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________________________________________ Basel iii Compliance Professionals Association (BiiiCPA)

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,

We have the ninth progress report on adoption of the Basel regulatory framework (October 2015) This report sets out the adoption status of Basel III regulations for each Basel Committee on Banking Supervision (BCBS) member jurisdiction as of end-September 2015.

It updates the Committee’s previous progress reports, which have been published on a semiannual basis since October 2011. In 2012, the Committee started the Regulatory Consistency Assessment Programme (RCAP) to monitor progress in introducing domestic regulations, assessing their consistency and analysing regulatory outcomes. As part of this programme, the Committee periodically monitors the adoption status of the risk-based capital requirements (since October 2011) and (since October 2013) the requirements for global and domestic systemically important banks, the liquidity coverage ratio (LCR) and the leverage ratio. From this report (October 2015), the Committee extends its monitoring of the adoption progress to all Basel III standards, which will become effective

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by 2019. All 27 member jurisdictions have final risk-based capital rules in place, and all but two members have published final LCR regulations. Members are now turning to the implementation of the leverage ratio, the systemically important banks (SIBs) framework and the net stable funding ratio (NSFR). Regarding the consistency of regulatory implementation, the Committee has published its assessment reports on 22 members – Australia, Brazil, Canada, China, nine members of the European Union, Hong Kong SAR, India, Japan, Saudi Arabia, Mexico, Singapore, South Africa, Switzerland and the United States – regarding their implementation of Basel III risk-based capital regulations, which are available on the Committee’s website. This includes all members that are home jurisdictions of global systemically important banks (G-SIBs). The Committee has also published five assessment reports (Hong Kong SAR, India, Saudi Arabia, Mexico and South Africa) on the domestic adoption of the Basel LCR standards. The assessments of Russia, Turkey, South Korea and Indonesia are under way, including consistency of implementation of both risk-based capital and LCR standards. Further, preparatory work for the assessment of G-SIB standards has already started in mid-2015 and its assessment work will start later this year. By September 2016, the Committee aims to have assessed the consistency of risk-based capital standards of all 27 member jurisdictions and the consistency of G-SIB standards of all five member jurisdictions that are home jurisdictions of G-SIBs. Regarding the analysis of consistency of regulatory outcomes, the Committee is conducting additional analytical work on risk-weighted asset (RWA) variation in the banking book, which is expected to be published later this year. A report on the regulatory consistency of risk-weighted assets for

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counterparty credit risk (the third of the Committee’s publications on RWA variation in the trading book) has been published in October 2015. In addition, measures to address excessive RWA variation are under development.

Status of adoption of Basel III standards

Scope The Basel III framework builds on and enhances the regulatory framework set out under Basel II and Basel 2.5. The structure of the attached table has been revamped (effective from October 2015) to monitor the adoption progress of all Basel III standards, which will come into effect by 2019. The monitoring table no longer includes the reporting columns for Basel II and 2.5, as almost all BCBS member jurisdictions have completed their regulatory adoption. The attached table therefore reviews members’ regulatory adoption of the following standards: • Basel III Capital: In December 2010, the Committee released Basel III, which set higher levels for capital requirements and introduced a new global liquidity framework. Committee members agreed to implement Basel III from 1 January 2013, subject to transitional and phase-in arrangements. o Capital conservation buffer: The capital conservation buffer will be phased in between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019. o Countercyclical buffer: The countercyclical buffer will be phased in parallel to the capital conservation buffer between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019. o Capital requirements for equity investment in funds: In December 2013, the Committee issued the final standard for the treatment of banks’ investments in the equity of funds that are held in the banking book, which will take effect from 1 January 2017.

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o Standardised approach for measuring counterparty credit risk exposures (SA-CCR): In March 2014, the Committee issued the final standard on SA-CCR, which will take effect from 1 January 2017. It will replace both the Current Exposure Method (CEM) and the Standardised Method (SM) in the capital adequacy framework, while the IMM (Internal Model Method) shortcut method will be eliminated from the framework. o Securitisation framework: The Committee issued revisions to the securitisation framework in December 2014 to strengthen the capital standards for securitisation exposures held in the banking book, which will come into effect in January 2018 o Capital requirements for bank exposures to central counterparties: In April 2014, the Committee issued the final standard for the capital treatment of bank exposures to central counterparties, which will come into effect on 1 January 2017. • Basel III leverage ratio: In January 2014, the Basel Committee issued the Basel III leverage ratio framework and disclosure requirements. Implementation of the leverage ratio requirements began with bank-level reporting to national supervisors until 1 January 2015, while public disclosure started on 1 January 2015. The Committee will carefully monitor the impact of these disclosure requirements. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 (minimum capital requirements) treatment on 1 January 2018 based on appropriate review and calibration. • Basel III liquidity coverage ratio (LCR): In January 2013, the Basel Committee issued the revised LCR. It came into effect on 1 January 2015 and is subject to a transitional arrangement before reaching full implementation on 1 January 2019. • Basel III net stable funding ratio (NSFR): In October 2014, the Basel Committee issued the final standard for the NSFR. In line with the timeline specified in the 2010 publication of the liquidity

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risk framework, the NSFR will become a minimum standard by 1 January 2018. • G-SIB framework: In July 2013, the Committee published an updated framework for the assessment methodology and higher loss absorbency requirements for G-SIBs. The requirements will be introduced on 1 January 2016 and become fully effective on 1 January 2019. To enable their timely implementation, national jurisdictions agreed to implement by 1 January 2014 the official regulations/legislation that establish the reporting and disclosure requirements. ‘ • D-SIB framework: In October 2012, the Committee issued a set of principles on the assessment methodology and the higher loss absorbency requirement for domestic systemically important banks (D-SIBs). Given that the D-SIB framework complements the G-SIB framework, the Committee believes it would be appropriate if banks identified as D-SIBs by their national authorities were required to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016. • Pillar 3 disclosure requirements: In January 2015, the Basel Committee issued the final standard for revised Pillar 3 disclosure requirements, which will take effect from end-2016 (ie banks will be required to publish their first Pillar 3 report under the revised framework concurrently with their year-end 2016 financial report). The standard supersedes the existing Pillar 3 disclosure requirements first issued as part of the Basel II framework in 2004 and the Basel 2.5 revisions and enhancements introduced in 2009. • Large exposures framework: In April 2014, the Committee issued the final standard that sets out a supervisory framework for measuring and controlling large exposures, which will take effect from 1 January 2019.

Methodology The information contained in the following table is based on responses from Basel Committee member jurisdictions, and reports the status as of end-September 2015.

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The following classification is used for the adoption status of Basel regulatory rules: 1. Draft regulation not published: no draft law, regulation or other official document has been made public to detail the planned content of the domestic regulatory rules. This status includes cases where a jurisdiction has communicated high-level information about its implementation plans but not detailed rules. 2. Draft regulation published: a draft law, regulation or other official document is already publicly available, for example for public consultation or legislative deliberations. The content of the document has to be specific enough to be implemented when adopted. 3. Final rule published: the domestic legal or regulatory framework has been finalised and approved but is still not implemented by banks. 4. Final rule in force: the domestic legal and regulatory framework has been published and is implemented by banks. In order to support and supplement the status reported, summary information about the next steps and the adoption plans being considered are also provided for each jurisdiction. In addition to the status classification, a colour code is used to indicate the adoption status of each jurisdiction. The colour code is used for those Basel components for which the agreed adoption deadline has passed. To learn more: http://www.bis.org/bcbs/publ/d338.pdf

http://www.bis.org/bcbs/publ/d338.pdf

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Basel Committee on Banking Supervision

Frequently asked questions on the Basel III - Countercyclical Capital Buffer Introduction In 2010, the Basel Committee on Banking Supervision released the Basel III capital standards. The countercyclical capital buffer forms an integral part of the standards for risk-based capital, with implementation beginning in 2016, as described in Basel III: A global regulatory framework for more resilient banks and banking systems. In December 2010, the Basel Committee issued further information on procedures for operating the countercyclical capital buffer regime in Guidance for national authorities operating the countercyclical capital buffer. This document provides excerpts from those papers, as well as some clarifications, particularly on the role of jurisdictional reciprocity, and the computation of the capital buffer add-on. The countercyclical capital buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. Its primary objective is to use a buffer of capital to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of systemwide risk. Due to its countercyclical nature, the countercyclical capital buffer regime may also help to lean against the build-up phase of the credit cycle in the first place. In downturns, the regime should help to reduce the risk that the supply of credit will be constrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system.

