limits.

A new draft law on the separation of retail and some investment banking activities submitted to the German Parliament considers separation of retail banking if assets devoted to proprietary or high frequency trading and hedge fund financing operations are relatively large in relation to the banks’ balance sheet.

3. Implications for financial stability and systemic risk

Do the various structural regulatory initiatives strengthen financial stability?
















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The mechanisms listed above have intuitive appeal.

The question, though, is how far the various measures would be effective in realising the hoped-for benefits and whether they may have unintended side effects.

While it is difficult to provide an answer, it is possible to lay out the relevant considerations.

From a financial stability perspective, a precondition for the initiatives to be helpful is that banks which combine commercial and securities business are less safe or that their failure is more costly to the community.

The evidence suggests that the costs of failure of universal banks can be larger, since universal banking encourages size and complexity.

The evidence on the probability of failure is much more indirect and mixed but, on balance, points in a similar direction.

For instance, a general conclusion is that growing reliance on non-interest income – a very rough proxy for more investmentbanking-like activities – has not resulted in lower earnings volatility or adecline in bank systematic risk, as derived from stock market returns.

Similarly, Box 1 provides tentative evidence that profits of somewhat more diversified banks are higher, but also more volatile.

Moreover, risk diversification benefits appear to be mostly restricted to certain ranges of income sources or to geographical and loan portfolio diversification.

Against this backdrop, a number of questions about the design of structural regulation arise.

A first question concerns where the separation line is drawn.
















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Here, the philosophy behind the proposals is quite different.

The Liikanen Report opts for combining proprietary trading andmarket-making activities on the grounds that the line between the two is too fuzzy and hard to enforce – a controversial issue with the Volcker rule in the United States.

And the Vickers Report takes a very narrow view of the types of activity that need to be protected on the grounds that disruptions there can have a large impact on economic activity.

Moreover, while the Vickers Report argues for more stringent capital requirements for the protected activities, on importance grounds, the Liikanen Report argues for potentially more stringent ones for the trading business (and possibly for real-estate related lending), on risk grounds.

It is not unequivocally clear that the concentration of trading activities in separate entities will enhance financial stability.

These firms may have less stable, wholesale market-based funding structures, while still being highly interconnected with other parts of the global financial system.

This could give rise to considerable contagion risk, as demonstrated by the repercussions of the failure of Lehman Brothers on global bank funding markets.

A second question concerns the thickness of the line.

How effective is it in insulating the protected parts of the banking business?

One typical criticism of allowing the activities to coexist within the same group is that, especially at times of stress, the line will prove not sufficiently strong as reputational considerations loom large.
















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In turn, any expectation that the line will turn out to be ineffective would weaken market discipline.

Moreover, only the Vickers Report proposes major additional restrictions on the interactions between the protected banking units and the rest of the financial system.Their effectiveness is yet to be tested.

A third question concerns the possibility of sidestepping the line altogether.

The worry is that risky activities could migrate outside the regulatory perimeter.

In fact, one reason why the Liikanen Report opts for subsidiarisation rather than full separation is to limit this risk.

Migration would be a worry if those activities proved to be systemic in nature.

All this puts a premium on effective resolution mechanisms.

While structural separation may help resolvability, the benefits of the proposals do hinge on the adequacy of the resolution schemes in place.

The Liikanen Report, for instance, suggests several complementary steps in this area.

Effective resolution schemes are especially important if, contrary to expectations, the business lines left outside the protective umbrella result in systemic disruptions.

In this case, the pressure to “bail out” the legal entities involved could be very strong: this would put taxpayers’ money on the line ex post and raise moral hazard concerns ex ante.
















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Yet another question concerns the interaction between national structural bank regulation and international banking regulation, such as Basel I I I.

The two types of regulation differ in approach and scope.

The latter takes banks’ business models as given and imposes capital and liquidity requirements that depend on the riskiness of a banking group’s business.

The former imposes constraints on specific activities and types of business.

From this angle, the two approaches can be seen as complementary.

Indeed, certain aspects of structural regulation – restrictions on leverage for ring-fenced institutions – may reinforce elements of Basel I I I .

At the same time, there may be challenges.

One risk, already alluded to, is that banks may shift activities outside the perimeter of consolidated regulation in response to structural regulation.

Another risk is that structural regulation, especially if national approaches differ, will create business models that are difficult to supervise.

For example, resolution strategies may be rather complex to design for globally operating banks that have to face increasing heterogeneity in permitted business models at the national level.

Finally, structural regulation may lead to different capital and liquidity requirements for the core banking and trading entities within a single banking group.

Although this may be intended, in practice it has implications for regulatory standards applied at the consolidated level.
















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Some new evidence on risk diversification and economies of scope

This box presents some new preliminary evidence on the impact of combining different business lines on the risk return profile of banking organisations.

A novel aspect is that the analysis allows for the possibility of non-linear effects, so that the benefits may exist only within certain ranges.

The evidence is based on a sample of 108 international diversified banks. Product differentiation is proxied by the ratio of non-interest income (trade revenues, fees and commissions for services) to total income.

On balance, the evidence indicates that benefits do accrue up to a certain degree of diversification in terms of return on equity (ROE).

However, bank profitability tends to be more volatile for more diversified banks (for details of the econometric analysis, see Annex B).

The two lines in the upper part of the graph below represent the result of a panel regression of bank ROE on the ratio of non-interest to total income (diversification ratio) and its square.

The regression includes fixed effects for each bank, as well as a country year interaction term to control for idiosyncratic and macro factors.

The curves are drawn on the basis of the two estimated parameters.

Blue refers to the pre-crisis period (2000–07), while red indicates the crisis period (2008–11).

The symbols indicate average values obtained by grouping banks by jurisdiction in the two sub-periods.
















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The results indicate that revenue diversification does increase ROE, but only up to a point, after which ROE declines.

While the optimal mix may have shifted somewhat towards a smaller share of non-interest income in the post-crisis period, the results of this exercise suggest that economies of scope do exist only up to a certain degree of product diversification.

The green line in the lower panel represents the result of a cross-sectional regression of banks’ coefficients of variation of ROE – a proxy for risk – on the diversification ratio, its square and country fixed effects.

The green symbols indicate average values obtained by grouping banks by jurisdiction over the period 2000–11.The econometric analysis finds that ROE volatility also increases, up to a point, with revenue diversification, after which it declines again
















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To read this excellent paper:http://www.bis.org/publ/work412.pdf



http://www.bis.org/publ/work412.pdf




































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Challenges for banking regulation and supervision in the monetary union

Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the Deutscher Sparkassentag 2013, Dresden.

1. Introduction

Mr Fahrenschon, Mr Genscher, Mr Steinbrück, Ladies and

Gentlemen It gives me great pleasure to speak to you today at

the Sparkassentag2013.

For more than three years now, the financial, economic and sovereign debt crisis has been the dominant topic in the European monetary union and, at the same time, its biggest test.

Dated from the outbreak of the crisis on the US real estate market in the summer of 2007, this is already the fifth year in which we have been in crisis mode.

That said, Germany is still in relatively good shape – despite undergoing by far its worst postwar slump in 2009 and despite being one of the first countries to be affected by the spillover from the crisis on the US real estate market.

Germany has had to use considerable financial resources to stabilise the financial system.

Savings banks, too, felt the effects of the crisis – although they did so directly only in a few cases; mostly it was through their investments.
















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Even so, savings banks had a stabilising effect during the

crisis. They were a robust and reliable source of lending.

And they strengthened their capital base.

That is a major precondition for overcoming the challenges that are on the horizon – such as sustained pressure on margins and increased risk provisioning for the next economic downturn, which is bound to come at some time.

The various aspects of the crisis – first, only a financial crisis, then an economic crisis and, finally, the sovereign debt crisis – which is still with us – have prompted a large number of discussions, changes and upheavals.

This applies to the role of central banks and to the expectation of what central banks can and should – or cannot and should not – do to help resolve the crisis.

It also applies to the financial system and the way it is perceived by the public at large.

Mr Steinbrück will undoubtedly explain in more detail soon how he wishes to “tame the financial markets”.

Overcoming the crisis requires considerable efforts in many areas.

But, as important as the issues of government debt, monetary policy and competitiveness are, I would now like to turn my attention to banking regulation and supervision.

2. Reform of financial market regulation – objectives and measures
















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Roughly ten years ago, the principal issue in banking regulation wasBasel I I and the regulatory changes it brought about.

At the time, only very few of those involved could have guessed that, just a short while later, the political agenda would be dominated by probably the most all-encompassing changes ever to the regulatory framework of the financial markets in the shape of Basel I I I and further regulatory initiatives – and all starting off with an awe-inspiring zeal for reform.

Basel I I took five years from the first consultation paper up to a policy agreement on the new principles.

Basel I I I only needed one year for that.

The new regulatory measures, which are designed to have a longer-term impact, are focused less on the acute management of the crisis and are geared more to preventing new crises from emerging in the future in the first place.

The changes initiated since the G20 meeting in Washington in November 2008, have the key objective of making financial systems more stable and therefore more resistant to shocks.

Furthermore, the aim is that the taxpayer no longer has to step in to correct difficulties in the financial system.

And it was also imperative to ensure that the financial system has a clear value added for the economy as a whole.

There is good empirical evidence that growth in the financial sector also strengthens a country’s overall economic growth.

On the other hand, studies by the IMF indicate that, along with increasing financial sector growth, this effect becomes weaker and might even go into reverse.
















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It is not necessary to agree with Paul Volcker’s deliberately provocatively worded opinion that there hasn’t been a useful innovation in the financial industry since the invention of the ATM, and derivatives do not have to be regarded as financial weapons of mass destruction.

Nevertheless, if the financial sector is too large, there is evidently an increase in the risks to stability and the percentage of less beneficial transactions.

Cyprus is undoubtedly a telling example and provides an urgent warning that the supervisory and regulatory requirements have to keep pace with the size of the financial system relative to economic power.

A stable and efficient financial system that enhances growth and prosperity can be achieved only with a whole package of measures.

With this in mind, the G20, at their meeting in Washington at the end of 2008, defined various fields in which there was a particular need for action.

Let me outline a few major points.

•Risks and mutual interdependencies in the financial system have to be more transparent.

•Banks should hold more and higher-quality capital so as to better shoulder losses themselves.

•Systemically important financial institutions – the hubs of the financial system – must meet special, stricter requirements, for example, with regard to capital adequacy and risk management.

•In the event of difficulties, it must also be possible to resolve or restructure large, international and particularly interconnected banks.
















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•Areas of the financial system which have hitherto been subject to no – or very little – regulation, but which perform tasks similar to those of banks and are linked directly or indirectly to the banking system, should be better regulated – the shadow banking system and derivatives trading are key issues here.

At this point, I would like to refer to a fundamental point that is particularly important to me.

The connecting link between the stated aims and the means of achieving them is a strengthening of the principle of liability.

In his Principles of Economic Policy, Walter Eucken declared the principle of liability to be a constituent principle of the market economy, referring to the established legal principle that “those who benefit should also bear the costs”.

Ensuring that players in the financial system have to, and are able to, better bear losses and risks themselves in future will make the financial system more stable and more focused on transactions that are beneficial to the economy as a whole and make the taxpayer the last rather than the first line of defence again in the event of crises.

Liability is therefore a step towards overcoming the crisis and not a negative concept – quite the opposite!

It is the counterpart of the freedom to take decisions as an entrepreneur or investor in a self-determined manner.

Freedom of choice and liability therefore belong together as a conceptual pair or two sides of the same coin.

That applies incidentally to the financial system just like it does to the member states within the monetary union.
















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Some of the measures taken during the crisis undermine the principle of liability rather than strengthening it.

It is against that background that we should also assess the newly resurfaced debate in Europe on the right course in fiscal policy.

Of course, a major role is played by the political acceptability of the reform course that has been embarked on.

At least with regard to the programme countries, however, more time also means greater recourse to European solidarity: more funds are needed from the rescue package or maybe even transfers that have to be accepted politically by the “donor countries”.

The non-programme countries, in turn, should not repeat the mistakes of 2004 and not interpret the strengthened Stability Pact too flexibly when it is first put to the test.

France, in particular, has an important role in setting an example in terms of the credibility of the rules and confidence in the sustainability of public finances.

But back to regulation.

At times, concerns are raised or the criticism is made that the implementation of these noble intentions is not making much headway and that enthusiasm for reform has waned significantly.

I can quite understand a certain amount of impatience.

For example, with regard to the shadow banking system, an total integrated package with recommendations on regulation will not be ready until September and it will be even longer before concrete decisions have been made and enshrined in law.
















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The reform objective of clearing all standardised OTC derivatives through central counterparties and recording them by the end of 2012 has not been achieved.

There are still several sticking points – starting with a lack of standards and ranging as far as data protection problems, and, in particular, the impasse in negotiations on cross-border coordination between the United States and Europe.

Progress has also been mixed on the “too big to fail” issue – more specifically the implementation of internationally agreed standards for resolution regimes.

Here we have to contend with a certain tendency toward national protection and the fragmentation of the financial markets.

Otherwise there is the threat of competitive distortions and new risks to stability.

Just recently, Börsenzeitung gave a categorical and lucid warning against a new nationalism on the part of the supervisors.

The US proposals on regulating the capital and liquidity of foreign institutions are a prime negative example of this.

A great deal therefore still needs to be done and we have to maintain political interest in a stable financial system.

Regulation is not an end in itself, however.

The costs and benefits of the planned measures, including theirside-effects and interactions, have to be weighed up against one another.

This type of analysis is time-consuming and input-intensive, especially since the particular given country-specific aspects also have to be taken into consideration when the measures are actually implemented.
















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And many of the implications are not immediately obvious, but still have the potential to be highly charged.

One example of this is the planned financial transaction tax and its implications for monetary policy.

While a fundamental consensus has been achieved on the introduction of the tax, the unintended side-effects might be considerable.

In its currently envisaged form, the tax would also cover collateralised money market transactions, known as repo transactions, and would cause considerable harm to the repo market.

The repo market plays a key role in the redistribution of liquidity among commercial banks, however.

If the market is not able to function properly, the relevant transactions will be shifted to the Eurosystem and central banks will remain heavily involved in the redistribution of liquidity among banks long after the crisis is over.

From a monetary policy standpoint, therefore, a very critical view has to be taken of the financial transaction tax in its current form, and this shows how important it is to scrutinize regulatory measures before they are introduced.

But, again, that takes time.

However, this does not mean that regulatory reform has been a complete failure, because a whole series of measures is now in place with which the principle of liability is being strengthened.

Let me just mention the example of stricter capital requirements in the form of Basel I I .5 and Basel I I I.
















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At the end of February this year, political agreement was reached in the European Union concerning the implementation of Basel I I I through the Capital Requirements Directive IV and the Capital Requirements Regulation.

The European Parliament also gave the draft legislation its seal of approval just last week.

It may seem ambitious, but implementation of Basel I I I will therefore be possible in Europe from the beginning of 2014.

Basel I I I will take full effect in 2019.

Banks are using the interim period to raise their capital to the required level.

In the case of credit growth, however, there is the opposite fear is that the reforms are proving too successful.

Deleveraging is still urgently required to overcome the crisis.

However, this deleveraging process is also a contributory factor in the low growth rates for lending in some European countries.

Developments in lending therefore reflect a necessary correction and are not in themselves an indication of the need for further economic policy action.

Incidentally, the cost-benefit analyses conducted before the adoption of Basel I I I show that these measures will, at most, have a very limited impact in terms of dampening economic growth.

Sadly, however, there are still those in the banking industry – especially in the United States, but also in Europe – who are campaigning against the introduction of higher capital requirements.
















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In a recently published book, Bonn-based economist Martin Hellwig examined the arguments which are advanced in this context.

According to Mr Hellwig and his co-author, there is no simpler and more cost-effective approach to crisis prevention than reducing large banks’ dependency on borrowed money – in other words, increasing their capital requirements.

At the same time, it is also true that the large number of different regulatory initiatives makes it difficult to maintain an overview and evaluate the consequences.

Acting on the principle that it is better to be thorough than hasty, it would therefore be necessary to estimate the overall impact of the regulatory agenda and evaluate it in a cost-benefit analysis.

Above and beyond all these regulatory reforms, Europe has another top priority on its agenda – the banking union and the organisation of banking supervision.

3. Banking supervision – on the road to a European banking union

The crisis has highlighted the need for a general overhaul of the financial market architecture of monetary union.

The banking union is closing an open flank that was already identified but not closed when the currency union was set up.

If done properly, the banking union must have two pillars – a single supervision and a single resolution and restructuring mechanism.