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The Basel III countercyclical capital buffer is calculated as the weighted average of the buffers in effect in the jurisdictions to which banks have a credit exposure. It is implemented as an extension of the capital conservation buffer. It consists entirely of Common Equity Tier 1 capital and, if the minimum buffer requirements are breached, capital distribution constraints will be imposed on the bank. Consistent with the capital conservation buffer, the constraints imposed relate only to capital distributions, not the operation of the bank. The countercyclical capital buffer regime will be phased-in in parallel with the capital conservation buffer between 1 January 2016 and end-2018, becoming fully effective on 1 January 2019. This means that, for example, if activated at a value of 2.5% of risk-weighted assets (RWA), reciprocity of up to 0.625% (2.5% divided by 4) of RWA is required on 1 January 2016 and this rate will increase each subsequent year by an additional 0.625 percentage points, to reach its final value of 2.5% of RWA on 1 January 2019. Jurisdictions may choose to reciprocate beyond these rates. Jurisdictions that experience excessive credit growth during this transition period may consider accelerating the build-up of the countercyclical buffer.

1. National buffer decisions To make decisions regarding the level of the countercyclical capital buffer add-on, domestic authorities are required to monitor credit growth and make assessments of whether such growth is excessive, leading to the build-up of system-wide risk. Given differences across jurisdictions, there is no global minimum standard for an assessment framework. Authorities are expected to apply judgment in setting the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risks that signal the need to activate the countercyclical capital buffer.

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Nevertheless, as an internationally consistent buffer guide, authorities are expected to calculate the credit-to-GDP guide, which serves as a common reference point for taking buffer decisions. Authorities are not expected to rely on this guide mechanistically, but rather to incorporate the best information available, including expert judgment, when arriving at buffer decisions. Therefore, the credit-to-GDP guide does not necessarily need to play a dominant role, but at the same time it should not be disregarded. Guidance for national authorities operating the countercyclical capital buffer sets out five principles to assist authorities in determining an appropriate framework. It also discusses the calculation and rationale for the buffer guide in greater detail. The five principles are:

Principle 1: (Objectives) Buffer decisions should be guided by the objectives to be achieved by the buffer, namely to protect the banking system against potential future losses when excess credit growth is associated with an increase in system-wide risk.

Principle 2: (Common reference guide) The credit-to-GDP guide is a useful common reference point in taking buffer decisions. It does not need to play a dominant role in the information used by authorities to take and explain buffer decisions. Authorities should explain the information used, and how it is taken into account in formulating buffer decisions.

Principle 3: (Risk of misleading signals) Assessments of the information contained in the credit-to-GDP guide and any other guides should be mindful of the behaviour of the factors that can lead them to give misleading signals.

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Principle 4: (Prompt release) Promptly releasing the buffer in times of stress can help to reduce the risk of the supply of credit being constrained by regulatory capital requirements.

Principle 5: (Other macroprudential tools) The buffer is an important instrument in a suite of macroprudential tools at the disposal of authorities

Questions related to national buffer decisions 1.1 Is there a maximum level of the countercyclical capital buffer add-on and does it have to be set in certain steps, eg in steps of 25bps? Response – The countercyclical capital requirement that is relevant for the reciprocity provision can vary between zero and 2.5% of RWA. National authorities can also implement a buffer of more than 2.5% for banks in their jurisdiction, if they deem this as appropriate in their national context. However, there are no requirements for other countries to apply buffers above 2.5% when implementing reciprocity; they may choose to do so at their discretion. In general, national authorities are free to choose the specific level and can change the buffer add-on rate by whatever amount they deem necessary. 1.2 How should the credit-to-GDP guide be interpreted? Response – The credit-to-GDP gap, calculated in accordance with the credit-to-GDP guide, is a reliable indicator for periods of excess credit growth, in line with the objective of the countercyclical capital buffer. As such, it is a measure of the credit cycle as distinct from the business cycle. It should not be viewed as a deviation from, for instance, the equilibrium

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level of credit in the economy. See Annex 1 of Guidance for national authorities operating the countercyclical capital buffer for a more complete discussion. 1.3 Is the credit-to-GDP guide unduly influenced by measurement problems? Response – The internationally defined credit-to-GDP gap was found to be the best performing measure from a statistical perspective in a range of early warning indicators of incipient banking crises assessed in the Guidance document. Being based on credit, it has the significant advantage over many other variables of appealing directly to the objective of the countercyclical capital buffer. It often points to the correct timing and provides stable signals, which are two important policy requirements. But, as it is not immune to measurement problems, national authorities have to be mindful about these when evaluating the credit-to-GDP guide. For instance: • The credit-to-GDP gap is influenced by the behaviour of GDP as the denominator. If the gap has risen purely because of a cyclical slowdown, for instance, this may not always reflect a build-up of system-wide risks. Similarly, if the credit-to-GDP has been trending upwards for a long time, the gap to the trend may be underestimating the boom. • The trend underlying the credit-to-GDP gap requires sufficient data to be robust. Ideally, there should be a minimum of 10 years of data before the trend is used. • As is typical for macroeconomic indicators, routine statistical revisions

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can affect the underlying data. The available evidence, however, suggests that statistical revisions do not impair the signalling quality of the credit-to-GDP gap

2. Jurisdictional reciprocity Jurisdictional reciprocity will be applied in the context of internationally active banks. Reciprocity ensures that the application of the countercyclical buffer in a given jurisdiction does not distort the level playing field between domestic banks and foreign banks with exposures to counterparties in the same jurisdiction. Through this process, credit exposures to a private sector entity located in any given jurisdiction will attract the same buffer requirement, irrespective of the location of the bank providing credit (please see Section 3 regarding identification of credit exposures). The answers below consider the cases for which reciprocity is mandatory rather than those where home authorities are free to reciprocate at their own discretion. While not mandatory, home authorities may voluntarily reciprocate buffer add-on rates that are higher than the mandatory requirement, as well as requirements set by jurisdictions outside the scope of mandatory reciprocity. They may also match the host jurisdiction’s buffer rate when the rate is cut.

Questions related to jurisdictional reciprocity 2.1 For which jurisdictions is reciprocity mandatory? Response – As part of the Basel III framework, reciprocity is mandatory for all Basel Committee member jurisdictions. A full list of these jurisdictions can be found here. The Basel Committee will continue to review the potential for mandatory

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reciprocity of other non-member jurisdictions’ frameworks and, in the interim, strongly encourages voluntary reciprocity. 2.2 What is the maximum level of the buffer rate for which reciprocity is mandatory? Response – Subject to the transitional arrangements (see question 2.3) before the countercyclical capital buffer is fully implemented in 2019, reciprocity is mandatory for Basel Committee member jurisdictions up to 2.5% under the Basel framework, irrespective of whether host authorities require a higher add-on. 2.3 How do the transitional arrangements operate? Response – As noted in Section 1, if activated, the countercyclical capital buffer will be phased in starting in 2016, with the rate increasing in equal increments each year so that it is in full force on 1 January 2019. For example, if the buffer is activated at 2.5% of RWA, mandatory reciprocity would be 0.625% on 1 January 2016; 1.25% on 1 January 2017; 1.875% on 1 January 2018; and 2.5% on 1 January 2019. While both home and host authorities may accelerate the phase-in, the mandatory reciprocity provisions of the regime will not apply to any additional amounts or earlier time frames. 2.4 When should the host authorities’ rates be reciprocated, and can there be deviations (higher or lower)? Response – Home authorities must reciprocate buffer add-on rates imposed by any other member jurisdiction, in accordance with the scope of mandatory reciprocity and applicable processes. In particular, home authorities should not implement a lower buffer add-on in respect of their bank’s credit exposures to the host jurisdiction, up to a maximum of the buffer rate of 2.5% (or the relevant thresholds during the transition period).

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For levels in excess of the relevant maximum buffer add-on rate, home authorities may, but are not required to, reciprocate host authorities’ buffer requirements. In general, home authorities will always be able to require that the banks they supervise maintain higher buffers if they judge the host authorities’ buffer to be insufficient. 2.5 How do banks learn about different countercyclical capital buffer requirements in different countries? Response – When member jurisdictions make changes to the countercyclical capital buffer add-on rate, authorities are expected to promptly notify the BIS, so that authorities can require their banks to comply with the new rate. A list of prevailing and preannounced buffer add-is to be published on the Basel Committee's website. 2.6 What are the reciprocity requirements for sectoral countercyclical capital buffers or for countercyclical capital buffers introduced by non-Basel Committee members? Response – National authorities can implement a range of additional macroprudential tools, including a sectoral countercyclical capital buffer, if this is deemed appropriate in their national context. The Basel III mandatory reciprocity provisions only apply to the countercyclical capital buffer, as defined in the Basel III framework, and not to sectoral requirements or other macroprudential tools, or to countercyclical capital buffer requirements introduced by jurisdictions outside the scope of mandatory reciprocity. However, the Basel III standards do not preclude an authority from voluntarily reciprocating beyond the mandatory reciprocity provisions for the countercyclical capital buffer or from reciprocating other policy tools

3. Identification and calculation of geographic credit exposures As the countercyclical capital buffer is activated on a jurisdictional basis,

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the buffer add-on that will apply to each bank will reflect the geographic composition of its portfolio of private-sector credit exposures. Banks must therefore identify the geographic location of their exposures. Banks must determine whether the ultimate counterparty is a private sector exposure, as well as the location of the “ultimate risk”, to the extent possible.

Questions related to the identification and calculation of geographic credit exposures 3.1 What are “private sector credit exposures”? What does “geographic location” mean? How should the geographic location of exposures on the banking book and the trading book be identified? Response – “Private sector credit exposures” refers to exposures to private sector counterparties which attract a credit risk capital charge in the banking book, and the riskweighted equivalent trading book capital charges for specific risk, the incremental risk charge, and securitisation. Interbank exposures and exposures to the public sector are excluded, but non-bank financial sector exposures are included. The geographic location of a bank’s private sector credit exposures is determined by the location of the counterparties that make up the capital charge, irrespective of the bank’s own physical location or its country of incorporation. The location is identified according to the concept of “ultimate risk” (see below). The geographic location identifies the jurisdiction whose announced countercyclical capital buffer add-on rate is to be applied by the bank to the corresponding credit exposure, appropriately weighted. 3.2 What is the difference between (the jurisdiction of) “ultimate risk” and (the jurisdiction of) “immediate counterparty” exposures? Response –

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The concepts of “ultimate risk” and “immediate risk” are those used by the BIS' International Banking Statistics. The jurisdiction of “immediate counterparty” refers to the jurisdiction of residence of immediate counterparties, while the jurisdiction of “ultimate risk” is where the final risk lies. For the purpose of the countercyclical capital buffer, banks should use, where possible, exposures on an “ultimate risk” basis. Table A.1 in the Annex illustrates the potential differences in determining jurisdictions of ultimate risk versus immediate counterparty for various types of credit exposure. For example, a bank could face the situation where the exposures to a borrower is in one jurisdiction (country A), and the risk mitigant (eg guarantee) is in another jurisdiction (country B). In this case, the “immediate counterparty” is in country A, but the “ultimate risk” is in country B.

4. Calculation of the final bank-specific buffer add-on

Questions related to the final bank-specific buffer add-on 4.1 Does the countercyclical capital buffer apply to total RWA (credit, market, and operational risk), or only to credit risk exposures? Response – The bank-specific buffer add-on rate (ie the weighted average of countercyclical capital buffer rates in jurisdictions to which the bank has private sector credit exposures) applies to bank-wide total RWA (including credit, market, and operational risk) as used in for the calculation of all risk-based capital ratios, consistent with it being an extension of the capital conservation buffer. 4.2 How is the final bank-specific buffer add-on calculated? Response – The final bank-specific buffer add-on amount is calculated as the weighted average of the countercyclical capital buffer add-on rates applicable in the

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jurisdiction(s) in which a bank has private sector credit exposures (including the bank’s home jurisdiction) multiplied by total risk-weighted assets. The weight for the buffer add-on rate applicable in a given jurisdiction is the credit risk charge that relates to private sector credit exposures allocated to that jurisdiction, divided by the bank’s total credit risk charge that relates to private sector credit exposures across all jurisdictions. Where the private sector credit exposures (as defined above) to a jurisdiction, including the home jurisdiction, are zero, the weight to be allocated to the particular jurisdiction would be zero. 4.3 What are the relevant exposures on the trading book for the computation of geographical weights in the buffer add-on? Response – As noted in paragraphs 143 and 145 of the rules text, private sector credit exposures subject to the market risk capital framework are the risk weighted equivalent trading book capital charges for specific risk, the incremental risk charge, and securitisation. For the VaR for specific risk, the IRC, and the comprehensive risk measures, banks should work with their supervisors to develop an approach that would translate these charges into individual instrument risk weights that would then be allocated to the geographic location of specific counterparties. However, it may not always be possible to break down the charges in this way due to the charges being calculated on a portfolio by portfolio basis. In such cases, one method is that the charge for the relevant portfolio should be allocated to the geographic regions of the constituents of the portfolio by calculating the proportion of the portfolio’s total exposures at default (EAD) that is due to the EAD resulting from counterparties in each geographic region. The Basel Committee will monitor implementation practices and provide more prescriptive guidance should circumstances warrant it. 4.4 At what level of consolidation should the countercyclical capital buffer be calculated?

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Response – Consistent with Basel III, the minimum requirements are applied at the consolidated level. In addition, national authorities may apply the regime at the solo level to conserve resources in specific parts of the group. Host authorities would have the right to demand that the countercyclical capital buffer be held at the individual legal entity level or consolidated level within their jurisdiction, in line with their implementation of the Basel capital requirements.

5. Public disclosure requirements The Basel III framework includes public disclosure requirements for both national authorities and banks. Banks must disclose their countercyclical capital buffer requirement on at least the same frequency as the minimum capital requirements. The overall level must be disclosed consistently with the Basel III disclosure framework. Authorities are required to disclose the overall framework and information used to inform decision-making. This will help to make the countercyclical capital buffer both easier to interpret and enhance its credibility.