The SSM (single supervisory mechanism) and SRM (single resolution mechanism) are two more ingredients to the alphabet soup that is
















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European crisis policy, but, in my opinion, they are two very important ingredients.

Creating a banking union involves a large amount of institutional construction work.

Preparation of the relevant legal groundwork is in full swing at EU level for both pillars.

In all likelihood, the single supervisory mechanism at least will be able to commence operation in the second half of 2014.

3.1 Single supervisory mechanism (SSM) under the ECB

The aim of the single supervisory mechanism (SSM) is to ensure that the same high standard of supervision applies throughout Europe, thus consistently containing excessive risks.

It aims to make developments and risks in national banking systems more transparent and prevent domestic problems being glossed over.

It will also be better able to monitor cross-border interactions than the sum total of national supervisors.

The SSM will not only supervise the most important banks

directly. Not just the bank’s absolute size or cross-border

activities are ofrelevance, but also its significance for the respective economy.

The three most important banks of each member state will therefore be among the institutions which are supervised directly, irrespective of their absolute size.

In total, some 130 banks throughout Europe will therefore be under the direct supervision of the SSM.
















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The SSM is to be placed under the auspices of the ECB.

The Bundesbank is unhappy with this arrangement, as it gives rise to potential conflicts of interest between monetary policy and supervision on the Governing Council.

As Klaas Knot put it, “letting banking supervision get started within the ECB so that it at least gets off the ground.”

However, I very much hope that this solution is not the final stage of development and that, in the medium term at least, the EU treaties will be amended to ensure a clear separation of monetary policy and supervisory responsibilities.

In terms of the distribution of responsibilities within Germany, it is crucial that the Bundesbank remain firmly involved in banking supervision so that we can share our extensive expertise and utilise the findings from supervisory activities for other tasks.

This is even more important since the Bundesbank recently took on an even more significant role in the monitoring of financial stability in Germany through the Financial Stability Committee.

In this context, we are also keeping a watchful eye on the situation in the real estate market, which is no doubt a topic in your discussions, too.

For one thing, the crisis has once again underlined the risk ofexaggerations on the real estate market.

A recent Bundesbank discussion paper1 even concludes that the “Great Recession” of 2008/ 2009 and the weak recovery that followed were largely due to problems in the real estate sector and, moreover, that negative shocks on the real estate market have a more significant impact on the real economy than positive shocks.
















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For another, there has been a marked rise in real estate prices in Germany recently – by around seven per cent in major cities in the last two years, for example.

However, the Bundesbank does not currently perceive any credit-driven bubble.

3.2 Resolution mechanism

To achieve its full potential, the single supervisory mechanism needs to be augmented by a single resolution mechanism (SRM).

As in the case of the SSM, a solution that satisfies the requirements of European law ultimately calls for an amendment of the EU treaties.

This has been quite rightly been emphasised by Federal Minister of Finance.

Essentially, the SRM is an important embodiment of the principle of liability.

After all, liability also means that, in case of doubt, it should be possible to resolve banks without significant economic harm to the economy as a whole – and to see this through if the worst comes to the worst.

Resolving and closing a bank is by no means a cure-all and it is certainly not an easy task.

Where possible, things should not be allowed to go that far in the first place.

And that is where strict capital requirements, effective supervision and deposit business shielded from riskier business lines come into play.

The banking union also needs to be supported by an appropriate regulatory structure.
















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In other words, banks must be required to hold sufficient capital for claims on government and not be allowed to accumulate them on too large a scale in future.

It would be dishonest to assert that all these measures will make it impossible for banks to get into difficulties in the future.

Therefore, if that actually does happen at some time, having a reliable procedure in place that creates planning certainty will be all the more important.

With this in mind, the main task of the single resolution mechanism that is currently being developed is to ensure the correct sequence of liability is applied in such a process.

If a bank is to be restructured or resolved, equity investors should be the first port of call, followed by the providers of debt capital, and only then the depositors, taking due account of deposit guarantees in the respective member states.

National and European taxpayers should only be called upon as a very last resort.

If public funds are used, the question arises as to how liability is to be apportioned between the European level and the member states.

Joint liability of all member states can only exist at EU level for those institutions directly supervised by the SSM.

In such a case, it is also appropriate, however.

Having said that, it is unclear whether the member states are to be discharged of all liability or whether a certain percentage of the costs is still to be apportioned to them.
















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The latter is suggested by fact that, in the current framework of monetary union, member states are still able to exert a perceptible influence on financial stability through their national economic and financial policies – say, encouraging the emergence of a real estate bubble through special tax benefits.

This should be kept separate from the treatment of balance-sheet burdens that arose while the various banking systems were still under national supervision.

If the unity of liability and control is also taken seriously on this point, too, the member states in question should themselves also be liable for these burdens as well.

As the case of Spain shows, the ESM is ready to step in if raising the necessary funds on the capital market proves difficult.

Ultimately, what to do with legacy debts is a supervisory problem, not a question that has to be answered by politicians.

If politicians actually do decide to communitise legacy debts, it will be nothing other than a financial transfer.

Transparency for members of the general public and taxpayers then also requires that this transfer be disclosed as such.

The single resolution mechanism reduces uncertainty and mitigates the risk of contagion effects.

The discretionary approach taken in the case of Cyprus is therefore not a blueprint for similar situations that may arise in other countries.

Events in Cyprus have shown that a bail-in is possible.
















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But they have also highlighted the importance of establishing a clear sequence of liability and an orderly procedure, especially if turbulence due to depositor uncertainty is to be avoided.

After all, the debate on to the extent of depositor involvement has caused major uncertainty – in other countries, too.

This was all the more the case as there was discussion about the possibility of using deposits that were actually protected by the Cypriot deposit guarantee scheme.

In connection with the security of customer deposits at banks, the question of whether a banking union should not include a single Europe-wide deposit guarantee scheme is also regularly under of discussion.

The German Savings Bank and Giro Association has repeatedly expressed its very critical stance regarding a single European deposit guarantee scheme.

And, indeed, it is important not to put the cart before the horse in tackling such projects.

Given the current degree of integration among member states and financial systems, a single Europe-wide deposit guarantee scheme would not be practical.

Even more than is the case for the costs of resolution and restructuring, it is true to say that bank balance sheets reflect economic developments in the individual member states that are currently beyond European control. Otherwise, taxpayers who are not involved would be made liable for mistakes in other countries without being responsible for those mistakes.

It is much more important to set up the single supervisory mechanism and single resolution mechanism and put them on a firm footing.
















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4. Conclusion

In summarising my thoughts, I would like to stress that, yes, reforming financial market regulation is still a major task, but it is making headway, both in Europe and internationally.

This means that, step by step, we are approaching the goal of bringing about an overall reduction in the risks to individual economies and the monetary union which stem from the financial systems without undermining their efficiency.

A key task in designing specific reforms is to give a more scope again to the principle of liability.

The Bundesbank is diligently pursuing this aim by bringing its expertise to bear and, if it is necessary, is in for the long haul.

Thank you for your attention.
















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MONETARY AND FINANCIAL DEVELOPMENTSMarch 2013

Price Conditions: Headline inflation, as measured by the annual percentage change in the Consumer Price Index (CPI) was marginally higher at 1.6% in March 2013 (February: 1.5%).

Inflation in the transport category rose by 1.0% (February: 0.4%), due mainly to the upward adjustment in the price of RON97 petrol to RM2.90 per litre from RM2.70 per litre.

Meanwhile, prices in the clothing and footwear category declined at a slower rate of 0.5% (February: -1.2%) due to the upward adjustment in prices after the Chinese New Year sales.

Inflation in the food and non-alcoholic beverages category, however, remained unchanged at 3.3%.

Monetary Conditions: Interbank rates were stable in March. In terms of retail lending rates, the average base lending rate (BLR) of commercial banks remained unchanged at 6.53%.

Retail deposit rates were also relatively stable during the

period. Broad money (M3) grew by 9.1% in March on an

annual basis,underpinned by the extension of credit to the private sector.

On a monthly basis, the expansion was moderated somewhat by Government fundraising.

Net financing to the private sector grew at a slower pace in March (11.0%) due to a moderation in the growth of both outstanding banking system loans and net issuances of private debt securities (PDS).
















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While the growth of business loans outstanding moderated during the month following large repayments, loans disbursed to businesses remained strong with more loans extended mainly to the manufacturing; wholesale and retail, restaurants and hotel; finance, insurance and business services, and construction sectors.

Loans to households also grew at a more moderate pace.

The overall loan demand, however, remained strong with higher loan applications from both businesses and households.

Banking System: Capitalisation remained strong under the new Basel I I I Capital Adequacy Framework with common equity tier 1 capital ratio, tier 1 capital ratio and total capital ratio of 12.2%, 13.1% and 14.5% respectively.

The level of net impaired loans improved to 1.3% of net loans, while the loan loss coverage remained well above 90%.

Exchange Rates and International Reserves: In March, the ringgit broadly appreciated against the currencies of Malaysia’s major trading partners with the exception of the Chinese renminbi, against which the ringgit depreciated by 0.1%.

Ringgit’s strength was due mainly to the release of positive domestic and global economic data, which contributed to favourable investor sentiment towards domestic and regional financial assets.

The ringgit appreciation, however, was partially offset by uncertainties surrounding the banking crisis in Cyprus.

In April, the ringgit continued to appreciate against the currencies of Malaysia’s major trading partners.

The international reserves of Bank Negara Malaysia stood at RM432.1 billion (equivalent to USD139.9 billion) as at 15 April 2013, sufficient to
















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finance 9.9 months of retained imports and are 4.6 times the short-term external debt.

Bank Negara Malaysia 30 April 2013
















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Chairman Ben S. BernankeAt the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bankof Chicago, Chicago, I llinois

Monitoring the Financial System

We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains.

Our economy has not yet fully regained the jobs lost in the recession that accompanied the financial near collapse.

And our financial system--despite significant healing over the past four years--continues to struggle with the economic, legal, and reputational consequences of the events of 2007 to 2009.

The crisis also engendered major shifts in financial regulatory policy and practice.

Not since the Great Depression have we seen such extensive changes in financial regulation as those codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in the United States and, internationally, in the Basel I I I Accord and a range of other initiatives.

This new regulatory framework is still under construction, but the Federal Reserve has already made significant changes to how it conceptualizes and carries out both its regulatory and supervisory role and its responsibility to foster financial stability.

In my remarks today I will discuss the Federal Reserve's efforts in an area that typically gets less attention than the writing and implementation of new rules--namely, our ongoing monitoring of the financial system.
















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Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes.

However, in recent years, we have both greatly increased the resources we devote to monitoring and taken a more systematic and intensive approach, led by our Office of Financial Stability Policy and Research and drawing on substantial resources from across the Federal Reserve System.

This monitoring informs the policy decisions of both the Federal Reserve Board and the Federal Open Market Committee as well as our work with other agencies.

The step-up in our monitoring is motivated importantly by a shift in financial regulation and supervision toward a more macroprudential, or systemic, approach, supplementing our traditional microprudential perspective focused primarily on the health of individual institutions and markets.

In the spirit of this more systemic approach to oversight, the Dodd-Frank Act created the Financial Stability Oversight Council (FSOC), which is comprised of the heads of a number of federal and state regulatory agencies.

The FSOC has fostered greater interaction among financial regulatory agencies as well as a sense of common responsibility for overall financial stability.

Council members regularly discuss risks to financial stability and produce an annual report, which reviews potential risks and recommends ways to mitigate them.

The Federal Reserve's broad-based monitoring efforts have been essential for promoting a close and well-informed collaboration with other FSOC members.
















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A Focus on Vulnerabilities

Ongoing monitoring of the financial system is vital to the macroprudential approach to regulation.

Systemic risks can only be defused if they are first identified.

That said, it is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis.

To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities.

The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will.

For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages.

In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks.

Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system.

Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises; the collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets which greatly increased its impact.Basel iii Compliance Professionals Association















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Of course, monitoring can and does attempt to identify potential triggers--indications of an asset bubble, for example--but shocks of one kind or another are inevitable, so identifying and addressing vulnerabilities is key to ensuring that the financial system overall is robust.

Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks.

Two other related points motivate our increased monitoring.

The first is that the financial system is dynamic and evolving not only because of innovation and the changing needs of the economy, but also because financial activities tend to migrate from more-regulated toless-regulated sectors.

An innovative feature of the Dodd-Frank Act is that it includes mechanisms to permit the regulatory system, at least in some circumstances, to adapt to such changes.

For example, the act gives the FSOC powers to designate systemically important institutions, market utilities, and activities for additional oversight.

Such designation is essentially a determination that an institution or activity creates or exacerbates a vulnerability of the financial system, a determination that can only be made with comprehensive monitoring and analysis.

The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable.
















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Indeed, it may be that prolonged economic stability is a double-edged sword.

To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduce the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities.

Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them.

The Federal Reserve's Financial Stability Monitoring Program So, what specifically does the Federal Reserve monitor?

In the remainder of my remarks, I'll highlight and discuss four components of the financial system that are among those we follow most closely: systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

Systemically Important Financial Institutions

SIFIs are financial firms whose distress or failure has the potential to create broader financial instability sufficient to inflict meaningful damage on the real economy.

SIFIs tend to be large, but size is not the only factor used to determine whether a firm is systemically important; other factors include the firm's interconnectedness with the rest of the financial system, the complexity and opacity of its operations, the nature and extent of its risk-taking, its use of leverage, its reliance on short-term wholesale funding, and the extent of its cross-border operations.

Under the Dodd-Frank Act, the largest bank holding companies aretreated as SIFIs; in addition, as I mentioned, the act gives the FSOC the
















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power to designate individual nonbank financial companies as systemically important.

This designation process is under way.

Dodd-Frank also establishes a framework for subjecting SIFIs to comprehensive supervisory oversight and enhanced prudential standards. For all such companies, the Federal Reserve will have access to confidential supervisory information and will monitor standard indicators such as regulatory capital, leverage, and funding mix.

However, some of these measures, such as regulatory capital ratios, tend to be backward looking and thus may be slow to flag unexpected, rapid changes in the condition of a firm.

Accordingly, we supplement the more standard measures with other types of information.

One valuable source of supplementary information is stress testing.

Regular, comprehensive stress tests are an increasingly important component of the Federal Reserve's supervisory toolkit, having been used in our assessment of large bank holding companies since 2009.

To administer a stress test, supervisors first construct a hypothetical scenario that assumes a set of highly adverse economic and financial developments--for example, a deep recession combined with sharp declines in the prices of houses and other assets.

The tested firms and their supervisors then independently estimate firms' projected losses, revenues, and capital under the hypothetical scenario, and the results are publicly disclosed.

Firms are evaluated both on their post-stress capital levels and on their ability to analyze their exposures and capital needs.
















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Stress testing provides a number of advantages over more-standard approaches to assessing capital adequacy.

First, measures of capital based on stress tests are both more forward looking and more robust to "tail risk"--that is, to extremely adverse developments of the sort most likely to foster broad-based financial instability.

Second, because the Federal Reserve conducts stress tests simultaneously on the major institutions it supervises, the results can be used both for comparative analyses across firms and to judge the collective susceptibility of major financial institutions to certain types of shocks.

Indeed, comparative reviews of large financial institutions have become an increasingly important part of the Federal Reserve's supervisory toolkit more generally.

Third, the disclosure of stress-test results, which increased investor confidence during the crisis, can also strengthen market discipline in normal times.

The stress tests thus provide critical information about key financial institutions while also forcing the firms to improve their ability to measure and manage their risk exposures.

Stress-testing techniques can also be used in more-focused assessments of the banking sector's vulnerability to specific risks not captured in the main scenario, such as liquidity risk or interest rate risk.

Like comprehensive stress tests, such focused exercises are an important element of our supervision of SIFIs.

For example, supervisors are collecting detailed data on liquidity that help them compare firms' susceptibilities to various types of funding stresses and to evaluate firms' strategies for managing their liquidity.Basel iii Compliance Professionals Association















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Supervisors also are working with firms to assess how profitability and capital would fare under various stressful interest rate scenarios.

Federal Reserve staff members supplement supervisory and stress-test information with other measures.

For example, though supervisors have long appreciated the value of market-based indicators in evaluating the conditions of systemically important firms (or, indeed, any publicly traded firm), our monitoring program uses market information to a much greater degree than in the past.

Thus, in addition to standard indicators--such as stock prices and the prices of credit default swaps, which capture market views about individual firms--we use market-based measures of systemic stability derived from recent research.