Questions related to public disclosure requirements 5.1 What are authorities required to disclose when they set the countercyclical capital buffer rate or change the previously announced rate? How should this be disclosed to other authorities, banks, and the general public? Response – Authorities need to communicate all buffer decisions. All decisions should also be reported promptly to the BIS.

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This will enable a list of prevailing buffers, preannounced buffers, and policy announcements to be published on a dedicated page at the Basel Committee's website. Authorities are expected to provide regular updates on their assessment of the macrofinancial situation and the prospects for potential buffer actions to prepare banks and their stakeholders for buffer decisions. Explaining how buffer decisions were made, including the information used and how it is synthesised, will help build understanding and the credibility of buffer decisions. Authorities are free to choose the communication vehicles they see as most appropriate for their jurisdiction. Authorities are not formally required to publish a given set of information regarding their countercyclical capital buffer regime and policy decisions. However, as noted in Guidance for national authorities operating the countercyclical capital buffer, since the credit-to-GDP guide should be considered as a useful starting reference point, there is a need to disclose the guide on a regular basis. The transition phase can be used to develop a strategy for how to best communicate assessment of the macro-financial situation and the prospects for potential buffer actions. 5.2 How often are authorities expected to communicate buffer decisions? Do they need to communicate a decision to leave a previously announced countercyclical capital buffer rate unchanged? Response – Authorities should communicate buffer decisions at least annually. This includes the case where there is no change in the prevailing buffer rate. More frequent communications should be made, however, to explain buffer actions when they are taken. 5.3 What are banks required to publicly disclose? Is there a standardised template for banks’ public disclosures, eg Pillar 3

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disclosures? Response – Banks must ensure that their disclosed countercyclical capital buffer requirements are based on the prevailing jurisdictional countercyclical capital buffers that are available at the date that they calculate their minimum capital requirement. Banks must disclose their overall countercyclical capital buffer requirement under the common template set out in the Basel III composition of capital disclosure requirements, expressed as a percentage of RWA (see line 66 of the common template). In addition, when disclosing their overall buffer requirement, banks must also disclose the geographic breakdown of their private sector credit exposures used in the calculation of the buffer requirement. However, for the time being, there is no standardised template

6. Timing and frequency of changes in the buffer rates As macroeconomic, financial and prudential information are usually updated on at least a quarterly basis, it is reasonable that authorities review this information at their disposal and take countercyclical capital buffer decisions on a quarterly or more frequent basis. Moreover, given the need to preannounce prospective buffer requirements with a lead time of up to 12 months, taking decisions at this frequency helps to reduce the risk of the buffer not being in place before the credit cycle turns.

Questions related to timing and frequency of changes in the buffer rates 6.1 How much time do banks have to build up the capital buffer add-on? Are there differences between decisions by home and host supervisors? Response – The time period between the policy announcement date and the effective date for any increase in the countercyclical buffer is to give banks time to

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meet the additional capital requirements before they take effect. This time period should be up to 12 months, ie if deemed necessary by the host supervisor, the effective date may be accelerated to less than 12 months following the policy announcement date. Under jurisdictional reciprocity, home authorities should seek to ensure their banks meet any accelerated timeline where practical, and in any case, subject to a maximum of 12 months following the host jurisdiction’s policy announcement date. Finally, banks have the discretion to meet the buffer sooner. 6.2 When there has been a decrease in the buffer rate, how quickly can banks use the portion of the buffer that has been released? Response – Under Basel III, banks may, in accordance with applicable processes, use the released portion of the countercyclical capital buffer that has been built up as soon as the relevant authority announces a reduction in the capital buffer add-on rate (including the case where the buffer is released in response to a sharp downturn in the credit cycle). This is intended to reduce the risk that the supply of credit will be constrained by regulatory requirements, with potential consequences for the real economy. This timeline also applies to reciprocity; that is, banks in other jurisdictions may also use the buffer immediately once the host authority reduces the buffer rate for credit exposures to its jurisdiction. Notwithstanding this, home and subsidiary regulators could prohibit capital distributions if they considered it imprudent under the circumstances.

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Basel Committee on Banking Supervision Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III risk-based capital regulations – Saudi Arabia

Preface The Basel Committee on Banking Supervision sets a high priority on the implementation of regulatory standards underpinning the Basel III framework. The prudential benefits from adopting Basel standards can only fully accrue if these are implemented appropriately and consistently by all member jurisdictions. The Committee established the Regulatory Consistency Assessment Programme (RCAP) to monitor, assess, and evaluate its members’ implementation of the Basel framework. This report presents the findings of the RCAP Assessment Team on the domestic adoption of the Basel risk-based capital standards in the Kingdom of Saudi Arabia (KSA) and its consistency with the minimum requirements of the Basel III framework. The assessment focuses on the adoption of Basel standards applied to the KSA banks that are internationally or regionally active and of significance to the Kingdom’s domestic financial stability. Over recent years, Saudi Arabian Monetary Agency (SAMA) has undertaken several noteworthy initiatives designed to strengthen the prudential framework relating to bank capital. SAMA issued the final rule on Basel III risk-based capital in December 2012 to implement the first phase of Basel III (taking effect on 1 January 2013). A number of new rules and policies were also put in place in October and December 2012, particularly on capital requirements for bank exposures to central counterparties (CCPs) and Pillar 3, respectively.

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The RCAP Assessment Team was led by Mr Stephen Bland, Director, and Strategic Policy Adviser of the United Kingdom Prudential Regulation Authority (UK PRA). The Assessment Team comprised seven technical experts drawn from China, the Financial Stability Institute, Germany, New Zealand, South Africa, Sweden and Turkey (Annex 1). The assessment relied upon the data, information and materiality computations provided by SAMA up to 31 July 2015. The assessment findings are based primarily on an understanding of the current processes in the KSA as explained by the counterpart staff and the expert view of the Assessment Team on the documents and data reviewed. The overall work was coordinated by the Basel Committee Secretariat. The assessment began in February 2015 and consisted of three phases: (i) completion of an RCAP questionnaire (a self-assessment) by SAMA; (ii) an off- and on-site assessment phase (February to May 2015); and (iii) a post-assessment review phase (June to August 2015). The off- and on-site phases included an on-site visit for discussions with SAMA and representatives of the KSA banks (which were used as the RCAP sample banks for the purpose of impact assessment) and external audit firms. These exchanges provided the Assessment Team with a deeper understanding of the implementation of the Basel risk-based capital standards in the KSA. The third phase consisted of a two-stage technical review of the assessment findings: first by a separate RCAP Review Team and feedback from the Basel Committee’s Supervision and Implementation Group; and secondly, by the RCAP Peer Review Board and the Basel Committee. This two-step review process is a key instrument of the RCAP process to provide quality control and ensure integrity of the assessment findings.

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The focus of the assessment was on the consistency and completeness of the domestic regulations in the KSA with the Basel minimum requirements. Issues relating to adequacy of prudential outcomes, capital levels of individual banks, the adequacy of loan classification practices, or SAMA’s supervisory effectiveness were not in the scope of this RCAP assessment exercise. Where domestic regulations and provisions were identified to be not in conformity with the Basel framework, these deviations were evaluated for their current and potential impact (or, non-impact) on the reported capital ratios for a sample of internationally active KSA banks. Some findings were evaluated on a qualitative basis. The assessment outcome was based on the materiality of findings and use of expert judgment. The report has three sections and a set of annexes: (i) an executive summary with a statement from SAMA on the material findings; (ii) the context, scope and methodology, and the main set of assessment findings; and (iii) details of the deviations and their materiality along with other assessmentrelated observations. The RCAP Assessment Team acknowledges the professional cooperation received from SAMA counterparts throughout the assessment process. In particular, the team sincerely thanks the staff of SAMA for playing an instrumental role in coordinating the assessment exercise. The series of comprehensive briefings and clarifications provided by SAMA enabled the RCAP assessors to arrive at their expert assessment. The Assessment Team would also like to thank the representatives of the KSA banks that provided data and information to the Assessment Team.