These measures use correlations of asset prices to capture the market's perception of a given firm's potential to destabilize the financial system at a time when the broader financial markets are stressed; other measures estimate the vulnerability of a given firm to disturbances emanating from elsewhere in the system.

The further development of market-based measures of systemic vulnerabilities and systemic risk is a lively area of research.

Network analysis, yet another promising tool under active development, has the potential to help us better monitor the interconnectedness of financial institutions and markets.

Interconnectedness can arise from common holdings of assets or through the exposures of firms to their counterparties.

Network measures rely on concepts used in engineering, communications, and neuroscience to map linkages among financial firms and market activities.Basel iii Compliance Professionals Association















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The goals are to identify key nodes or clusters that could destabilize the system and to simulate how a shock, such as the sudden distress of a firm, could be transmitted and amplified through the network.

These tools can also be used to analyze the systemic stability effects of a change in the structure of a network.

For example, margin rules affect the sensitivity of firms to the conditions of their counterparties; thus, margin rules affect the likelihood of financial contagion through various firms and markets.

Shadow Banking

Shadow banking, a second area we closely monitor, was an important source of instability during the crisis.

Shadow banking comprises various markets and institutions that provide financial intermediation outside the traditional, regulated banking system.

Shadow banking includes vehicles for credit intermediation, maturity transformation, liquidity provision, and risk sharing.

Such vehicles are typically funded on a largely short-term basis from wholesale sources.

In the run-up to the crisis, the shadow banking sector involved a high degree of maturity transformation and leverage.

Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos).
















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The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal.

As it turned out, the ultimate investors did not fully understand the quality of the assets they were financing.

Investors were lulled by triple-A credit ratings and by expected support from sponsoring institutions--support that was, in fact, discretionary and not always provided.

When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran.

Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy.

Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation.

To finance their own and their clients' securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders.

The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free.

As questions emerged about the nature and value of collateral, worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely.
















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Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation.

To monitor intermediation by broker-dealers, the Federal Reserve in 2010 created a quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms, which asks dealers about the credit they provide.

Modeled on the long-established Senior Loan Officer Opinion Survey on Bank Lending Practices sent to commercial banks, the survey of senior credit officers at dealers tracks conditions in markets such as those for securities financing, prime brokerage, and derivatives trading.

The credit officer survey is designed to monitor potential vulnerabilities stemming from the greater use of leverage by investors (particularly through lending backed by less-liquid collateral) or increased volumes of maturity transformation.

Before the financial crisis, we had only very limited information regarding such trends.

We have other potential sources of information about shadow

banking. The Treasury Department's Office of Financial

Research and FederalReserve staff are collaborating to construct data sets on triparty andbilateral repo transactions, which should facilitate the development of better monitoring metrics for repo activity and improve transparency inthese markets.

We also talk regularly to market participants about developments, paying particular attention to the creation of new financial vehicles that foster greater maturity transformation outside the regulated sector, provide funding for less-liquid assets, or transform risks from forms that are more easily measured to forms that are more opaque.
















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A fair summary is that, while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities.

For example, although money market funds were strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010, the possibility of a run on these funds remains--for instance, if a fund should "break the buck," or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008.

The risk is increased by the fact that the Treasury no longer has the power to guarantee investors' holdings in money funds, an authority that was critical for stopping the 2008 run.

In November 2012, the FSOC proposed for public comment somealternative approaches for the reform of money funds.

The SEC is currently considering these and other possible steps.

With respect to the triparty repo platform, progress has been made in reducing the amount of intraday credit extended by the clearing banks in the course of the daily settlement process, and, as additional enhancements are made, the extension of such credit should be largely eliminated by the end of 2014.

However, important risks remain in the short-term wholesale funding markets.

One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower.

The Dodd-Frank Act has provided important additional tools to deal with this vulnerability, notably the provisions that facilitate an orderly resolution of a broker-dealer or a broker-dealer holding company whose imminent failure poses a systemic risk.Basel iii Compliance Professionals Association















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But, as highlighted in the FSOC's most recent annual report, more work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.

Asset Markets

Asset markets are a third area that we closely monitor.

We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others.

Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on U.S. markets.

Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets.

We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets.

These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts.

In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.

It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices.
















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For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move.

Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

From a financial stability perspective, however, the assessment of asset valuations is only the first step of the analysis.

Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset's value to changes in broad financial conditions.

Differences in these factors help explain why the correction in equity markets in 2000 and 2001 did not induce widespread systemic disruptions, while the collapse in house prices and in the quality of mortgage credit during the 2007-09 crisis had much more far-reaching effects:

The losses from the stock market declines in 2000 and 2001 were widely diffused, while mortgage losses were concentrated--and, through various financial instruments, amplified--in critical parts of the financial system, resulting ultimately in panic, asset fire sales, and the collapse of credit markets.

Nonfinancial Sector

Our financial stability monitoring extends to the nonfinancial sector, including households and businesses.

Research has identified excessive growth in credit and leverage in the private nonfinancial sector as potential indicators of systemic risk.
















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Highly leveraged or financially fragile households and businesses are less able to withstand adverse changes in income or wealth, including those brought about by deteriorating conditions in financial and credit markets.

A highly leveraged economy is also more prone to so-called financial accelerator effects, as when financially stressed firms are forced to lay off workers who, in turn, lacking financial reserves, sharply cut their own spending.

Financial stress in the nonfinancial sector--for example, higher default rates on mortgages or corporate debt--can also damage financial institutions, creating a potential adverse feedback loop as they reduce the availability of credit and shed assets to conserve capital, thereby further weakening the financial positions of households and firms.

The vulnerabilities of the nonfinancial sector can potentially be captured by both stock measures (such as wealth and leverage) and flow measures (such as the ratio of debt service to income).

Sector-wide data are available from a number of sources, importantly the Federal Reserve's flow of funds accounts, which is a set of aggregate integrated financial accounts that measures sources and uses of funds for major sectors as well as for the economy as a whole.

These accounts allow us to trace the flow of credit from its sources, such as banks or wholesale funding markets, to the household and business sectors that receive it.

The Federal Reserve also now monitors detailed consumer- and business-level data suited for picking up changes in the nature of borrowing and lending, as well as for tracking financial conditions of those most exposed to a cyclical downturn or a reversal of fortunes.

For example, during the housing boom, the aggregate data accurately showed the outsized pace of home mortgage borrowing, but it could not
















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reveal the pervasive deterioration in underwriting that implied a substantial increase in the underlying credit risk from that activity.

More recently, gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis.

Moreover, many homeowners remain "underwater," with their homes worth less than the principal balances on their mortgages.

Thus, more detailed information clarifies that many households remain more financially fragile than might be inferred from the aggregate statistics alone.

Conclusion

In closing, let me reiterate that while the effective regulation and supervision of individual financial institutions will always be crucial to ensuring a well-functioning financial system, the Federal Reserve is moving toward a more systemic approach that also pays close attention to the vulnerabilities of the financial system as a whole.

Toward that end, we are pursuing an active program of financial monitoring, supported by expanded research and data collection, often undertaken in conjunction with other U.S. financial regulatory agencies.

Our stepped-up monitoring and analysis is already providing important information for the Board and the Federal Open Market Committee as well as for the broader regulatory community.

We will continue to work toward improving our ability to detect and address vulnerabilities in our financial system.Basel iii Compliance Professionals Association















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Erkki Liikanen: Banking structure and monetary policy – what have we learned in the last 20 years?

Presentation by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel Expert Group on the structure of the EU banking sector, at the conference “Twenty years of transition – experiences and challenges”, arranged by the National Bank ofSlovakia, Bratislava.

How is today’s perspective on monetarypolicy different from what prevailed 20 years ago?

Twenty years ago, the world of today was being formed in many

ways. 1993 was the year when the Economic and Monetary Union

project wasbecoming political reality: the Maastricht treaty had been signed and wasin the process of being ratified.

It was also the time when the mainstream approach to monetary policy was beginning to converge to the flexible inflation targeting framework.

A number of countries had then just adopted an explicit inflation targeting strategy.

In the sphere of banking regulation, too, a new era was beginning.

A significant reorientation was going on, away from regulating the conduct of banks and towards the new risk-based approach.
















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The regulatory trend, based on increased freedom for banks but subject to risk based capital requirements, would continue all the way to the eruption of the financial crisis in 2008.

In the EU, the second banking directive took effect from the beginning of 1993, creating a single market in banking.

The directive sought to prevent discrimination and to increase efficiency through competition.

There was discussion on the implications of this for supervision, but little action.

So, while European banking markets were being integrated, financial supervision remained a national competence.

In the U.S., deregulation was also moving forward.

For instance the Glass-Steagall Act, separating banking from securities and insurance, was under growing criticism and would be ultimately repealed in 1995.

One reason for the dissatisfaction with the Glass-Steagall system in the US was competition from European banks which were less restricted in what they could do.

Twenty years ago, the striking improvement in macroeconomic performance, later named “the great moderation” by chairman Bernanke, was spreading to the whole developed world.

The almost surprising success of monetary policy in improving price stability and reducing fluctuations in economic activity, while also keeping interest rates at historically low levels, was interpreted as a major victory for the art of economic policy making.

Now we know that there was trouble brewing under the surface.Basel iii Compliance Professionals Association















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The underpinnings of global financial stability were becoming weaker. Global indebtedness increased, fuelled by current account balances and the “deepening” of international financial markets (read: recycling the same funds several times over).

The decline of inflation was not only due to monetary policy, but also the avalanche of cheap consumer goods from the emerging economies such as China contributed to it.

For banks, the new financial environment was characterized by low interest rates and low perceived risks.

It also turned out that the new risk-based capital requirements allowed the banks to expand their balance sheets enormously without increasing their equity capital in the same proportion.

So, gradually the large banking groups started to increase their trading portfolios.

This development happened in a gradual fashion in the 1990’s but accelerated dramatically from about 2004.

Banks redirected their business focus from interest margins to fee-based and trading activities.

Universal banking, as it had been known in Europe, started to change.

The asset mix of the largest banks changed so that securities portfolios activities grew more and more important.

Only now, from the perspective given by the worst financial crisis since the Second World War, do we see clearly the fragility and weakness of the regulatory arrangements which came into force in the 1990s.

From today’s point of view, they performed well only as long as no major systemic risks materialized.Basel iii Compliance Professionals Association















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Even worse, they allowed risks to accumulate in the financial system which were only waiting to be realized.

Then came 2007 and the collapse of the US property market; 2008 and the collapse of interbank money markets following the Lehman Brothers crisis; and 2009 with The Great Recession.

The painful process of competitive deleveraging started.

The reassessment of economic policies followed in the last two decades has also started.

Especially financial regulation has been reconsidered and is being strengthened.

We need to think of monetary policy, too, especially in its connection to financial stability.

Monetary policy and financial stability

There is a common dictum that a stable financial system is a necessary condition for successful monetary policy, and that price stability in turn creates the best preconditions for financial stability.

I agree.

Still, the experience of this crisis has thought us a lot more.

First of all, we now know that price stability does not by itself guarantee financial stability.

Risks can accumulate in the banking system even if monetary policy succeeds in maintaining price stability and controlling inflationary expectations really well.
















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Second, we also know that central banks can maintain an admirable degree of price stability even when financial stability is under a lot of strain.

Do these two points mean that financial stability and monetary policy are not connected after all?No.

They are very closely related.

Independence of monetary policy

One of the lasting lessons learned in the last decades is the value of the independence of monetary policy.

The independence of central banks has been essential keeping inflation expectations as well anchored as they have been in this crisis despite all the turmoil in the financial markets.

Independence has also made it easier for central banks to act quickly when it has been necessary in order to maintain financial stability.

It is especially important to avoid two threats to independence: fiscal dominance and financial dominance.

Fiscal dominance is the older concept of the two.

It would arise if the government financing constraint would become an overriding influence on monetary policy.

The idea of fiscal dominance was formalized by Tom Sargent and Neil Wallace in 1981, but of course the worry that deficit financing may cause inflation has much longer roots in monetary thought.
















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The idea that tight monetary policy may become impossible without accompanying fiscal adjustment was also well understood when the blueprints for the EMU were being prepared.

This is why the Maastricht treaty had its fiscal policy clauses and also why the Stability and Growth Pact was concluded.

Also the prohibition of direct central bank credit to the government and the institutional independence of the central banks are in effect protections against fiscal dominance.

Now we know, of course, that the fiscal framework as put in place before the start of the EMU was not strong enough to prevent fiscal problems from emerging.

Some have argued that fiscal dominance has taken hold in the in the big industrialized countries during the crisis when the central banks have used government bond purchases in order to stabilize the markets (as the ECB) or to produce additional monetary stimulus when the interest rate instrument has already been used to the maximum (like the Federal Reserve and the Bank of Japan).

As to the euro area, for me there is now no evidence of fiscal dominance. Fiscal dominance implies that monetary policy would break its price stability objective for the sake of maintaining the solvency of the government sector.

This is not the case.

Price stability has not and will not be abandoned.

We have well known fiscal problems in some of the euro area

countries. Still, the ECB’s ability to go on maintaining price

stability has not beenweakened. Basel iii Compliance Professionals Association















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In particular the inflation expectations, which are the most essential indicators of the credibility of monetary policy, have remained well in line with the price stability objective.

The parallel idea of financial dominance is more recent than fiscal dominance.

Financial dominance refers to the possibility that the condition of the banking system could become a constraint, or dominant influence, on monetary policy, effectively forcing the central bank to pursue second- or third-best monetary policies in order to maintain financial stability.

Is the spill-over from financial instability to monetary policy a realistic threat?

Can financial stability considerations lead the central banks to tolerate too high inflation, just to keep the banking sector afloat?

In principle it is easy to see why it could be.

One can imagine a central bank which would have to tighten its monetary policy for price stability reasons, but is prevented from doing so for the fear that the value of the assets of the banking system would decrease and a financial crisis could ensue.

Episodes which fit the description of financial dominance have been observed in emerging economies after some banking crises in the past.

But looking at recent experience, this has not been the case in the developed economies.

The bust of the credit boom has not led monetary policy to tolerate a higher-than-mandated rate of inflation.

Instead, in the large developed economies at least, the bursting of the
















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bubble has coincided with a sudden contraction of private demand and a deep recession.

The negative effect of the bust on economic activity has actually reduced inflationary pressures and in some cases (such as in Japan in the 1990’s) created a real danger of deflation.

The main problem has then become how to prevent the credit contraction from starting a deflationary spiral.

In such conditions, the same monetary policy will then both ease the strain on the banking sector and support price stability.

This observation does not mean that financial instability would not pose a serious challenge to monetary policy.On the contrary, the downward impact of a bust, if it is large, may bemore difficult to control than the preceding period of credit expansion.

There was a famous discussion on how monetary policy should relate to asset prices in the Jackson Hole conference of 2007, where Rick Mishkin introduced the topic.

At that time, the prevalent thinking in central banking circles was what professor Issing later called “the Jackson Hole consensus”, meaning that it is better for monetary policy only to “clean” (up afterwards) than to “lean” (against the wind).

After the hard lessons we learned over the last five years the case for benign neglect of asset booms and only picking up the pieces afterwards is not so strong any more.

The crisis experience supports rather the idea that financial excesses are better prevented as they happen than only managed after they have caused a recession.
















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This would be the best way to prevent “downward financial dominance” which could arise if monetary policy could not effectively counteract credit contraction.

Unconventional tools and the independence of monetary policy

Recent experience shows that the central banks’ box of potential tools is actually very deep, and if it has become necessary to utilize unconventional tools, as in the present crisis, these new tools have been developed and deployed.

In the case of the ECB, the new tools have included the transition to full allotment auctions, the long term refinance operations up to three years, widening of the scope of eligible collateral, and the various bond purchase programmes.

The most recent of these is the OMT programme announced last summer but not yet commenced in practice.

The development of new tools has been justified.

The slip of the depressed economies to dangerous deflation has been averted, and the debt and banking problems have not developed into systemic financial meltdowns in the affected countries.

We have seen that central banks can pursue successful price stability policy also under very difficult conditions.

The events around the world since the collapse of Lehman Brothers are evidence of that.

Deflation has been avoided despite a severe recession in many countries.

However, there are also certain problems with relying on the enlarged toolkit of the central banks.Basel iii Compliance Professionals Association















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The ability to act in crisis has led to the central banks being even called “the only game in town”.

We should resist this idea and beware of the danger that problems which are fundamentally political could be pushed to central banks to solve.

A division of responsibilities between appointed officials and elected politicians should be preserved.