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The Assessment Team is hopeful that the RCAP assessment exercise will contribute towards strengthening prudential effectiveness and full implementation of the recent reform measures in the KSA.

Executive summary SAMA has implemented the Basel III risk-based capital regulations consistently with the internationally agreed timeline and has also applied the transitional arrangements in line with Basel III. SAMA’s risk based capital rules apply to all 12 locally incorporated banking institutions. Overall, the Assessment Team finds SAMA’s prudential regulations to be compliant with the standards prescribed under the Basel framework. All 14 components of this review are assessed as compliant with the Basel standards. SAMA made a number of rectifications in response to the findings of its self-assessment and of the Assessment Team. In all, SAMA’s capital framework benefited during the course of the RCAP assessment work from 93 rectifications. These findings were mostly not material and largely related to incomplete or inaccurate incorporation of Basel text. There was only one finding which has not been rectified. SAMA applies a zero (0%) risk weight for banks' sovereign exposures to Gulf Cooperation Council (GCC) countries and this requirement has been applied since the local implementation of the Basel I accord in 1992. Under the Basel framework’s standardised approach for credit risk, a zero risk weight is only available for banks' exposures to sovereigns of at least AA– credit rating and for banks' exposures to sovereigns to which a zero risk weight is applied by the relevant supervisory authority in the issuing country. The Assessment Team noted that there are some GCC exposures which do not comply with this test, notably Oman and Bahrain.

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While paragraph 54 of Basel II allows for national discretion to apply a lower risk weight to the sovereign exposures of these two countries, the exposures must be denominated in the domestic currency and funded in that currency. With respect to KSA banks with exposures to Oman and Bahrain, SAMA should only apply a zero risk weight if the supervisory authorities in these countries allow their banks to apply a zero risk weight to sovereign exposures in their respective countries. Based on the discussion during the on-site visit, SAMA stated that this preferential treatment was agreed and implemented due to the collective agreement made by all GCC members. At present, these exposures are not material in amount. Nevertheless, this could possibly change in the future due to an increase in banks’ exposures or a downgrade in the sovereign rating of other GCC countries and might thus potentially become a material deviation from Basel standards. Several elements of the Basel capital framework, notably the Internal Ratings-Based (IRB) Approach for credit risk, the Internal Models Approach (IMA) for market risk, and the Advanced Measurement Approach (AMA) for operational risk have not at this point been adopted by KSA banks (one bank is in parallel run for the IRB approach, but SAMA has not yet granted it approval to migrate to an advanced approach). SAMA regulates Sharia-compliant banks in the same way as it does non-Sharia banks in the KSA. This does not currently lead to any deviation from Basel standards. Nevertheless, if there were a greater variety of Sharia-compliant activities and/or if the International Financial Reporting Standards were differently applied to Sharia-compliant activities in the KSA, this could change. More generally, the Basel Committee may wish to consider whether the application of its standards take full account of Islamic financial activities. Several aspects of SAMA’s framework are more conservative than the Basel framework and these are summarised in Annex 10. They are listed in the report but have not been taken into account for the final assessment of compliance as per the agreed assessment methodology.

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The Assessment Team recognises the amendments made by SAMA to strengthen alignment of its capital rules to the Basel III framework throughout the course of the assessment process. These amendments became effective on 31 July 2015 (see Annex 6 for a complete list of the amendments).

Response from SAMA SAMA welcomes this opportunity to respond to the findings and comments of the RCAP Assessment Team on the implementation of Basel III Capital Adequacy Regulations in Saudi Arabia. SAMA also wishes to acknowledge and appreciate the commitment, professionalism and expertise of the RCAP Assessment Team, under the leadership of Mr Stephen Bland, and would like to thank the Assessment Team for the proficiency with which the entire RCAP exercise for Saudi Arabia was completed. This assessment has provided a comprehensive and thorough review of the level II implementation of the Basel regulatory capital framework in Saudi Arabia and we are pleased that Saudi Arabia has received an overall compliant rating. SAMA has always considered a strong capital adequacy framework to be the cornerstone of a sound banking system. This important principle was embedded in the Banking Control Law which provided for a capital adequacy ratio and a capital leverage ratio for Saudi banks as far back as 1966. In the following years, SAMA led the way in this region, introducing the Basel I Capital Adequacy Accord in 1992, and the Basel II Framework in 2008. Since becoming a member of the Basel Committee, SAMA has introduced Basel III Capital Adequacy rules with effect from 2013, in accordance with the Basel-agreed timelines. SAMA has always encouraged Saudi banks to maintain high levels of capital adequacy; consequently, since the 1990’s, Saudi banks have maintained a Basel capital ratio of on average around 18% to 20%.

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It is worth noting that about 85% of banks’ regulatory capital is composed of Common Equity Tier 1 (CET1). Based on SAMA’s self-assessment and as identified by the RCAP Assessment Team, SAMA has carried out a number of modifications to the existing regulations and guidelines before the cut-off date of 31 July 2015. We believe that these modifications will further strengthen the implementation of the Basel capital adequacy framework in Saudi Arabia. Overall, SAMA considers the RCAP process to be a useful exercise, and is supportive of the Basel goals to promote consistency of implementation of rules among member countries. SAMA also concurs that the RCAP process promotes a level playing field among Basel member jurisdictions, which reduces regulatory arbitrage and promotes safety, soundness and stability in the global financial system.

Assessment context and main findings 1.1 Context Status of implementation SAMA, the central bank of the KSA is responsible for the regulation and supervision of the banking sector. SAMA is empowered by the Banking Control Law (BCL) (1966) and SAMA Charter (1957) to issue banking regulations, rules and guidance to licensed banks in the KSA. The Basel II standards have been in effect from 1 January 2008 and, subsequently, Basel 2.5 and Basel III were implemented with effect from 1 January 2013 via the issuance of regulations and circulars (see Annex 2 for a complete timeline). These are all in effect as on the date of the assessment.

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Regulatory system and model of supervision, and binding nature of prudential regulations

The following chart provides an overview of the legal hierarchy of banking regulations in the KSA

1.2 Structure of banking sector As at December 2014, 24 banks were licensed in the KSA (12 banks are locally incorporated), with total bank assets (including off-balance sheet equivalents) amounting to SAR 4.2 trillion (approximately USD 1.1 trillion – see Annex 8 for an overview of selected key indicators of the KSA banking sector).

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The financial system is dominated by the five largest internationally active commercial banks, which hold about 63% of total banking assets. There are no global systemically important banks (G-SIBs) in the KSA, but three of the 24 banks in the KSA are branches of foreign G-SIBs. SAMA has finalised the framework for identification of domestic systemically important banks (D-SIBs) and has identified six banks as DSIBs. Under the new Basel III standards, the weighted average total capital ratio of the five largest banks stood at 18.3% (31 December 2014). The Tier 1 ratio and the CET1 ratio were 16.8%. Credit risk is the predominant risk type for KSA banks, and accounts for approximately 90% of total risk-weighted assets, followed by market risk (3%) and operational risk (7%). SAMA has been cautious in allowing banks to engage in complex financial activities.

1.3 Scope of the assessment Scope The RCAP Assessment Team has considered all documents that effectively implement the risk-based Basel capital framework in the KSA as of end-July 2015, the cut-off date for the assessment (Annex 4). The assessment focused on two dimensions: • A comparison of domestic regulations with the capital standards under the Basel framework to ascertain that all the required provisions have been adopted (completeness of SAMA domestic regulation); and • Whether there are any differences in substance between the domestic regulations and the capital standards under the Basel framework and their significance (consistency of SAMA regulations). In carrying out the above, the RCAP Assessment Team considered all binding documents that effectively implement the Basel framework in the KSA as discussed above.

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Importantly, the assessment did not evaluate the adequacy of capital or resilience of the banking system in the KSA or the supervisory effectiveness of the KSA regulatory authorities. Any identified deviation was assessed for its materiality (current and potential, or having an insignificant impact) by using both quantitative and qualitative information. For potential materiality, in addition to the available data, the assessment used expert judgment on whether the domestic regulations met the Basel framework in letter and spirit (see also Section 1.4).

Bank coverage For the purposes of assessing the materiality of deviations, data were collected from the following five banks: National Commercial Bank, Al Rajhi Bank, Riyadh Bank, Samba Financial Group and Saudi British Bank. These banks are internationally active and are the largest banks in the KSA. They represent more than 63% of total assets of the banking system in the KSA (31 December 2014).

Assessment grading and methodology As per the RCAP methodology approved by the Basel Committee, the outcome of the assessment was summarised using a four-grade scale, both at the level of each of the 14 key components of the Basel framework and overall assessment of compliance: compliant, largely compliant, materially non-compliant and non-compliant. The materiality of the deviations was assessed in terms of their current or, where applicable, potential future impact (or non-impact) on the capital ratios of the banks. The quantification was, however, limited to the agreed population of internationally active banks. Wherever relevant and feasible, the Assessment Team, together with SAMA, attempted to quantify the impact based on data collected from the KSA banks in the agreed sample (see Annex 8).

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The non-quantifiable aspects of identified deviations were discussed and reviewed in the context of the prevailing regulatory practices and processes with SAMA. Ultimately, the assignment of the assessment grades was guided by the collective expert judgment of the Assessment Team. In assigning grades, the Assessment Team relied on the general principle that the burden of proof rests with the assessed jurisdiction to show that a finding is not material or not potentially material. A summary of the materiality analysis is given in Section 2 and Annex 9. In a number of areas, the KSA rules go beyond the minimum Basel standards. Although these elements provide for a more rigorous implementation of the Basel framework in some aspects, they have not been taken into account for the assessment of compliance under the RCAP methodology as per the agreed assessment methodology (see Annex 10 for a listing of areas of super-equivalence).

1.4 Main findings A summary of the main findings is given below.

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Main findings by component

Scope of application SAMA’s implementation of the scope of application is compliant with the Basel Framework. The Basel framework applies to internationally active banks on a fully consolidated basis as well as at every tier within a banking group, including the holding company that is the parent entity within a banking group. This is to ensure that the Basel requirements capture the risk of the banking group holistically. SAMA applies the Basel framework to all licensed banks including foreign banks’ branch operations, on a solo and a consolidated basis. There were several areas where SAMA adopts a stricter approach. For example, it applies a materiality level of 10% of the bank’s capital (instead of 15% under the Basel II) to determine significant investments in commercial entities, which will be 1250% risk-weighted. The list of areas where SAMA rules are stricter than the Basel standards can be found in Annex 10.

Transitional arrangements Under the Basel framework, banks using the Basel II advanced approaches are subject to a capital floor based on the application of the 1988 Accord (ie Basel I). SAMA states that the capital floor continues to apply beyond 2009 (as envisaged by paragraph 48 of the Basel II standard). SAMA has modified the transitional arrangements – which were previously slightly different – to be fully consistent with Basel III arrangements. Based on the rectified regulations, the Assessment Team considers SAMA’s rules on the transitional arrangements to be compliant.

Definition of capital

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Basel III’s overarching objective is to ensure that banks’ risk exposures are sufficiently backed by highquality capital, ie maintain a sufficient level of capital comprising CET1, additional Tier 1 and Tier 2 capital instruments. This is to ensure adequate loss absorbency capacity in the capital instruments, as well as to harmonise capital deductions and prudential filters applied at the common equity level. SAMA requirements on definition of capital are generally a reproduction of the Basel III requirements. As such, SAMA’s implementation of the definition of capital is assessed as compliant with the Basel standards.

Point of non-viability (PON) Basel III requires that all Additional Tier 1 and all Tier 2 capital instruments include a contractual principal loss absorption mechanism that is activated by the “trigger event” (broadly speaking, non-viability of the bank) unless the governing jurisdiction of the bank has in place laws that (i) require such Tier 1 and Tier 2 instruments to be written off upon such event, or (ii) otherwise require such instruments to fully absorb losses before taxpayers are exposed to loss. SAMA has issued a circular (#BCS 5611) which requires banks to comply with these requirements when planning to issue any additional Tier 1 or Tier 2 capital instruments. The Assessment Team considers SAMA’s rules for PON to be compliant with the Basel III.

Capital conservation buffer In addition to the minimum capital requirements, Basel III includes a capital conservation buffer, to be phased in by 1 January 2019, that will ultimately require banks to maintain an additional 2.5% of CET1 capital or face constraints on capital distributions and discretionary bonus payments. SAMA rules reproduce the Basel III capital conservation buffer requirements, and are therefore assessed as compliant.

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Countercyclical buffer Basel III has established a countercyclical buffer between zero and 2.5% through an extension of the capital conservation buffer, based on the local authority’s judgment as to the extent of the build-up of system-wide risk. The countercyclical buffer is to be phased in in parallel with the capital conservation buffer and becomes fully effective on 1 January 2019. SAMA rules reproduce the Basel III capital countercyclical buffer requirements, and are assessed as compliant with the Basel III.

Credit risk: Standardised Approach In general, SAMA’s regulatory requirements for the credit risk Standardised Approach are assessed to be compliant with the Basel standards. There was one issue identified by the Assessment Team which is assessed to have a potentially material impact. The Assessment Team notes that SAMA has provided a concession for banks’ to apply a zero (0%) risk weight for banks’ GCC sovereign exposures for the purpose of computing the credit risk capital charge. The preferential treatment was granted since the publication of the Basel I standard, based on the mutual agreement that all GCC members (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) would apply a similar treatment to GCC sovereign exposures. S AMA did not use the discretion allowed in Basel II’s paragraph 54 to allow for such treatment and this provision was implemented without ensuring whether or not other GCC members would apply the requirements set out in paragraph 54. This paragraph provides for a preferential risk weight for exposures to a jurisdiction’s own sovereign provided the exposures are denominated and funded in the local currency. Based on the risk weight table in paragraph 53 of Basel II, all of the GCC countries fulfil the preferential risk weight criteria (ie AA– and above rating), except for Bahrain (BBB–, which corresponds to a risk weight of 50%) and Oman (A–, a risk weight of 20%).

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At present, KSA banks have no exposure to Oman and only minimal exposure to Bahrain. However, KSA banks may increase their exposures to these countries or there may be a downgrade in the sovereign rating of other GCC countries. SAMA believes that these exposures are likely to decrease rather than increase, but the risk of a further country downgrade cannot be ruled out. The impact of this deviation is thus assessed to be potentially material. Additionally, the team also notes that SAMA regulates Sharia-compliant banks in the same way as it regulates non-Sharia banks and hence, no special treatment is applied to Islamic products. However, the Assessment Team is aware that, in some markets with Sharia-compliant banks, different treatments are applied to certain Islamic banking products. For example, deposits collected by Islamic banking institutions in some markets are subject to certain Sharia-compliant features which do not guarantee the return/profit paid to the deposit holders and are linked to the performance of a particular asset, eg financing/loans. In this case, the deposit holders will additionally be exposed to the default risk of the loan. Further, conversion factors (ie an alpha factor which effectively reduces the exposure amount) are applied to the financing extended utilising these participation accounts. These exposures would then be subjected to relevant risk weights, since such credit risk exposure is shared with the deposit holders. In the event that such products become available in the KSA and the local accounting rules subject these products to an alpha factor which reduces the exposure amount, this could result in a deviation from the Basel standards.