Monetary policy cannot administer the needed structural transformation in the real sector of the economy or solve excessive deficit problems of governments.

There are situations where the central banks just have to act and do their best to stabilize the economy, even if they would have to use tools which go beyond just adjusting the short rate of interest or the aggregate liquidity of the banking system.

The present financial crisis has constituted one such situation.

Avoiding the busts which seem to follow credit booms and periods of “financial exuberance” would make the tasks of monetary policy much easier and protect the independence of central banks.

But there are also difficulties with the leaning against the wind.

One has to do with the problem of detecting the credit cycle in time, and correctly timing the monetary policy response.

Another problem is that price stability might get less attention.

To mitigate these problems, something else besides more vigilant interest rate policy is needed to prevent low and stable interest rates from leading to excesses in banks and financial markets.
















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One development can be the development of macro-prudential instruments which are designed to improve the stability of the financial system as a whole.

The major work in this field was done by the de Larosière group.

Otmar Issing was a member of the group.

Especially interesting are those macro-prudential instruments which have a time dimension so that they can be adjusted according to the changing situation in the credit markets.

Such instruments include, in particular, the countercyclical capital requirements, as well as the adjustable restrictions on Loan-to-Value ratios.

The CRD IV directive will make the former instrument obligatory in the EU countries; implementation of the latter is left to national discretion.

Now it is very important to establish an effective toolkit for both European and national authorities.

We must also create institutional conditions which do not prevent these tools to be used when needed.

Therefore, we need clear decision making competences at all levels.

The connection between macro-prudential policy and its time dimension with monetary policy is so intimate that central banks must be closely involved in macro-prudential analysis and decision making.

Macro-prudential policy is important, but it needs to be supported by structural reforms which would make the banking system more resilient, and - I emphasise - less prone to unstable behaviour.
















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The Structural reform proposals

In order to prevent the present crisis from being ever repeated, governments and authorities have started a large-scale overhaul of financial regulation.

The regulatory agenda can be broadly divided into the following areas:

•Strengthening of the prudential regulation of solvency and liquidity

• Improving the institutional basis for supervision and crisis management

•Introduction of macro-prudential instruments to prevent systemic risks in the banking system and financial markets

• Regulating the structure of the banking sector

The structural reform proposals which appear as the last item on this list aim to separate the riskiest securities and derivatives business from the deposit banking activities.

This is the essential content of the proposals by the EU High Level Expert Group, which I chaired, published last autumn.

It is also at the core of the Volcker rule which is being implemented in the US, and the Vickers proposal in the UK.

The current legislative proposals which are underway in France and Germany are also in the same vein.

A particular concern of these proposals has been to limit the extent of explicit or implicit public guarantees, so that they would not induce additional risk taking.

This kind of competitive distortion could result in securities trading getting concentrated in the largest deposit banks, and these deposit
















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banks becoming enormous risk concentrations built on implicit or even explicit public guarantees.

Separation proposals try to isolate securities business from the sources of this distortion and reduce the incentives to excessive risktaking and risk concentration.

In must be emphasized that the structural reform we proposed is not a cure-all but should be seen as a part of a comprehensive regulatory agenda which is already moving forward.

This includes better solvency and liquidity rules.

Also, the EU will finally get supervision and resolution frameworks at the union level.

The different components of the current regulatory agenda complement and support each other.

In this European context, the structure and stability of the banking sector is of vital importance to the economy.

It is imperative to improve its resiliency.

The High Level Expert Group report contains five main recommendations on how to reform the banking sector.

I will just refer to three of them here:

•The first is to separate any significant proprietary trading in securities and derivatives from deposit banks.

These activities could be carried out in a separately capitalized and funded subsidiary, a trading entity, which could belong to the same banking group as the deposit bank.
















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We proposed that also market making be allocated to the trading subsidiary in order to prevent the use of trading inventory to circumvent the prohibition on proprietary trading.

•The use of trading subsidiaries would allow the banking groups to offer “one-stop banking” to their clients, but without the possibility of funding trading activities with insured retail deposits.

Financial linkages between the deposit bank and the trading unit would have to be restricted in accordance to normal large exposure rules.

•Another of our proposals is to develop specific, designated bail-in instruments to improve the loss absorbency of banks.

A requirement to issue such bail-in debt would help ensure the participation of investors to the recapitalization of a bank if this should become necessary.

Such designated bail-in instruments would clarify the hierarchy of debt commitments and allow investors to predict the eventual treatment of the respective instruments in case of recapitalization or resolution.

•The group also proposed that the capital requirements on trading assets and real estate related loans be reviewed.

Both of these asset categories came to have very low risk weights in the Basel I I regime, mostly because the way internal models were applied.

Why banking structure matters for monetary policy

Let me recapitulate my main points.

First, for monetary policy, financial stability is very important.

While monetary policy has proven to be able to pursue price stability even under rather strained financial conditions, the central banks are not able
















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to insulate the real economy completely from the after-effects of financial crises.

A more stable banking sector which is less prone to crisis will reduce the likelihood of crises and therefore protect the balance sheets of the central bank from financial risks and thereby protect its independence and credibility.

Second, the most important part of stability policy is crisis prevention.

Improving loss absorbency of banks and the crisis management powers of the authorities are necessary, but it is even more important to make sure that excessive growth of credit and indebtedness can be better controlled in the future.

In this way, credit crunches and banking crises can be made less likely – and milder, should they happen.

Third, financial stability would benefit from structural reform of the banking system.

By separating the most risky securities and derivative activities from deposit banking, the spill over from deposit protection to speculative risk taking would be prevented.

This would reduce the distorted incentives to expand trading activities and concentrate risks in deposit banks because of their privileged position in the deposit market.

Finally, the structural reform of banking is a complement, not a substitute for other regulatory improvements.

For central banks, the development of macro-prudential policies and instruments is especially relevant.
















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Those macro-prudential instruments which can be adjusted over time to manage the conditions in the credit market will offer a way to better control the accumulation of excess risk and help prevent future crises.

These instruments operate so close to monetary policy that central banks should be very closely involved, if not themselves responsible, in developing and using them.
















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APRA releases second consultation package on Basel I I I liquidity reforms

The Australian Prudential RegulationAuthority (APRA) has today released a second consultation package outlining its proposed implementation of the Basel I I I liquidity reforms for authorised deposit-taking institutions (ADIs) in Australia.

The package includes a discussion paper, a revised draft Prudential Standard APS 210 Liquidity (APS 210) and a draft Prudential Practice Guide APG 210 Liquidity.

The package addresses the main issues raised in submissions to APRA’s previous discussion paper released in November 2011, and incorporates revisions to the Basel I I I liquidity reforms published by the Basel Committee on Banking Supervision (Basel Committee) in January 2013.

In the 2011 discussion paper, APRA outlined proposals to implement the Basel I I I liquidity reforms.

These proposals included two new quantitative measures — a 30-day Liquidity Coverage Ratio (LCR) to address an acute stress scenario and a Net Stable Funding Ratio (NSFR) to encourage longer-term funding resilience.

These requirements would apply to those ADIs that are currently required to conduct scenario analysis of their liquidity needs under different operating circumstances.

This approach is unchanged in the updated draft APS 210.

In the 2011 paper, APRA also proposed that ADIs currently subject to the simple quantitative liquidity ratio requirement, the minimum liquidity holdings (MLH) regime, would not be subject to either of the two new Basel I I I global standards.Basel iii Compliance Professionals Association















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In response to submissions, APRA has made minor adjustments to the MLH regime.

The recent revisions to the LCR announced by the Basel Committee include discretion for national authorities to include a wider range of liquid assets in the definition of high-quality liquid assets (HQLA), some refinements to the assumed cash inflow and outflow rates, and a revised timetable for phase-in of the LCR.

In the package released today, APRA is not proposing to exercise discretion to widen the definition of HQLA; hence, the definition of H QLA in the updated draft APS 210 is unchanged.

In addition, APRA is proposing to implement the liquidity reforms on the previously published timetable.

APRA acknowledges this is a conservative approach, but one that is fully consistent with the capabilities and needs of the Australian banking system.

Accordingly, the Liquidity Coverage Ratio will become effective from 1 January 2015 and the Net Stable Funding Ratio from 1 January 2018.

The discussion paper released today also includes responses to the main issues raised in submissions on APRA’s 2011 proposals that have not been affected by the Basel Committee’s recent revisions.

APRA Chairman Dr John Laker said that, in implementing the Basel I I I liquidity reforms, APRA’s objectives are to strengthen the resilience of the Australian banking system and improve APRA’s ability to assess and monitor ADIs’ liquidity risk.

‘APRA believes ADIs are well-placed to meet the new liquidity requirements on the original timetable and doing so will send a strong message about the soundness of the Australian banking system.’
















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The discussion paper, draft prudential standard and draft prudential practice guide can be found on APRA’s website at: www.apra.gov.au/adi/PrudentialFramework/Pages/Implementing-Bas el-I I I-liquidity-reforms-in-Australia-May-2013.aspx

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry. APRA is funded largely by the industries that it supervises. I t was established on 1 July 1998. APRA currently supervises institutions holding $4.2 trillion in assets for almost 23 million Australian depositors, policyholders and superannuation fund members.

Discussion PaperImplementing Basel I I I liquidity reforms in Australia May 2013In November 2011, APRA released a discussion paper and draft prudential standard outlining its proposals to strengthen the liquidity risk management framework for authorised deposit-taking institutions (ADIs) in Australia.The discussion paper gave effect to reforms, announced by the Basel Committee on Banking Supervision (Basel Committee) in December 2010, to strengthen liquidity buffers so as to promote a more resilient global banking system.In January 2013, the Basel Committee released amendments to one of the key elements of these reforms — the Liquidity Coverage Ratio (LCR) — in its document Basel I I I: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools.APRA is now in a position to complete its consultations on the main elements of the Basel I I I liquidity framework.This consultation package outlines APRA’s proposed amendments to its 2011 proposals on the implementation of the LCR in Australia.Basel iii Compliance Professionals Association


http://www.apra.gov.au/adi/PrudentialFramework/Pages/Implementing-Basel-III-liquidity-reforms-in-Australia-May-2013.aspx


































































































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It also addresses the main issues raised in submissions, and in other dialogue with industry and other interested parties, on those of APRA’s earlier proposals that have not been affected by the Basel Committee’s recent revisions.The consultation package includes an updated draft of Prudential Standard APS 210 Liquidity (APS 210) and draft Prudential Practice Guide APG 210 Liquidity (APG 210).Qualitative requirementsThe Basel I I I liquidity framework is underpinned by qualitative requirements for liquidity risk management, based on the Basel Committee’s Principles for Sound Liquidity Risk Management and Supervision (Sound Principles) (2008).APRA proposed to incorporate these qualitative requirements in a revised APS 210.They included requirements for enhanced Board oversight of an ADI’s liquidity risk management framework, for an articulation of the Board’s tolerance for liquidity risk, for quantification and allocation of liquidity costs and benefits, and other matters. Submissions were supportive of APRA’s qualitative requirements and they are unchanged in the updated draft APS210.Quantitative requirements: scenario analysis ADIsThe Basel I I I liquidity framework involves two new minimum global standards:- a 30-day LCR to address an acute stress scenario; and- a Net Stable Funding Ratio (NSFR) to encourage longer-

term funding resilience.APRA proposed to apply these quantitative liquidity requirements to those ADIs that are currently required to conduct scenario analysis of their liquidity needs under different operating circumstances (‘scenario analysis’ ADIs).This approach is unchanged in the updated draft APS 210.
















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The Basel Committee is continuing to review the NSFR, which does not come into effect until 1 January 2018.APRA has not made any amendments to its proposed implementation of the NSFR, but will ensure that concerns raised in submissions are fed into the Basel Committee’s deliberations.The revisions to the LCR recently announced by the Basel Committee involve:- discretion for national authorities to include a wider range of

liquid assets in the definition of high-quality liquid assets (HQLA);

- some refinements to the assumed cash inflow and outflow rates; and

- a revised timetable for phase-in of the LCR.

Definition of HQLANational authorities have discretion to include certain additional assets in a new ‘Level 2B’ category of HQLA, subject to haircuts and provided the assets fully comply with the qualifying criteria.These assets are residential mortgage-backed securities (RMBS) with a long-term credit rating of AA or higher, corporate debt securities with a long-term credit rating between A+ and BBB–, and certain listednon-financial equities.APRA is not proposing to exercise this discretion.Accordingly, the definition of HQLA in the updated draft APS 210 is unchanged.APRA has considered the market characteristics of Australian dollar debt securities potentially eligible as Level 2B assets against the qualifying criteria that such assets must trade in large, deep and active markets, be liquid during a time of stress and, in most cases be eligible for use in central bank operations.In APRA’s view, the relevant securities do not meet all of these criteria. Further, APRA does not consider that the inclusion of equities as Level2B assets would contribute to the resilience of the Australian bankingsystem.
















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Equities are not repo-eligible with the Reserve Bank of Australia (RBA); hence, a large-scale forced sale of equity portfolios by one or more Australian banks could significantly exacerbate a stress event.However, some of the debt securities included in the definition of Level 2A and Level 2B assets are repo-eligible with the RBA for normal market operations and are eligible collateral for the Committed Liquidity Facility (CLF).ADIs with access to the CLF are likely to hold those assets as part of a well-diversified liquid assets portfolio.

Cash inflow and outflow ratesAPRA is proposing to adopt the revised Basel I I I assumed cash inflow and outflow rates, with only one minor modification related to maturing central bank funding transactions.In its 2011 discussion paper, APRA proposed some other modifications to the Basel I I I assumed cash inflow and outflow rates.These related to the treatment of self-managed superannuation funds, high run-off less stable retail and qualifying small and medium enterprise (SME) deposits, contingent funding obligations, and recognition of head office liquidity support to Australian branches of foreign banks. These modifications have not been materially changed in the updated draft APS 210.

Quantitative requirements: minimum liquidity holdings ADIsIn its 2011 discussion paper, APRA proposed that ADIs currently subject to a simple quantitative liquidity ratio requirement, the minimum liquidity holdings (MLH) regime, would not be subject to either of the Basel I I I global standards.APRA proposed to leave the MLH regime broadly unchanged but to revise the definition of assets that are eligible for inclusion in an ADI’s minimum liquidity holdings.Submissions raised concerns about the treatment of industry support schemes and the revised definition of assets eligible for inclusion in MLH

portfolios.
















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APRA has made some amendments in updated draft APS 210 in response to these submissions.

Reporting and prudential disclosure requirementsReporting requirements for scenario analysis ADIs have been the subject of a separate consultation process, based on APRA’s November 2012 discussion paper, Liquidity reporting requirements for authorised deposit-taking institutions.Since the Basel Committee is continuing to review the NSFR, APRA has decided to remove the NSFR from the standardised reporting framework at this stage.The Basel Committee is also continuing to develop disclosure requirements for bank liquidity and funding profiles. APRA intends to consult separately on its disclosure requirements once global disclosure standards are finalised.

Implementation timetableIn its 2011 discussion paper, APRA proposed to introduce the LCR requirement from 1 January 2015, in line with the-then internationally agreed timetable.As noted above, the revised timetable recently announced by the Basel Committee allows for a phase-in of the LCR, with a minimum requirement of 60 per cent from the original start-date rising in equal annual steps of 10 percentage points to reach 100 per cent on 1 January 2019.The graduated approach is designed to ensure that the LCR can be introduced ‘…without disruption to the orderly strengthening of banking systems.’APRA is not proposing to adopt the phase-in arrangements. These arrangements were introduced in light of the considerable stress facing banking systems in some regions. Australia, however, is not one of those regions.Moreover, most large internationally active banks are already compliant with the LCR.
















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Finally, APRA is cognisant of concerns, raised by the International Monetary Fund in its 2012 Financial System Stability Assessment of Australia, that the continued reliance of Australian banks on offshore funding leaves them exposed to disruptions to funding markets.Accordingly, APRA proposes to retain its original implementation timetable for the LCR.This is a conservative approach, but one that is fully consistent with the capabilities and needs of the Australian banking system.ADIs are, in any event, well placed to meet the requirement and, in doing so, will send a strong message about the soundness of the Australian banking system.APRA invites written submissions on its proposed response to the Basel Committee’s recent revisions to the Basel I I I liquidity framework, as set out in the updated draft APS 210.It also invites written submissions on the draft APG 210.Following consideration of submissions received, APRA intends to issue the final APS 210 and APG 210 in mid-2013.The new prudential standard is intended to come into force on 1 January 2014; the LCR and NSFR requirements are intended to commence on 1 January 2015 and 1 January 2018, respectively.