Credit risk: Internal Ratings-Based Approach SAMA’s standards are compliant with the Basel Framework for the Internal Ratings-Based Approach.

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SAMA rules are more conservative than required by the Basel standard in several areas. For instance, SAMA does not recognise certain types of collateral (referred to in the Basel standard as eligible IRB collateral) and for purchased corporate receivables the top-down approach is not permitted. Also under the foundation approach, senior claims on corporates, sovereigns and banks not secured by recognised collateral must be assigned a loss-given-default (LGD) estimate of 60%, which is higher than the LGD estimate of 45% in the Basel standard. At present, no bank in the KSA uses the IRB approach for regulatory capital purposes.

Credit risk: Securitisation framework The minimum capital requirements for the Securitisation framework set forth in the KSA regulation and guidance notes are consistent and compliant with Basel III. The Assessment Team notes that securitisation comprises a relatively minor proportion of the overall risk-weighted assets of the KSA banking sector and no bank currently adopts the advanced modelling approaches for regulatory capital purposes.

Counterparty credit risk framework In the KSA, all three approaches specified by the Basel framework to measure counterparty credit risk (CCR) exposures can be adopted by banks in the KSA. Currently, banks only apply the Current Exposure Method (CEM). The rules for these three approaches and both approaches for credit valuation adjustment (CVA) risk have been specified by SAMA in their local regulations. Also, rules on capital requirements for bank exposures to CCPs have been captured by a circular which makes direct reference to the applicable Basel framework. Overall, the CCR framework in the KSA is deemed to be compliant with the Basel framework.

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As an observation, the Assessment Team notes some ambiguity as to whether banks in Saudi Arabia can recognise bilateral netting of derivatives for capital adequacy purposes given the uncertainty surrounding the enforceability of netting agreements locally. However, the Assessment Team acknowledges that this issue goes beyond the scope of the RCAP assessment. The Assessment Team also notes that derivatives activity in the KSA and its corresponding CCR is relatively small. CCR riskweighted assets (RWA) currently represent on average around 1% of total RWA for banks captured within the RCAP sample for assessment, with the largest contribution being 2.4% of total RWA.

Market risk: Standardised Approach SAMA’s requirements on the Standardised Measurement Method for market risk are considered compliant with the Basel framework. No deviation has been identified.

Market risk: Internal Models Approach The minimum capital requirements for the IMA for market risk set forth in the KSA regulations and guidance notes are consistent and compliant with Basel III. Currently, no bank in the KSA adopts the IMA for market risk regulatory capital purposes. SAMA has, in addition to the regulations/guidelines, issued a circular stating that the original Basel texts for market risk are binding, thus preventing deviations.

Operational risk: Basic Indicator Approach, Standardised Approach, and Advanced Measurement Approaches The Basel Framework allows three approaches in order to calculate the capital requirements for operational risk, namely: the Basic Indicator Approach (BIA), the Standardised Approach (TSA) or its variant the Alternative Standardised Approach (ASA) and the Advanced Measurement Approach (AMA).

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SAMA permits all the above-mentioned approaches but no bank uses the advanced approach for regulatory capital purposes. SAMA’s rules for operational risk are compliant with the Basel Framework. The rules are more conservative than required by the Basel standard in a few areas (see Annex 10 for more details). For instance, the criteria under the Basel standard intended for internationally active banks to qualify for the standardised approach have been imposed by SAMA on all banks.

Supervisory review process The RCAP assessment of the supervisory review process covers the adoption of prescribed standards under Pillar 2 of the Basel II framework and the Supplementary Pillar II Guideline. SAMA’s Pillar 2 framework is considered compliant with the Basel framework as the domestic rules are broadly aligned with the Basel expectations on Pillar 2. The implementation of Pillar 2 in the KSA has been integrated by SAMA into their risk-based supervisory framework. Banks are required to submit an internal capital adequacy assessment process (ICAAP) document to their supervisor on an annual basis for review. This ICAAP is used by SAMA as one of the inputs to determine the individual capital adequacy ratio (CAR) targets that each bank must meet. These CAR targets – which cover both Pillar 1 and Pillar 2 risks – are set on an annual basis. SAMA uses its broad powers available under Article 7 of SAMA Charter 1957 and Article 22 of the Banking Control Law 1966 to impose the minimum requirements under Pillar 1 and the annual CAR targets and to take supervisory action where these requirements are not met. Further details of the supervisory review process in the KSA have been provided by SAMA in Annex 14.

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Disclosure requirements SAMA has implemented Pillar 3 by providing banks in the KSA with a set of prescribed templates supplemented by guidance notes, both of which are largely based on requirements of the Basel standards. Its Pillar 3 framework was first introduced in 2007 with Basel II, and has since been updated to reflect more recent expectations under Basel II.5 and Basel III on the composition of capital and on remuneration. Overall, SAMA’s regulations on Pillar 3 are assessed to be compliant with the Basel standards.

2 Detailed assessment findings The component-by-component details of the assessment of compliance with the risk-based capital standards of the Basel framework are detailed below. The focus of Sections 2.1 to 2.5 is on findings that were assessed to be deviating from the Basel minimum standards and their materiality. Section 2.6 lists some observations and other findings specific to the implementation practices in the KSA. This section is based on the assessment of the rules as at 31 July 2015 including the published amendments.

2.1 Scope of application

2.2 Transitional arrangements

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2.3 Pillar 1: Minimum capital requirements

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2.3.4 Credit risk: Internal Ratings-Based Approach

2.3.5 Securitisation framework

2.3.6 Counterparty credit risk framework

2.3.7 Market risk: The Standardised Measurement Method

2.3.8 Market risk: Internal Models Approach

2.3.9 Operational risk: Basic Indicator Approach and the Standardised Approach

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2.3.10 Operational risk: Advanced Measurement Approaches

2.4 Pillar 2: Supervisory review process

2.5 Pillar 3: Market discipline

2.6 Observations and other findings specific to the implementation practices in the KSA 2.6.1 Credit risk: Internal Ratings-Based Approach

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2.6.2 Counterparty credit risk

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Annexes

Annex 1: RCAP Assessment Team and Review Team

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Annex 3: List of capital standards under the Basel framework used for the assessment (i) International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Basel II), June 2006 (ii) Enhancements to the Basel II framework, July 2009 (iii) Guidelines for computing capital for incremental risk in the trading book, July 2009 (iv) “Basel Committee issues final elements of the reforms to raise the quality of regulatory capital”, Basel Committee press release, 13 January 2011 (v) Revisions to the Basel II market risk framework: Updated as of 31 December 2010, February 2011

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(vi) Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (revised June 2011) (vii) Pillar 3 disclosure requirements for remuneration, July 2011 (viii) Treatment of trade finance under the Basel capital framework, October 2011 (ix) Interpretive issues with respect to the revisions to the market risk framework, November 2011 (x) Basel III definition of capital – Frequently asked questions, December 2011 (xi) Composition of capital disclosure requirements: Rules text, June 2012 (xii) Capital requirements for bank exposures to central counterparties, July 2012 (xiii) Regulatory treatment of valuation adjustments to derivative liabilities: final rule issued by the Basel Committee, July 2012 (xiv) Basel III counterparty credit risk – Frequently asked questions, November 2011, July 2012, November 2012

Areas where SAMA rules are stricter than the Basel standards In several places, SAMA has adopted a stricter approach than the minimum standards prescribed by Basel or has simplified or generalised an approach in a way that does not necessarily result in stricter requirements under all circumstances but never results in less rigorous requirements than the Basel standards. The following list provides an overview of these areas. It should be noted that these areas have not been taken into account as mitigants for the overall assessment of compliance.