Chapter 3 – LCR — high-quality liquid assetsThe determination of the LCR has two components:- the value of the stock of HQLA in stressed conditions; and- total net cash outflows, calculated according to specified

scenario analysis.This chapter deals with the first of these components.

3.1 Original Basel Committee measuresUnder the Basel I I I liquidity framework, assets qualifying as HQLA for LCR purposes must be unencumbered, easily and immediately convertedBasel iii Compliance Professionals Association















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into cash with little or no loss of value under stressed market conditions and, ideally, be eligible for repurchase agreements with the central bank.In the Basel Committee’s original measures, HQLA were categorised into two buckets based on the liquidity characteristics of the assets8.The highest quality liquid assets, which APRA will refer to as HQLA1,can comprise an unlimited portion of the total stock of HQLA.

These assets are limited to:- cash;- central bank reserves (to the extent that these reserves can be

drawn down in times of stress); and- marketable securities representing claims on or claims

guaranteed by sovereigns, quasi-sovereigns, central banks and multilateral development banks, that have undoubted liquidity, even during stressed market conditions, and that are assigned a zero risk-weight under the Basel I I standardised approach to credit risk.

HQLA2 are assets with a proven record as a reliable source of liquidity even during stressed market conditions, and comprise:- marketable securities representing claims on or by

sovereigns,quasi-sovereigns, central banks and multilateral development banks, which are assigned a 20 per cent risk-weight under the Basel I Istandardised approach;

- corporate bonds (not issued by a financial institution or any of its affiliated entities) with a credit rating from a recognised external credit assessment institution of at least AA-; and

- covered bonds (not issued by the ADI itself or any of its affiliated entities) with a credit rating of at least AA-.

HQLA2 are limited to 40 per cent of the total shock of HQLA and attract a minimum 15 per cent haircut.
















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Following a review of a range of marketable instruments denominated in Australian dollars (AUD) against the Basel I I I criteria for HQLA, APRA advised that:- the only assets that qualify for HQLA1 are cash, balances

held with the RBA, and Commonwealth Government and semi-government securities; and

- there are no assets that qualify as HQLA2.

APRA also advised that it will keep this position under review, taking into account relevant market developments10.

2. Recent Basel Committee revisionsRecent revisions to the LCR announced by the Basel Committee introduced a third bucket (Level 2B assets) for categorising HQLA, which national authorities have discretion to include in LCR calculations if the assets fully comply with the qualifying criteria. Level 2B assets are limited to:- RMBS rated AA or higher not issued by the bank itself or any

of its affiliated entities;- corporate debt securities rated between A+ and BBB- not

issued by a financial institution or any of its affiliated entities; and

- ordinary shares not issued by a financial institution or any of its affiliated entities.

Level 2B assets are subject to higher haircuts than HQLA2, and to a limit of 15 per cent of total HQLA.The qualifying criteria include that the assets must trade in large, deep and active repo or cash markets characterised by a low level of concentration, and must have a proven record as a reliable source of liquidity even during stressed market conditions.Consistent with its review of the eligibility of marketable instruments for HQLA2, APRA has considered the range of possible Australian dollar Level 2B debt securities against the qualifying criteria.Basel iii Compliance Professionals Association















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This has taken into account the amount of these instruments on issue, the degree to which the instruments are broadly or narrowly held, and the degree to which the instruments are traded in large, deep and active markets.APRA has given particular attention to the liquidity of these instruments during the market disruptions of 2007–2009 in the more acute phases of the global financial crisis.Based on this review, APRA has concluded that there are no eligible Level 2B debt securities in Australia.APRA notes, however, that some types of debt securities included in the definition of Level 2A and Level 2B assets are repo-eligible with the RBA for normal market operations and are eligible collateral for the CLF from the RBA.These include certain sovereign, supranational and foreign agency Australian dollar-denominated bonds, RMBS rated AAA or higher, and some corporate debt securities.ADIs with access to the CLF are likely to hold these assets as part of a well-diversified liquid assets portfolio.APRA has also reviewed the eligibility of unencumbered non-financial equities for inclusion in Level 2B assets. Although the market for many listed equities in Australia is liquid, APRA does not consider that the inclusion of equities as Level 2B assets would contribute to the resilience of the Australian banking system.Equities are not repo-eligible with the RBA and any large-scale forced sale of equity portfolios by one or more Australian banks could significantly exacerbate a stress event.Accordingly, APRA is not proposing to exercise the discretion available to it to introduce the third bucket of HQLA and it has not included Level 2B assets in the definition of HQLA in the updated draft APS 210.

However, as with HQLA2 assets, APRA will keep this position under review, taking into account relevant market developments.
















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HQLA for a consolidated banking groupAPRA acknowledges that other national authorities may exercise their discretion to include Level 2B assets for LCR purposes in their jurisdictions.In such cases, APRA may allow an ADI with material banking subsidiaries in such jurisdictions to hold some amount of Level 2B assets to meet the LCR requirements imposed by the host supervisor. No change to draft APS 210 is required.However, until it is able to gain confidence in the liquidity of foreign currency Level 2B assets in stressed circumstances, APRA does not believe that such assets should be recognised in LCR calculations for the consolidated (Level 2) banking group.At the group level, ADIs will be required to hold sufficient liquid assets that satisfy the HQLA1, HQLA2 and, where relevant, Alternative Liquid Assets criteria to ensure that the minimum LCR level of 100 per cent is met.This approach is set out in Attachment A of updated draft APS 210.

Use of H QLA in a time of stressIn its recent revisions to the LCR, the Basel Committee re-affirmed that the stock of HQLA is available for use during a period of financial stress.APRA endorses this approach, which is reflected in updated draft APS 210.APRA acknowledges that, in a time of stress, an ADI may need to liquidate part of its stock of HQLA and/ or draw on its CLF with the RBA, using the cash generated to cover cash outflows and, thereby, falling below the 100 per cent LCR requirement.The updated draft APS 210 requires that an ADI must inform APRA immediately in the event that it becomes aware of the circumstances that will result in a breach of its LCR requirement.APRA’s supervisory response to a breach of an ADI’s LCR requirement will be appropriate to the circumstances.
















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Operational requirements for the management of H QLAThe Basel Committee’s original LCR measures, which APRA proposed to adopt, imposed operational requirements for the management of HQLA.These included that the stock must be under control of the specific function or functions charged with managing the liquidity risk of the bank.In its recent revisions, the Basel Committee has refined and clarified its operational requirements.The amended wording is that the stock of HQLA must be under the control of the function charged with managing the liquidity of the bank, meaning the function has the continuous authority, and legal and operational capability, to monetise any asset in the stock.APRA proposes to adopt the amended wording.This is expected to result in some assets that were previously excluded now becoming eligible for inclusion in the stock of HQLA.

3.3 Other matters raised in submissionsAlternative liquid asset treatment — The CLF review processIn recognition of jurisdictions with an insufficient supply of HQLA, the Basel I I I liquidity framework incorporates scope for alternative treatments for the holding of HQLA.One alternative treatment is to allow banking institutions to establish contractual committed liquidity facilities provided by their central bank, subject to an appropriate fee, with such facilities counting towards the LCR requirement.As the current supply of HQLA in Australia is not adequate to satisfy ADIs’ LCR requirements, APRA and the RBA announced in December 2010 that an ADI will be able to establish a secured CLF with the RBA for the purposes of meeting its LCR requirement in Australian dollars.The CLF will be sufficient in size to cover any shortfall between the ADI’s holdings of HQLA and its LCR needs (both in Australian dollars).
















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APRA has previously stated that ADIs will be required to demonstrate that they have taken all reasonable steps towards meeting their LCR requirements through their own balance sheet management, before relying on the CLF.APRA will be reviewing each ADI’s liquidity risk management framework and funding practices as the basis for approving the size of the CLF for LCR purposes.

Comments receivedSubmissions sought further information on APRA’s method of approving access to the CLF.Submissions also raised concern that overly conservative funding obligations would limit the industry’s ability to provide maturity transformation, shifting liquidity risk into unregulated parts of the financial services sector.Submissions also requested further guidance on the practical definition of a ‘minor LCR shortfall’ for CLF and self-securitisation purposes. APRA had previously proposed that where an ADI expected to have only a minor LCR shortfall without a CLF, the ADI would need to manage its liquidity requirements on its own resources, rather than relying on a CLF.Some submissions raised the concern that this approach may create competitive disadvantages for some scenario analysis ADIs in regard to CLF access.Other submissions argued that the use of self-securitised assets as collateral for the CLF may create competitive disadvantages for MLH ADIs, since such assets are not counted as part of their minimum liquidity holdings.

APRA’s responseAPRA does not propose to elaborate on the process for providing access to, or the appropriate composition of eligible assets for, the CLF in APS 210.These issues will be dealt with under APRA’s supervision framework. APRA has commenced its engagement with ADIs on the process forBasel iii Compliance Professionals Association















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setting CLF size and composition within the LCR and will expand this engagement over coming months. APRA will also consider the need to publish further guidance on access to the CLF in due course.

Chapter 4 – LCR — net cash outflowsThe second component in the determination of the LCR requires ADIs to calculate their total net cash outflows over the next 30 calendar days under a stress scenario.The original Basel I I I liquidity framework provided many of the cashflow assumptions to be used for this purpose and APRA proposed to adopt these assumptions, except for minor modifications or clarifications.The Basel I I I cashflow assumptions are based on the behaviour, during a stressed period, of the counterparties providing funding to the ADI and of those to which the ADI provides facilities (either credit, liquidity or contingency).In its recent revisions, the Basel Committee has made a number of amendments to the calculation of net cash outflows. These include additional cash outflow categories, revisions to the cash outflow rates and some revised definitions.This chapter discusses APRA’s proposed response to these amendments. It also provides APRA’s response to submissions on its 2011 proposals onnet cash outflows that are unchanged by the Basel Committee’s recentrevisions.

4.1 Recent Basel Committee revisionsThis section addresses the main Basel Committee revisions to the cash outflow assumptions. A number of minor revisions, which are not discussed here, have been incorporated into the updated draft APS 210.

Fully guaranteed retail depositsThe revised Basel I I I liquidity framework includes an additional retail deposit category for deposits that are fully insured under a pre-funded deposit insurance scheme.
















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The deposit insurance scheme in Australia, the Financial Claims Scheme (FCS), is not pre-funded and, as such, this category is not relevant for domestic deposits

Non-financial corporate, sovereigns, central banks and public sector entity (PSE) depositsThe revised framework has reduced the assumed cash outflow rate for non-operational non-financial corporate, sovereign, central bank and PSE deposits from 75 per cent to 40 per cent.APRA proposes to adopt this amendment.

Liquidity facilities for non-financial corporatesThe revised framework has reduced the cash outflow rate for liquidity facilities provided to non-financial corporate customers from 100 per cent to 30 per cent. APRA proposes to adopt this amendment.

Collateral outflows attributable to market movesThe original Basel I I I liquidity framework gave national authorities discretion in setting the methodology for the calculation of collateral outflows related to market movements of derivative positions.The revised framework has removed this discretion and provides a standardised method for this calculation.APRA proposes to incorporate the standardised method into APS 210. This method requires ADIs to take the largest absolute net 30-daycollateral flow realised in the past 24 months and model this balance as anoutflow.The revised Basel I I I rules text also states that ‘supervisors may adjust the treatment flexibly according to circumstances’.APRA acknowledges industry arguments, discussed later in this chapter, that a liquidity stress event is much more likely to be associated with a falling Australian dollar than a rising one.
















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Accordingly, APRA invites feedback from industry as to an alternative outflow treatment that would acknowledge this probable direction but would be consistent with the Basel Committee’s intent.

Committed but unfunded inter-financial liquidity and credit facilitiesThe revised framework has reduced the cash outflow rate for committed but unfunded liquidity and credit facilities provided to banking institutions that are prudentially supervised from 100 per cent to 40 per cent.APRA proposes to adopt this amendment.

Additional derivatives risksThe revised framework includes a number of additional collateral outflow categories designed to ensure that risks associated with derivative positions are correctly captured in the LCR.The cash outflow rate for these categories is 100 per cent of the measured value.APRA proposes to adopt these amendments.

Derivatives secured by H QLAThe revised framework has clarified that where a derivative cash flow is secured with HQLA1, a cash outflow rate of zero per cent is to be applied. APRA proposes to adopt this amendment.

Maturing secured funding transactionsThe revised framework has reduced the outflow rate on maturing secured funding transactions with a central bank from 25 per cent to zero per cent.In the event that a secured funding transaction backed by CLF eligible collateral matures during a stress event, an ADI with a CLF will be able to re-execute the secured funding transaction because of the RBA’s commitment under the CLF.This will result in an outflow against this transaction of zero per cent. However, if the same transaction matured for an ADI that did not have a
















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CLF, that ADI would have no guaranteed ability to roll the transaction, resulting in a possible outflow rate of 100 per cent.APRA proposes to include an additional category for maturing secured funding transactions backed by CLF eligible debt securities (where the ADI has capacity available under its CLF limit) with an outflow rate of zero per cent.Following consultations with the RBA, APRA proposes that all other maturing secured funding transactions with the RBA that are not backedby HQLA will receive an outflow rate of 100 per cent.Fully insured unsecured wholesale fundingThe revised framework includes an additional outflow category for fully insured non-operational, non-financial, unsecured wholesale deposits. APRA proposes to adopt the outflow rate of 20 per cent.

4.2 Other matters raised in submissions4.2.1 Cash outflowsRetail and qualifying small and medium enterprises (SME) deposit run-offWithin the LCR, retail deposit balances are classified as either ‘stable’ or ‘less stable’.Stable deposit balances are those that are considered to have the lowest propensity to be withdrawn during times of stress and, hence, receive a low three or five per cent cash outflow rate.Less stable deposits are considered to have a higher propensity to be withdrawn and as a result, depending on deposit characteristics, receive a 10 per cent or higher cash outflow rate.APRA proposed to adopt the Basel I I I treatment of stable deposits and, consistent with the Basel I I I approach, to introduce two higher run-off categories for less stable deposits, with run-off rates of 10 per cent and 30 per cent, respectively.APRA proposed a simple scorecard approach to determine which of these two run-off rates applied.
















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SME deposits that satisfy certain criteria regarding balance and behaviour, as outlined in draft APS 210, are considered retail for LCR purposes.

Comments receivedClarification was requested on the treatment of deposits with a total balance above the guarantee limit of the FCS, which is AUD 250,000 for account-holder per ADI.Submissions sought to understand whether the amount below the limit would receive a stable outflow rate and the amount above the limit receive a less stable outflow rate.Submissions suggested including client relationship characteristics, such as the term of a relationship, the number of products and the use of a relationship manager, to assist categorisation of the deposit.They also proposed that dormant accounts be classified as stable due to their expected inactivity in a stress event and that self-managed super fund (SMSF) deposits be eligible to be classified as stable deposits as the trustee overseeing the SMSF deposit account is not necessarily a financially sophisticated individual.Some submissions argued that the categories for stable and less stable deposits were too broad and proposed that APRA provide more precise definitions of the various criteria that define these categories.It was suggested that the outflow rate of 30 per cent for higher run-off less stable deposits was too high as it did not reflect industry experience or assessments of expected run-off under stress.Alternatives proposed were that the outflow rate be lowered or that an additional lower cash outflow category between 10 per cent and 30 per cent be introduced.A number of submissions objected to the inclusion of internet access as a criterion in the less stable deposit scorecard.These submissions argued that means of access was not a strong indicator of withdrawal propensity and it should be removed from the
















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scorecard; instead, greater emphasis should be placed on deposit size as this was more consistent with ADI experience.Some submissions considered that the FCS limit should be the sole determinant of a higher outflow rate as deposits below the limit would be expected to be withdrawn at a much lower rate given that they are guaranteed.Other submissions opposed the implication in the scorecard that a deposit could get a 30 per cent outflow rate even when covered by the FCS if it met the other scorecard criteria.Concern was also expressed that all New Zealand transactional accounts where established customer relationships cannot be evidenced would need to be classified as higher run-off less stable deposits under APRA’s proposed approach as the New Zealand government guarantee is no longer available.A number of submissions argued for amendments to the treatment of funds received via an intermediary as that treatment would result in differential outflow rates being applied by ADIs to an equivalent customer depending on the source of the deposit.This issue was raised, in particular, in relation to deposits received from SMSF customers rather than via APRA-regulated superannuation funds.Another issue raised was that SME customers with no deposits could not be classified under APRA’s proposed approach as the definition of SME in draft APS 210 is linked to deposit size.This is an issue for SME customers who do not have deposit products with an ADI but have other dealings with the ADI that would be captured by the LCR.Another issue raised concerned the possible offering of the maturing31-day notice period term deposit which has recently been the subject of an Australian Securities and Investments Commission consultation, andwhether the ability of a depositor to withdraw a deposit in the proposed term deposit grace period would result in the entire portfolio beingconsidered in breach of the requirements for retail fixed-term deposits in
















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Attachment A to draft APS 210, and needing to be modelled as at-call deposits.

APRA’s responseAPRA agrees that the FCS limit may be a determinant of customer behaviour.Consistent with this, for any deposit meeting the criteria of paragraph 36 in Attachment A of updated draft APS 210, that portion of the deposit covered by the FCS can be treated as stable and any balance above the limit is to be treated as less stable.For stable deposits, APRA considers that paragraph 36 of Attachment A adequately describes the characteristics of stable deposits and does not need amending.For defining the difference between less stable and higher run-off less stable deposits, APRA agrees that client relationship characteristics may play a part but it does not propose to include these in the scorecard as they are already used in the definition of stable deposits and their inclusion in the scorecard would introduce ambiguities between less stable and stable deposits.For dormant accounts, APRA considers that a depositor’s response to a liquidity stress situation is uncertain at best and that dormant accounts are not necessarily a good indicator of a stable deposit.Hence, dormant deposits are to be treated equivalently to other deposits. As explained in its November 2011 discussion paper, APRA considersSMSF depositors to be self-selected, financially sophisticated individuals,which is an indicator of a greater propensity to withdraw funds in a stress situation.As such, SMSF deposits are appropriately categorised as less stable.APRA has considered its proposed scorecard criteria for less stable deposits against the arguments made in submissions but has not identified compelling reasons to change these criteria.Basel iii Compliance Professionals Association















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However, APRA will amend the wording of the scorecard category ‘Deposit is primarily internet accessed’ to ‘Deposit is an on-line account’ in order to better reflect its objective.Deposits that would be expected to fall into this category are those where the internet is integral to the design, marketing and usage of the product.It is not intended to capture deposits where the internet is simply one of several means of accessing and transacting on the account.Further guidance on these deposit classifications can be found in the draft APG 210.In the case of deposits in jurisdictions (such as New Zealand) that do not have government deposit guarantees, the absence of a deposit guarantee effectively removes a size criterion from the scorecard and lowers the hurdle for higher run-off deposits.APRA considers that having a size criterion in the scorecard is appropriate.Hence, the first category of the scorecard will be altered to read ‘Deposit balance is greater than any government deposit guarantee limit where it exists and, in its absence, where the deposit balance is greater than the equivalent of AUD 250,000’.This will also address the concerns regarding New Zealand deposits mentioned above.In addition, APRA has reduced the outflow rate for higher run-off less stable deposits from 30 per cent to 25 per cent.This provides a more appropriate calibration with other category outflow rates, such as operational deposits.For deposits sourced via an intermediary, where the intermediary retains investment responsibility or has a fiduciary duty to the underlying customer, APRA considers it is appropriate to assume the intermediary will observe the responsibility and duty in a time of liquidity stress.This fiduciary duty is not removed when customers have an investment discretion when initiating an intermediated deposit.
















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Accordingly, these deposits are most appropriately classified as being sourced from a financial institution, regardless of the nature of the customer placing funds with the intermediary.This interpretation will not affect SMSF deposits; SMSF deposits are considered to be those of a natural person and not sourced via an intermediaryWhere an SME client has no deposits with an ADI, APRA proposes for contingent obligation purposes to use the definition of an SME in Prudential Standard APS 113 Capital Adequacy: Internal Ratings–based Approach to Credit Risk (APS 113).Paragraph 47 of APS 113 states that ‘To be regarded as a retail exposure, the total business-related exposure of the Level 2 group to asmall-business obligor or group of connected small-business obligors must be less than $1 million.’For 31-day notice period term deposits that are in a grace period, an ADI will be expected to model the term deposit on an equivalent basis to a demand deposit, consistent with the requirements of paragraphs 40 and 41 in Attachment A of updated draft APS 210.In addition, a 100 per cent outflow rate is to apply to any 31-day notice period deposit that has been called.

Unsecured wholesale funding run-offIn the LCR, unsecured wholesale funding is funding provided by non-financial corporate, sovereigns, central banks and PSEs on an unsecured basis.The cash outflow rates against these categories of deposits are set out in the Basel I I I liquidity framework and APRA proposes to implement them without amendment.

Comments receivedSome submissions raised the concern that industry experience of unsecured wholesale run-off rates in a stress scenario in Australia is lacking and available international data suggest a lower run-off experience than the LCR assumptions.
















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These submissions argued that cash outflow rates should be identified through empirical calibration.The issue was also raised that small changes in the size of an account or interpretation of account type will have a material impact on the outflow assumption to be applied in the LCR, particularly given the difference in the cash outflow assumptions for operational deposits and other types of deposit from corporations.It was suggested that where accounts are managed through the active participation of a relationship manager, this should significantly reduce the propensity for deposit withdrawal in a stress event.Clarity was also requested on the definition of operational deposits, particularly on the possible inclusion of defining criteria such as transaction volume, interest rate level and customer relationship. Submissions also argued that correspondent banking (Vostro) accounts are operational deposits and should be included in this category.

APRA’s responseThe Basel I I I cash outflow rates are intended to provide a globally consistent representation of an idiosyncratic and/ or systemic liquidity stress event.The cash outflow rates represent a plausible estimate of behaviours across a range of categories that are intentionally specified at a conservative level.The Basel I I I liquidity framework provides simplicity and ensures a globally consistent application.APRA acknowledges the significant difference in outflow rates for an individual deposit depending on its classification.However, in APRA’s view, the outflow categories and outflow rates will achieve an appropriate outcome from a total portfolio perspective.Recent Basel Committee revisions to the cash outflow rates of unsecured wholesale funding, which APRA proposes to adopt, were discussed earlier in this chapter.Basel iii Compliance Professionals Association















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The Basel Committee has determined that Vostro accounts do not have operational deposit status and APRA agrees.The criterion for an operational deposit is that the depositor has a substantive dependency on the continued operation of the account that acts as a practical impediment to closing or moving the account.That is, the account is so integral to the business operations of the depositor that it is unlikely the depositor would be able to transfer this activity to another ADI within 30 days.This is not consistently the case with correspondent banking accounts and, for this reason, they are not included.

Unsecured financial institution funding run-offUnsecured financial institution funding in the Basel I I I liquidity framework is divided into three categories: operational deposits that receive either a five or 25 per cent cash outflow rate and other deposits that receive a 100 per cent cash outflow rate.

Comments receivedA number of submissions sought clarity on the definition of a financial institution, expressing concern that the definition in draft APS 210 was too broad.Submissions also argued that lower cash outflow rates could be included for certain types of financial institutions such as health insurers or government sector financial institutions, as these entities are perceived to be less sophisticated than others such as banks.Submissions noted the omission of a Basel I I I run-off rate for financial institution operational deposits in the cash outflow table in Attachment A of draft APS 210.Submissions also argued that financial institution intercompany demand deposits would not be withdrawn in a crisis and should receive a cash outflow rate of less than 100 per cent.
















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APRA’s responseAPRA has recently released Prudential Standard APS 001 Definitions, which includes a definition of financial institutions. Most entities noted as being financial institutions in the previous draft APS 210 are covered in that definition.APRA will use that definition in APS 210 but, for the sake of clarity, will make specific reference to money market corporations, finance companies, superannuation / pension funds, public unit trusts / mutual funds, cash management trusts and friendly societies.Amendments have been made to ‘Table 3 – Cash outflow categories’ in Attachment A of the updated draft APS 210 to clearly identify operational and non-operational deposits of financial institutions and their cash outflow rates.APRA does not propose to include additional financial institution run-off categories; all financial institution non-operational deposits receive a 100 per cent cash outflow rate if their residual maturity or notice period is within 30 days.

Other liabilitiesThe Basel I I I framework identifies specific cash outflow assumptions for other liabilities, committed credit and liquidity facilities provided to the ADI’s customers, and items where increased liquidity needs are likely to be required under the LCR scenario. APRA proposed to adopt these assumptions.

Comments receivedSome submissions suggested that the definition of a liquidity facility was too broad and could be interpreted to include revolving credit facilities, which was inconsistent with the Basel I I I liquidity framework.Concerns were raised that the cash outflow rate for a financial institution committed and uncommitted liquidity facility was too high in itself and high in comparison to the equivalent cash outflow rates for other counterparty types.
















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These submissions argued that the cash outflow rates did not reflect the expected behaviour of these types of facilities during a period of stress.

APRA’s responseThe recent Basel Committee revisions include a minor clarification to the definition of a committed liquidity facility to ensure that facilities provided to hedge funds, money market funds and special purpose funding vehicles are captured in their entirety as liquidity facilities.APRA proposes to incorporate the full definition of a liquidity facility into APS 210.This inclusion will also provide clarity on items that should be modelled as liquidity facilities and those that should be modelled as credit facilities.Financial institutions generally have more exposure to liquidity risk than non-financial corporations.A facility provided to a financial institution would represent a ‘wrong-way’ risk during a systemic crisis and would be subject to a greater propensity for drawdown.This justifies a higher cash outflow rate for such a facility.

4.2.1.1 Other contingent funding obligationsThe Basel I I I framework leaves to national discretion the run-off assumptions to be applied to contingent funding obligations that are not committed credit and liquidity facilities.In its 2011 discussion paper, APRA proposed to require ADIs to include the following contingent obligations as a cash outflow:Revocable credit and liquidity facilities;Guarantees, letters of credit and other trade finance instruments; Debt buybacks – domestic Australian debt securities;Structured products, managed funds and other non-contractual obligations; andIssuers with an affiliated dealer or market maker.
















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APRA received a number of submissions on contingent funding obligations which are addressed in this section.

Buyback of debt securities Comments receivedSubmissions on the buyback of securities argued for relief from the application of a cash outflow rate where there is a policy enforced by the ADI to either not honour debt buyback requests in times of stress, place limits on the quantum of debt buybacks, or require that Group Treasury sign-off on buybacks over a certain threshold.These submissions argued that these criteria should be sufficient to evidence a behaviour of not honouring buybacks in all circumstances.

APRA’s responseAPRA expects that in a time of stress, even with a policy to limit debt buybacks in place, some buyback requests may still be honoured due to reputational considerations or because it may take a period of time for the full extent of the liquidity stress to be realised and restrictions on debt buybacks activated.APRA will maintain its buyback assumptions of 10 per cent of short-term debt securities and 5 per cent of long-term debt securities issued in the domestic Australian market.An ADI can apply to APRA for an agreed lower debt buyback rate where the ADI can demonstrate that:(a)it has adopted tangible measures in policy and practice (e.g. through the implementation of hard limits on buybacks) to reduce the incidence of buybacks; and(b) these measures are operating effectively on an ongoing basis.

Unconditionally revocable uncommitted facilities Comments receivedBasel iii Compliance Professionals Association















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Concerns were raised that the cash outflow assumptions for unconditionally revocable uncommitted facilities were too high for all categories of borrowers and that the difference betweenretail/non-financial wholesale customers and financial institutions was larger than expected behaviour in a stress event would suggest.Some submissions argued that where there are contractual terms that constrain drawdown, a lower outflow rate should be applied; where the terms exclude drawdown in 30 days, these facilities should receive a zero per cent cash outflow rate.Submissions also argued that applying the same outflow rate for uncommitted and committed facilities is unreasonable as ADIs have the ability not to honour the drawdown request on unconditionally revocable uncommitted facilities.In a liquidity stress situation, it was argued, such facilities would be cancelled by the provider; hence no cash outflow assumption should be applied.

APRA’s responseAPRA remains of the view that reputational considerations, business budget targets and the possibility of a delayed response to an emerging liquidity stress may mean that ADI lending staff and treasurers will not necessarily respond to a liquidity stress event by cancelling or withdrawing these facilities.Nevertheless, from a liquidity cost-benefit perspective, APRA accepts that some uncommitted facilities could require a smaller liquidity reserve than committed facilities.APRA will therefore amend the cash outflow rate for unconditionally revocable uncommitted facilities to five per cent for all categories.

Trade financeAPRA proposed that ADIs include a cash outflow in the LCR for trade finance facilities based on actual monthly experience over 12 months of data, to be updated on at least an annual basis.
















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Submissions expressed concern that holding liquid assets against uncommitted trade facilities for typical Asian businesses, based on outflows modelled on the past 12 months of going concern behaviour, would be excessive and unnecessary.It was argued that in a liquidity stress event, these facilities would be withdrawn or suspended; hence, a zero per cent outflow should beapplied.APRA’s responseThe recent Basel Committee revisions include guidance that the cash outflow rates modelled against trade finance facilities should be between zero and five per cent.APRA expects that its proposed methodology for the modelling of cash outflows against these facilities will result in a cash outflow rate consistent with the Basel Committee’s guidance.As such, no amendment to the methodology is proposed.Guarantees not related to trade financeAPRA proposed that cash outflows for guarantees not related to trade finance be modelled in the LCR using the average of actual monthly outflows over a recent 12-month period.Comments receivedSubmissions expressed concern that APRA’s proposed methodology did not recognise that the cash outflow can be contingent upon a non-ADI related credit default event, rather than a liquidity stress event for the ADI.APRA’s responseAPRA considers that this argument is reasonable.It will amend APS 210 to reflect that where outflows under such guarantees are wholly contingent on events independent of the ADI (i.e. a default by a third party), the outflow rate is to be modelled as 50 per centof the average of actual monthly outflows in a recent 12-month period. Structured products, managed funds (that are marketed with theobjective of maintaining a stable value) and other non-contractualobligations.
















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APRA proposed that these non-contractual obligations be modelled in the LCR with a minimum five per cent cash outflow rate.Comments receivedSubmissions requested clarification on the particular obligations this category is seeking to capture.APRA’s responseThis category is intended to capture ADI-sponsored investment vehicles or structured products that may require liquidity support.

The global financial crisis has provided many examples of specialised investment vehicles, previously considered to be remote from the sponsoring bank, that required support.

Managed funds needing to maintain a stable value can also fall into this category.

In addition, some structured investment products may require additional liquidity in times of stress as customers seek to liquidate their investments due to the impact of market volatility on the value of these investments.

APRA acknowledges that these investment vehicles and structured products are not widespread in Australia and this category may not be relevant for many ADIs.Market valuation changes on derivative transactionsThis outflow category seeks to capture the potential for substantial collateral outflows relating to changes in the market value of derivative positions during a liquidity stress.

APRA had proposed that ADIs must model a cash outflow against these positions.

As noted earlier in this chapter, the recent Basel Committee revisions

have removed national discretion for this category and have set out a
















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standardised approach for liquidity risk for market value changes in derivatives positions.

ADIs are also required to consider the additional collateral that would need to be posted in the event of a 3-notch credit rating downgrade.

Submissions argued that in a systemic liquidity stress event in Australia, the Australian dollar would be more likely to depreciate than to appreciate.

This would result in cash inflows for ADIs that source offshore funding denominated in major currencies and that have currency swaps with ‘Credit Support Annex’ agreements against them.

Therefore, a conservative liquidity approach would model no cash outflows for such an event.

Submissions also suggested that the stress events modelled in the LCR should be consistent with a liquidity stress, not the market risk stress scenarios outlined in Reporting Standard ARS 116.0 Market Risk, which APRA had proposed.APRA’s responseAPRA agrees that an Australian dollar depreciation is a plausible assumption for a systemic liquidity stress event specific to the Australian banking system.

As noted above, APRA proposes to adopt the Basel Committee’s standardised approach to the calculation of outflows against market valuation changes.

However, APRA invites feedback from industry as to an alternative outflow treatment that would acknowledge the probable direction of the Australian dollar during a stress event but would be consistent with the Basel Committee’s intent. APRA also advises that, as the LCR stress scenario covers both systemic and idiosyncratic events, the 3-notchBasel iii Compliance Professionals Association















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downgrade is to be considered as an idiosyncratic event and modelled as such.4.2.2 The LCR and currency mismatchesIn its 2011 discussion paper, APRA proposed that ADIs be able to meet their liquidity needs in each material currency and maintain HQLA consistent with the distribution of their liquidity needs by currency.

APRA also proposed that ADIs must specifically address currency mismatches in their Board-approved statement of liquidity risk tolerance.Comments receivedSubmissions requested that APRA clarify its requirements with respect to currency mismatches.

In addition, submissions suggested that the CLF should be allowed to cover some portion of foreign currency cash outflows and liquidity needs in the consolidated (Level 2) banking group as locally incorporated ADIs operating in foreign jurisdictions may have limited ability to sell liquid assets in those jurisdictions in a time of stress.

This could be the case as a result of limited ability to participate in the market operations of the relevant central bank.APRA’s responseAPRA confirms that the LCR is to be met by an ADI on both a Level 1 and consolidated (Level 2) banking group basis.

For branches of foreign banks, the LCR must be met on a domestic books basis.This minimum requirement is to incorporate exposures in all currencies.

APRA also confirms that ADIs must be able to meet their liquidity needs in each material currency and maintain HQLA consistent with the distribution of their liquidity needs by currency.Basel iii Compliance Professionals Association















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APRA does not see it as appropriate for the CLF to cover non-Australian dollar outflows; other supervisors will define HQLA specific to their jurisdiction and domestic currency that ADIs will be able to hold to meet net cash outflows in that currency.4.2.3 Home/host liquidity requirements for the LCRAPRA’s 2011 discussion paper proposed that, in arriving at their consolidated (Level 2) banking group LCR, ADIs apply the host jurisdiction cashflow treatments for retail and SME deposits in those jurisdictions as this reflects the behaviour of local depositors.

This was specified in the Basel I I I liquidity framework.

In addition, where the host regulator elects to use one of the alternative liquid assets treatments allowed by Basel I I I , APRA stated that it is likely to recognise this for the purposes of calculating the local currency LCR.

Where an ADI has a material banking subsidiary in a jurisdiction that does not implement the Basel I I I framework, APRA proposed to apply the cashflow assumptions outlined in draft APS 210.Comments receivedConcern was expressed that the use of APRA’s cashflow assumptions in non-Basel I I I jurisdictions meant that different assumptions would need to be applied to the same deposit to meet the requirements of different regulators.

Submissions stated a preference to apply the assumptions of thenon-Basel I I I jurisdiction host regulator to calculate the consolidated banking group LCR, so as to avoid complexity and inefficiencies in liquidity risk modelling in that jurisdiction.

It was also claimed that this problem could extend to Basel I I I jurisdictions that have not clarified their proposed rules for implementation of the LCR.Basel iii Compliance Professionals Association















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APRA’s responseThe Basel Committee expects that all Basel I I I jurisdictions will have their LCR requirements in place by 1 January 2015.

Hence, there should be no concerns regarding unclarified rules amongst Basel I I I jurisdictions. APRA also considers that it would be inconsistent to allow stressed cash outflow rates to apply for deposits in non-Basel I I I jurisdictions that are different to the LCR stress scenario.

Hence, APRA does not see any reason to depart from its proposed approach.4.2.4 LCR requirement for foreign bank branchesIn its 2011 discussion paper, APRA proposed that foreign-owned ADIs in Australia that are subject to the scenario analysis approach will need to meet the LCR requirements on a stand-alone basis.

However, in arriving at a balanced approach for foreign bank branches, APRA proposed to recognise a committed funding line from head office for inclusion as a cash inflow from day 16 of the LCR scenario under certain circumstances.Comments receivedSome submissions argued that it would be unduly restrictive not to recognise head office support until day 16, noting that APRA allows recognition of head office support in a shorter timeframe within the ‘name crisis’ scenario in the current APS 210.

These submissions argued that it would be reasonable to expect head office to provide liquidity support on a much shorter notice period.

It was also claimed that it was unfair not to extend the recognition of head office support to foreign-owned ADIs that operate in Australia as both a subsidiary and a branch.Basel iii Compliance Professionals Association















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Other submissions suggested that the LCR for foreign branches should be lower than 100 per cent and that APRA should recognise that branches depend on globally managed liquidity.

Some submissions also argued that foreign bank branches should be exempt from ‘going concern’ reporting as this is a less meaningful task due to the nature of some operations and imposed a significant reporting burden.

Some submissions sought clarity on functions, tasks and roles that may be completed at the global level rather than at the foreign branch level as they pertain to the qualitative requirements of APS 210.

APRA’s responseUnder APRA’s LCR requirement, all ADIs, including branches of foreign banks, must have sufficient Australian dollar liquidity to meet potential Australian dollar cash outflows.

The recognition of head office support for branches from day 16 is intended to ensure a minimum level of liquidity self-reliance by these branches.

APRA does not believe it is prudent to place reliance on a centrally managed liquidity pool alone as this may result in insufficient liquidity being available for the local operation.

APRA is aware of practices that have the potential to transfer liquidity needs between a local subsidiary and a related branch, which could possibly result in increased levels of reliance on parental support than would otherwise be the case.

Submissions received did not address this issue. Consequently, APRA confirms that it will not extend the recognition of head office support to foreign-owned ADIs that operate in Australia under both a subsidiary and a branch banking authority.
















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Local staff responsible for liquidity management and oversight in foreign bank branches may fulfil liquidity risk management governance roles by having the appropriately approved job mandates and delegated authorities.

As per paragraph 47 of updated draft APS 210, APRA intends to continue to require the production of going concern reports by all ADIs, including foreign bank branches.

The production of going concern reports by all ADIs will enable APRA to more fully understand the maturity mismatch and funding task of the ADI industry in Australia.
















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Michael S. Gibson, Director, Division of Banking Supervision and Regulation

Cross-Border Resolution

Before the Subcommittee on National Security and International Trade and Finance, Committee on Banking, Housing,and Urban Affair, U.S. Senate, Washington, D.C.

Chairman Warner, Ranking Member Kirk, and other members of the Subcommittee, I appreciate the opportunity to testify today on the challenges to achieving an orderly cross-border resolution of a failed systemic financial firm.

In my remarks, I would like to first reflect on the improvements that have been made in the last few years in the underlying strength and resiliency of thelargest U.S. banking firms, and then turn to a discussion of what has been accomplished and what remains to be accomplished in facilitating a cross-border resolution.

A Look Back

The recent financial crisis was unprecedented in its scope and

severity. Some of the world's largest financial firms nearly or

completely collapsed,sending shock waves through the highly interconnected global financial system.

The crisis made clear that our regulatory framework for reducing the probability of failure of systemic financial firms was insufficient and that governments everywhere had inadequate tools to manage the failure of a systemic financial firm.
















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Since 2008, the United States and the international regulatory community have made meaningful progress on policy reforms to reduce the moral hazard and other risks associated with financial firms perceived to be too big to fail.

In broad terms, these reforms seek to eliminate too-big-to-fail in two ways:

(1)by reducing the probability of failure of systemic financial firms through stronger capital and liquidity requirements and heightened supervision, and

(2)by reducing the costs to the broader system in the event of the failure of such a firm.

My testimony today relates principally to the second of these two aspects of reform, but I want to begin by highlighting some of the material achievements we have made to reduce the likelihood of failure of systemic financial firms.

The Basel I I I capital and liquidity reforms are the foundation of the global efforts to improve the resilience of the international banking system.

These reforms are being implemented in the United States and elsewhere.

In addition, the Federal Reserve has significantly strengthened its supervision of the largest, most complex financial firms since the financial crisis.

For example, the Federal Reserve now conducts rigorous annual stress tests of the capital adequacy of our largest bank holding companies.

As a result of these efforts, the overall strength of the largest U.S. banking firms has significantly improved.
















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The aggregate tier 1 common equity ratio of the 18 largest U.S. banking firms has more than doubled, from 5.6percent of risk-weighted assets at the end of 2008 to 11.3percent at the end of 2012.

In absolute terms, these firms have increased their aggregate levels of tier 1 common equity from just under $400 billion in late 2008 to almost $800 billion at the end of 2012.

Higher capital puts these firms in a much better position to absorb future losses and continue to fulfill their vital role in the economy.

In addition, the U.S. banking system's liquidity position relative to pre-crisis levels has materially improved.

Accomplishments to Date on Cross-Border Resolution

Congress and U.S. regulators have made substantial progress since the crisis in improving the process for resolving systemic financial firms.

The core areas of progress include adoption and implementation of statutory resolution powers, adoption and implementation of resolution planning requirements, increased international coordination efforts, and the Federal Reserve's foreign bank regulatory proposal.

Title I I of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) created the Orderly Liquidation Authority (OLA), a statutory resolution mechanism designed to improve the prospects for an orderly resolution of a systemic financial firm.

In many ways, OLA has become a model resolution regime for the international community.

The Financial Stability Board (FSB) in 2011 adopted the Key Attributes of Effective Resolution Regimes for Financial Institutions, a new standard for resolution regimes for systemic firms.
















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The core features of this global standard are already embodied in

OLA. By acting early through the passage of the Dodd-Frank

Act, Congresspaved the way for the United States to be a leader in shaping the development of international policy for effective resolution regimes for systemic financial firms.

The Federal Reserve supports the progress made by the Federal Deposit Insurance Corporation (FDIC) in implementing OLA, including, in particular, by developing a single-point-of-entry (SPOE) resolution approach.

SPOE is designed to focus losses on the shareholders and long-term unsecured debt holders of the parent holding company of the failed firm.

It aims to produce a well-capitalized bridge holding company in place of the failed parent by converting long-term debt holders of the parent into equity holders of the bridge.

The critical operating subsidiaries of the failed firm would bere-capitalized, to the extent necessary, and would remain open for business.

The SPOE approach should work to significantly reduce incentives for creditors and customers of the operating subsidiaries to run and for host-country regulators to engage in ring-fencing or other measures disruptive to an orderly, global resolution of the failed firm.

The Dodd-Frank Act requires all large bank holding companies to develop, and submit to supervisors, resolution plans.

The largest U.S. bank holding companies and foreign banking organizations submitted their first annual resolution plans to the Federal Reserve and the FDIC in the third quarter of 2012.
















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These "first-wave" resolution plans have yielded valuable information that is being used to identify, assess, and mitigate key challenges to resolvability under the Bankruptcy Code and to support the FDIC's development of backup resolution plans under OLA.

These plans are also very useful supervisory tools that have helped the Federal Reserve and the firms focus on opportunities to simplify corporate structures and improve management systems in ways that will help the firms be more resilient and efficient, as well as easier to resolve.

Internationally, the Federal Reserve has been an active participant in theFSB's work to address the challenges of cross-border resolutions.

For example, the Federal Reserve, together with the FDIC, participated in the development of the Key Attributes.

We are also an active participant in the FSB's many committees and technical working groups charged with developing policy guidance on a broad range of technical areas that affect the feasibility of cross-border resolution.

Moreover, as the home-country supervisor of eight of the 28 global systemically important banks (G-SIBs) identified by the FSB, the Federal Reserve has the responsibility of establishing and routinely convening for each U.S. G-SIB a crisis management group.

These firm-specific crisis management groups, which are comprised primarily of the firm's prudential supervisors and resolution authorities in the United States and key foreign jurisdictions, are working to mitigate potential cross-border obstacles to an orderly resolution of the firms.

Last year, the Federal Reserve also sought public comment on a proposal that would generally require foreign banks with a large U.S. presence to organize their U.S. subsidiaries under a single intermediate holding company that would serve as a platform for consistent supervision and regulation.
















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Just as other countries already apply Basel capital requirements to U.S. bank subsidiaries operating in their countries, our proposal would subject the U.S. intermediate holding companies of foreign banks to the same capital and liquidity requirements as U.S. bank holding companies.

We believe that the proposal would significantly improve our supervision and regulation of the U.S. operations of foreign banks, help protect U.S. financial stability, and promote competitive equity for all large banking firms operating in the UnitedStates.

The proposal would enhance the ability of the United States, as ahost-country regulator, to cooperate with a firm-wide, global resolution of a foreign banking organization led by its home-country authorities.

Challenges Ahead on Cross-Border Resolution

Despite the progress that is being made within the FSB and in our domestic efforts with the FDIC, developing feasible solutions to the obstacles presented by cross-border resolution of a systemic financial firm remains necessary and work toward this end is under way.

The key remaining obstacles include:

(1)adopting effective statutory resolution regimes in other countries;

(2)ensuring systemic global banking firms have sufficient "gone concern" loss-absorption capacity;

(3)completing firm-specific cooperation agreements with foreign regulators that provide credible assurances to those host-country regulators to forestall disruptive ring-fencing; and

(4) coordinating consistent treatment of cross-border financial contracts.

First, although the United States has had OLA in place since 2010, and

the FDIC has made good progress in developing the framework for using
















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OLA over the past three years, most other major jurisdictions have not yet enacted national legislation that would create a statutory resolution regime with the powers and safeguards necessary to meet the FSB's Key Attributes.

Mitigating the obstacles to cross-border resolution will, at a minimum, require key foreign jurisdictions to have implemented national resolution regimes consistent with the Key Attributes.

Therefore, we will continue to encourage our fellow FSB member jurisdictions to move forward with such reforms as quickly as possible.

Second, key to the ability of the FDIC to execute its preferred SPOE approach in OLA is the availability of sufficient amounts of debt at the parent holding company of the failed firm.

Accordingly, in consultation with the FDIC, the Federal Reserve is considering the merits of a regulatory requirement that the largest, most complex U.S. banking firms maintain a minimum amount of outstanding long-term unsecured debt on top of its regulatory capital requirements.

Such a requirement could have a number of public policy benefits.

Most notably, it would increase the prospects for an orderly resolution under OLA by ensuring that shareholders and long-term debt holders of a systemic financial firm can bear potential future losses at the firm and sufficiently capitalize a bridge holding company in resolution.

In addition, by increasing the credibility of OLA, a minimum long-term debt requirement could help counteract the moral hazard arising from taxpayer bailouts and improve market discipline of systemic firms.

Switzerland, the United Kingdom, and the European Commission are moving forward with similar requirements, and it may be useful to work toward an international agreement on minimum total loss absorbency requirements for globally systemic firms.
















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Third, we need to take additional actions to promote regulatory cooperation among home and host supervisors in the event of the failure of an internationally active, systemic financial firm. Importantly, OLA only can apply to U.S.-chartered entities.

Foreign subsidiaries and bank branches of a U.S.-based systemic financial firm could be ring-fenced or wound down separately under the insolvency laws of their host countries if foreign authorities did not have full confidence that local interests would be protected.

Further progress on cross-border resolution ultimately will require significant bilateral and multilateral agreements among U.S. regulators and the key foreign central banks and supervisors for the largest global financial firms.

It also may require that home-country authorities provide credible assurances to host-country supervisors to prevent disruptive forms of ring-fencing of the host-country operations of a failed firm.

The ultimate strength of these agreements will depend on whether they have adequately addressed the shared objectives, as well as theself-interests, of the respective home and host authorities.

The groundwork for these agreements is being laid, but many of the most critical issues can be addressed only after other jurisdictions have effective resolution frameworks in place.

Fourth, we must help ensure that a home-country resolution of a global systemic financial firm does not cause key creditors and counterparties of the firm's foreign operations to run unnecessarily.

One of the key challenges to the orderly resolution of an internationally active, U.S.-based financial firm is that certain OLA stabilization mechanisms authorized under title I I of the Dodd-Frank Act, including the one-day stay provision with respect to over-the-counter derivatives
















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and certain other financial contracts, may not apply outside the United States.

Accordingly, counterparties to financial contracts with the foreign subsidiaries and branches of a U.S. firm may have contractual rights and substantial economic incentives to terminate their transactions as soon as the U.S. parent enters into resolution.

Regulators and the industry are focused on the potential for addressing this concern through modifications to contractual cross-default and netting practices and through other means.

The Federal Reserve will continue to support these efforts.

Conclusion

The financial regulatory architecture is stronger today than it was in the years leading up to the crisis, but considerable work remains to complete implementation of the Dodd-Frank Act and the post-crisis global financial reform program.

A key prong of that program is making sure that government authorities in the United States and around the world can effect an orderly resolution of a systemically important, internationally active financial firm.

Much has been accomplished in this area, but much remains to be done.

In the coming years, the FederalReserve will be working with other U.S. financial regulatory agencies, and with foreign central banks and regulators, to make an orderly resolution of a global systemic financial firm as feasible as possible.

Thank you for your attention. I am happy to answer any questions you might have.
















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Hitting the limits of "outside the box" thinking? Monetary policy in the crisis and beyond

Speech by Jaime Caruana, General Manager of the Bank for International Settlements, to OMFIF (Golden Series Lecture), London, 16 May 2013

Central banks have had to "think outside the box" to address unprecedented financial instability and to provide monetary stimulus in trying times.

Monetary accommodation has been critical to stabilise the financial system and the economy.

But questions remain about the efficacy of such policies as long asbalance sheets and structural headwinds are not more fully addressed.

Monetary accommodation can only be as helpful as the balance sheet, fiscal and structural policies that accompany it.

Looking ahead, central banks will continue to face daunting challenges as they navigate in uncharted waters, including how best to integrate new perspectives on the financial cycle and global spillovers into their monetary policy frameworks.

Full speech

Ladies and gentlemen,

It is a great pleasure to be here at OMFIF.
















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The crisis and its aftermath have posed formidable challenges for central banks.

They have had to "think outside the box" to address unprecedented financial instability and provide monetary stimulus in the face of the constraint imposed by the zero lower bound of policy rates.

Looking ahead, the challenges remain daunting. Central banks have to navigate uncharted waters.

In the near term, the question is how monetary policy can best contribute to what has so far been an uneven recovery.

Can't central banks do much more?

Perhaps the relevant question is whether central banks can make up for insufficient action elsewhere.

What monetary policy can substitute for balance sheet repair by banks and borrowers?

What monetary policy can remove impediments to a worker moving from an overbuilt sector to a more promising one?

These kinds of question require a medium-term perspective, and in a medium-term perspective monetary accommodation will prove only as good as the balance sheet, fiscal and structural policies that accompany it.

From a longer-term perspective, a challenge is to better integrate financial stability considerations into monetary policy frameworks.

The recent crisis brought the global financial system to the verge of collapse and has had dire social and economic consequences.
















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This has raised fundamental questions about how to integrate a modern understanding of the financial system into our traditional monetary policy models.

These are all exceedingly difficult questions, the situation is different from country to country and no one can claim to have a crystal ball that provides definite answers.Yet, experience does offer at least some pointers for the future.

In the following, I will therefore start by reviewing the main insights suggested by monetary history, before turning to the current challenges.

Insights from monetary history

The past century saw considerable changes in the conduct of monetary policy.

These changes were often the result of both historical events and new ways of thinking about the role of central banks.

By the end of the 20th century, there was a clear consensus that a remit of monetary policy focused on price stability had many benefits.

This view reflected lessons from the painful experience of double-digit inflation rates and erratic growth that prevailed in many countries worldwide in the 1970s, and in some emerging market economies well into the 1990s.

The main reason for this dismal inflation and economic performance was that monetary policy neglected price stability.

Instead, central banks pursued other goals, which turned out to be inconsistent with price stability.
















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In many advanced economies, for example, monetary policy was too accommodative during the 1970s, and central banks ended up pushing output beyond sustainable levels.

In emerging market economies, political pressures to generate seigniorage income and finance public spending programmes via the printing press were frequent sources of high inflation.

In all these experiences, the neglect of price stability did not improve economic performance.

Over time, we learned, quite painfully, that there is no beneficial long-run trade-off between inflation and growth.

Indeed, we learned that high and volatile inflation rates go hand in hand with erratic growth, large exchange rate swings, and even economic and political crises.

Chastened by these experiences of the 1970s and 1980s, central banks had to rethink their roles.

At that time, the result was to consider a narrow mandate for price stability.

To be sure, this required a very painful adjustment process.

Central banks had to squeeze inflation out of their economies at the cost of recessions. But that cost was well worth the price.

Those who had the courage to try were vilified then, only to be recognised as having done the right thing years later.

Another lesson learnt during this period was that central bank autonomy is critical to achieve price stability.
















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One main underlying cause of inflation instability was the failure to shield monetary policymakers sufficiently from short-term political cycles.

Some central banks, such as the Bundesbank and the Swiss National Bank, had led the way.

They enjoyed a high degree of effective independence and, on this basis, consistently delivered lower inflation than their peers during thepost-Bretton Woods era.

These are hard-earned lessons that should not be forgotten.

Today, central banks are once again "thinking outside the box" as new challenges have arisen.Even before the crisis, concerns among central bankers were growing that the policy environment was changing in ways that called for a further evolution of central banking.

In particular, the narrow focus on near-term domestic price stability did not seem to be enough in an environment in which the financial cycle and global spillovers were becoming more prominent.

With respect to the financial cycle, we now see that monetary policy played an important part in the build-up of financial imbalances during the 2000s.

After the bust of the dotcom boom, monetary policy in the advanced economies remained accommodative for many years. Interest rates were low, and credit and house prices soared.

Of course, the relevance of the financial cycle for central banks is not an entirely new insight.

The forging of many central banks, such as that of the Federal Reserve in 1913, was the direct result of the banking crises of the 19th and early 20th century.
















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It became less relevant in the early postwar period against the background of tightly regulated financial systems put in place after the Great Depression and the Second World War.

But the far-reaching financial deregulation pursued since the 1970s allowed the financial cycle to re-emerge as a major macroeconomic force that grew ever stronger.

Globalisation, too, has been changing the policy environment in significant ways.

In addition to the growing influence of global factors on domestic inflation dynamics, globalisation appears to have added fuel to the monetary easing in the run-up to the recent crisis.

The unusually low policy rates prevailing in the major advanced economies affected others via a resistance to currency appreciation pressures.

Many emerging market economies kept interest rates lower than would have been suggested by domestic macroeconomic conditions alone.

In turn, their accumulation of foreign exchange reserves put additional downward pressure on yields in the advanced economies.

The net result was unusually accommodative global monetary conditions. Real interest rates averaged a mere 1.5% globally between 2002 and 2007 while output grew robustly at roughly 4%.

Managing the post-crisis recovery

While the pre-crisis period already gave central banks much food for thought, the crisis has given them still more to chew on.
















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The financial crisis has tested the crisis-management readiness of central banks, and the subsequent phase their ability to nurse the economy back to growth.

Central banks have responded in an unprecedented way in both scale and scope.

They have provided ample liquidity in their lender of last resort functions, have committed to low - often effectively zero - interest rates, have engaged in large-scale balance sheet policies, have augmented this with enhanced forward guidance linked to real-economy outcomes, have put in place targeted lending schemes, have purchased risky assets and so on.

The response of central banks has had important benefits.

There is no question that in the most acute phase of the crisis it prevented the financial system from imploding, which would have brought the real economy down.

Low policy rates and the unprecedented deployment of balance sheet policies boosted confidence and improved financial market conditions.

And as doubts re-emerged in financial markets more recently, central bank measures effectively reduced perceived financial tail risks.

And yet, despite these unprecedented actions, the global recovery has been lacklustre.

Five years into the recovery, economic performance is lagging previous ones at the same stage.

Economic activity is well below its pre-crisis trend in the major advanced economies and unemployment is stubbornly high.

There is, understandably, frustration about this apparent lack of traction.
















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This frustration has led some to call for ever more monetary policy activism.

But is it really justified?

If a medicine does not work as expected, it's not necessarily because the dosage was too low.

Maybe instead the overall treatment, and the role of the medicine within it, should be reconsidered.

Most likely something else is needed.

Balance sheet recessions are special: it is less clear than often thought that monetary policy can foster a quick and robust recovery in a balance sheet recession.

When private sector balance sheets need repair, accommodative monetary policies are less effective.

When the problem is too much debt and agents are in the mood to retrench, it is unrealistic to expect monetary policy to revive strong growth by lowering interest rates.

When financial institutions are weak, it is equally unrealistic to expect them to effectively transmit monetary impulses.

Moreover, it is well known by now that growth tends to be weaker after financial crises than after ordinary economic downturns.

This is not just, or even primarily, a question of deficient demand.

It reflects the need for the economy to reabsorb the aggregate and sectoral real imbalances that built up during the preceding unsustainable expansion, hidden under the froth of the financial boom. Basel iii Compliance Professionals Association















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Such booms typically leave in their wake not only too much debt, but also too much capital and labour in the wrong sectors.

Therefore, the challenge for countries in the next few years will be to reallocate labour and capital among sectors both within and across national borders.

Structural reform to remove rigidities, not monetary policy, is the way to facilitate this.

True, monetary policy can buy time to implement the necessary balance sheet repair and structural reforms.

But it cannot substitute for them. After five years of buying time, one has to ask whether that time has been - or will be - used wisely.

Refocusing the policy mix to rely more on repair and reform and not to overburden monetary policy is crucial because the balance of risks of prolonged very low interest rates and unconventional policies is shifting.

The costs are growing in relation to the benefits, for a number of

reasons: First, prolonged monetary accommodation gives

borrowers, financialinstitutions and policymakers an incentive to keep "kicking the can down the road", delaying necessary repair and reform.

Certainly, progress has been made in a very trying

environment. But more needs to be done.

Indeed, the slow progress in the implementation of structural reforms and in the deleveraging process may signal that this delaying mechanism is at work.
















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Persistent high unemployment rates in many advanced economies indicate the challenges of labour rigidities and sectoral rebalancing that still face us.

At the same time, although some private sector deleveraging is occurring in some countries, and the financial system is better capitalised, the total debt figures are not reassuring.

Since the end of 2007, total debt of the G20 non-financial sector, both private and public, has risen by more than 30 trillion US dollars, which runs counter to deleveraging, at least as I understand the term.

It is noteworthy that over the same period global central bank assets have increased by roughly 10 trillion US dollars.

Second, prolonged accommodation can produce other unintended side effects.

In the 1970s, the desire to lift output and employment back to pre-crisis levels resulted in surging inflation.

One might argue that the situation today is quite different from

then. Inflation has remained low in most jurisdictions and close to

central banktargets.

However, monetary stimulus may find its way into asset prices and leverage before influencing goods and services price inflation.

Moreover, prolonged very low interest rates can distort market signals, mask underlying balance sheet weaknesses and undermine the earnings capacity of banks, the business models of life insurance companies and the solvency of pension funds.

This may further misallocate credit, weaken financial institutions' balance sheets and encourage excessive and unwelcome risk-taking.
















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Another significant side effect arises from global monetary policy spillovers.

Persistently low interest rates in the major advanced economies generally encourage capital flows to fast-growing emerging market economies and put upward pressure on emerging market exchange rates.

This can complicate the ability of emerging market central banks to pursue their stabilisation goals.

On the one hand, if central banks in emerging markets keep policy rates very low, capital inflows would be discouraged, but domestic credit growth would be encouraged.

If, on the other hand, they raise policy rates, the risks of destabilising capital flows would rise.

So far, we have been seeing a combination of these forces at

work. Despite some slowing of capital flows over the past year,

private sectorcredit and property prices have been surging in a number of theseeconomies, as well as in some open advanced economies.

Finally, prolonged accommodation raises risks to central banks themselves.

If economies remain weak and structural problems unresolved despite repeated rounds of further monetary stimulus, the credibility of central banks may suffer, and credibility is important for effectiveness.

Let me insist here that results in the real economy will depend on the extent that needed repair and reforms are carried out.

Results will depend to a large extent on factors that are not under central banks' control.
















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A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they actually can deliver.

This may ultimately undermine their credibility and, with it, their legitimacy and effectiveness.

All this underscores the importance of being prepared for the eventual exit from the extraordinarily accommodative monetary conditions that have prevailed for the past several years.

While central banks surely have all the tools available to technically engineer an exit, it cannot be taken for granted that it will be smooth.

The global bond market crash of 1994 is a cautionary tale of the risks involved in exiting from a prolonged period of low interest rates.

At the same time, we also have to recognise that the situation today is rather different from back then in at least one critical dimension: central banks are much more transparent about their policy intentions now and their communication is much better.

This should reduce the risk of major policy surprises.

That said, the policy environment central banks have to grapple with today is also much more complex in some important dimensions.

Record levels of debt have been issued at very low interest rates.

Central banks, at least for now, are playing an important, if not dominant, role in key financial market segments.

So, as interest rates rise and central banks pare back and eventually reverse large-scale asset purchases, financial markets will have much to digest.
















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Different national conditions will require unsynchronised exits, which may raise additional complexities.

Even in the current environment of enhanced central bank transparency and credibility, a choppy exit is a material risk.

It goes without saying that I would love to be proven wrong about this, and that a lot of work is being done to reduce exit risks.

Monetary policy and the financial cycle

As we peer further into the future, one key challenge central banks face is how to better integrate financial stability considerations into their monetary policy frameworks.

The economic and social damage of the recent crisis has painfully shown what is at stake.

And central banks must reflect on how they can forge a new consensus about the way forward.

This is not just a narrow operational issue, for example about how to respond to credit and asset price booms and busts.

It raises the much broader conceptual question of how to shift our traditional purely macroeconomic perspective towards a new, fully integrated macro-financial perspective.

As I see it, the crisis has not discredited the core elements of pre-crisis monetary policy frameworks.

The credibility of central banks as guarantors of price stability has been instrumental in anchoring inflation expectations, on both the downside and the upside, during the crisis and its aftermath.
















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A strong, credible anchor helps to counteract the destabilising forces hitting the economy and financial markets.

At the same time, the pre-crisis monetary policy frameworks did not prevent the crisis from happening.

The experience in the run-up suggests that central banks need to better appreciate their role in influencing the financial cycle.

For this purpose, by financial cycle I refer to the combined endogenous behaviour of credit and asset prices, particularly house prices.

Regulatory reform obviously plays a key role in mitigating financial cycles, and we have already seen significant progress in this area: better and higher buffers, the introduction of countercyclical capital buffers under the new Basel I I I framework and the development of macroprudential frameworks and tools.

To be sure, prudential and macroprudential measures are clearly necessary.

But they alone will not be enough and can also be circumvented by regulatory arbitrage.

This is why monetary policy has a complementary role to

play. The policy rate represents the universal price of

leverage in a givencurrency and cannot be bypassed easily.

In this respect, central banks will need to reflect on how best to respond to financial stability concerns in the future.

The crisis has clearly shown that financial stability is essential for lasting price stability.
















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One lesson is that monetary policy may need to respond more symmetrically to the financial cycle than in the past - tightening more strongly in booms and easing less aggressively, and persistently, in busts.

In practice, this means paying more attention to policy challenges beyond the conventional policy horizons of two or so years.

When financial stability concerns grow, policy horizons need to be lengthened to take account of the fact that the financial cycle is considerably longer than the business cycle.

Analytical frameworks also need to better reflect the characteristics of financial cycles and their interactions with financial and macroeconomic stability.

Central banks' pre-crisis workhorse models generally assigned no meaningful role to macro-financial linkages.

The financial crisis has demonstrated that such analytical perspectives are woefully inadequate.

Another dimension along which central banks need to reflect is a better appreciation of global monetary policy spillovers.

Global feedback effects amplified the pre-crisis financial boom, and we might be seeing this mechanism at work again.

In a highly globalised world, keeping one's own house in order surely is not enough.

What does this mean in practice?

It does not require central banks to coordinate their policies closely.

But, at a minimum, it does call for them to appreciate better the global side effects and feedbacks that arise from their monetary policy decisions.
















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This is in each central bank's own interest, especially if the spillovers have the potential to foster regional financial instability that ends in crisis, with significant global repercussions that swing back to the originating countries, like a boomerang.

A precondition for this shift in perspective is a more global analytical approach that factors in interactions and feedbacks appropriately.

Finally, I do not want to leave you with the impression that fiscal policy is irrelevant in this discussion.

Indeed, fiscal policy plays an important role in financial stability, too. The financial crisis has demonstrated the importance of having the fiscal capacity to support the financial sector through bank rescue packages and the real economy through fiscal buffers.

But the financial crisis has pushed fiscal policy in many economies onto an unsustainable path.

This is a lesson that we have to keep in mind for the future.

Accumulating budget surpluses in good times provides

governments withthe ability to respond flexibly to a financial crisis without putting fiscalsustainability at risk.

In other words, governments need to factor in the financial cycle and to build up additional fiscal buffers during good times that can be drawn down to provide support in bad times.

Summing up

Let me sum up. There is little disagreement that the past five years have been unusually challenging.

Central banks have played a critical role in managing the crisis and its aftermath.
















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They are now under huge pressure to promote a sustainable recovery under difficult circumstances.

And, looking ahead, they will continue to find themselves confronting major challenges.

I have suggested that monetary history provides a valuable compass to navigate these tricky waters: a clear focus on lasting price stability, a more symmetrical approach to the financial cycle, and a better appreciation of global spillover effects - these would appear to be the key elements of stronger monetary policy frameworks.

At the current juncture, there is also a premium on central bank communication.

Central banks need to clearly communicate the limits of monetary policy, both to the public and to other policymakers.

The private sector and policymakers, who have been facing their own set of daunting challenges in extraordinarily difficult times, will have to play a larger role in the next leg of the global recovery.

Crucially, this would also allow central banks to normalise monetary policy in a manner consistent with a return to sustainable and balanced growth.

Thank you.
















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News & Politics

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