Scope of application 1. Basel II paragraphs 20: While Basel II specifies that the framework will be applied to internationally active banks, SAMA’s rules are applied to all licensed banks in the KSA.

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2. Basel II paragraphs 35: While Basel II adopts a materiality level of 15% of the bank’s capital for individual significant investments in commercial entities, SAMA uses a stricter materiality level of 10% of the bank’s capital for individual significant investments in commercial entities.

Credit risk: standardised approach 1. Basel II paragraph 55: Basel II paragraph 55 allows the usage of Export Credit Agency (ECA) ratings but SAMA does not use the ECA ratings at all. 2. Basel II paragraph 56: Basel II paragraph 56 allows international organisations (BIS, IMF, and ECB) to be risk-weighted at 0% but SAMA considers these organisations as sovereigns and does not directly use a 0% risk weight. 3. Basel II paragraphs 72: Basel II paragraph 72 allows a risk weight of 35% for claims collateralised by residential mortgages but SAMA applies a 100% risk weight. 4. Basel II paragraphs 145: SAMA does not allow recognition of equities and mutual funds under the standardised approach for the purpose of credit risk mitigation, which is allowed by Basel paragraph 145 under certain conditions. Also SAMA has additional requirements for other eligible financial collaterals.

Credit risk: internal ratings-based approach 1. Basel II paragraph 287: Basel II states that under the foundation approach, senior claims on corporates, sovereigns and banks not secured by recognised collateral will be assigned a 45% LGD. SAMA’s standard requires an LGD of 60%. 2. Basel II paragraph 373 (i): For purchased receivables, subject to certain conditions, Basel II allows the double default framework to be used for dilution risk. SAMA’s standards state that the double default framework is only available when a contract covers only dilution risk, implying that if a contract covers

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default and dilution risk, the double default framework cannot be applied to dilution risk. 3. Basel II paragraph 459: Basel II paragraph 459 states the non-authorised overdrafts should be associated with a zero limit for IRB purposes, meaning that days past due commence once any credit is granted. SAMA’s standards incorporate this requirement but also classify temporary overdrafts in the same way.

Operational risk 1. Basel II paragraph 651: Basel II paragraph 651 states that banks using the BIA are encouraged to comply with the Basel Committee’s guidance on Sound Practices for the Management and Supervision of Operational Risk, February 2003. SAMA imposes (rather than encourages) compliance with this guidance. 2. Basel II paragraph 660–663: Basel II paragraph 663 sets out criteria for internationally active banks using the Standardised Approach. The footnote to paragraph 663 recommends but does not require supervisors to impose these criteria on non-internationally active banks as well. SAMA imposes the requirements of Basel II paragraph 663 on all banks, not just internationally active banks.

Glossary AMA Advanced Measurement Approach A-IRB Advanced Internal Ratings-Based Approach ASA Alternative Standardised Approach BCBS Basel Committee on Banking Supervision BCL Banking Control Law 1966 BIA Basic Indicator Approach CAR Capital adequacy ratio CCP Central counterparty CCR Counterparty credit risk CET1 Common Equity Tier 1 CEM Current exposure method CVA Credit valuation adjustment

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D-SIBs Domestic systemically important banks EL Expected loss FAQs Frequently asked questions FSAP Financial Sector Assessment Program FX Foreign exchange G-SIB Global systemically important bank GCC Gulf Cooperation Council HVCRE High-volatility commercial real estate ICAAP Internal Capital Adequacy Assessment Process IMA Internal Models Approach IMM Internal Models Method IPRE Income-producing real estate IRB Internal Ratings-Based Approach KSA Kingdom of Saudi Arabia LGD Loss-given-default MR Market risk OTC Over-the-counter PD Probability of default PON Point of non-viability RCAP Regulatory Consistency Assessment Programme RWA Risk-weighted assets SAMA Saudi Arabian Monetary Agency SAR Saudi Arabian riyal TSA The Standardised Approach UK PRA United Kingdom Prudential Regulation Authority

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Capital Regulation Across Financial Intermediaries Governor Daniel K. Tarullo, at the Banque de France Conference: Financial Regulation -- Stability versus Uniformity; A Focus on Non-bank Actors, Paris, France Strengthening the quantity and quality of capital held by banks has been a central element of post-financial crisis regulatory reform. Yet, as the topic of this conference reminds us, the crisis also exposed weaknesses in other financial intermediaries that carried systemic implications. In the United States, when Bear Stearns and Lehman Brothers failed, they were so-called freestanding investment banks, not subject even to the inadequate pre-crisis regulatory regime for bank holding companies. The stress at American International Group (AIG), an insurance company, and the vulnerability of money market funds to destabilizing runs contributed to a profound deepening of the crisis. Hence the theme for this session of the conference: In light of this recent history and, more generally, of the steady growth of nonbank financial intermediaries, to what degree should they be subject to the capital regulations developed by the Basel Committee on Banking Supervision and applied to bank holding companies in the United States and to all commercial and investment banks in Europe? At first glance, the answer to this question might seem intuitively obvious. After all, the risk of loss associated with a particular corporate loan or mortgage-backed security or, indeed, any other asset does not vary just because its legal owner is an insurance company or mutual fund, rather than a bank. Yet we all know that regulatory capital requirements sometimes do vary with the nature of the firm. And I suspect that most people in this room believe there are good reasons why they should vary under at least some circumstances.

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In my remarks this morning, I will explain how the identification of those circumstances should proceed--by looking not at the asset side of a financial intermediary's balance sheet, but at the liability side. The scope and nature of a firm's liabilities provide the justifications for capital requirements regulation. Differences in liabilities can, accordingly, sometimes warrant different capital requirements for portfolios of similar assets across firms. At the risk of packing too much into these introductory points, let me also note that an emphasis on a firm's liabilities is related to, but not synonymous with, an emphasis on its activities. Thus, for example, simply deciding that an intermediary provides mostly commercial banking services or insurance products does not fully answer the question of what its capital requirements should be. My purpose today is not to offer specific proposals, or even a comprehensive conceptual framework, but instead to propose an approach for thinking about the purposes of capital regulation across types of financial intermediaries that will suggest appropriate starting points for shaping--or reshaping--applicable capital regulation. This seems to me a particularly important effort at a time when the financial system is undergoing significant change.

Liability Structure and Capital Regulation To begin, we should remind ourselves that capital regulation of private corporations is unusual. Generally, market actors with actual or contemplated claims on a nonfinancial corporation are left to their own devices in protecting their interests, though various features of contract, securities, and insolvency law are designed to help them make these judgments more efficiently. In many kinds of financial intermediaries, on the other hand, capital levels are regulated, usually because of market failures attributable to some combination of information problems, moral hazard, collective action problems, and systemic risk.

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Scrutiny of the liability side of the balance sheet reveals whether and how these various justifications are present for different financial intermediaries. Let me start with a couple of straightforward examples, well-established in regulatory practice. The first example arises from the fact that, by the very nature of their business, many intermediaries have substantially more customer-facing liabilities on their balance sheets than nonfinancial firms. This characteristic often means that leverage is higher. It almost always means that a large portion of the liability side of the balance sheet is accounted for by such customers, who are not well-positioned to evaluate the soundness of these intermediaries' often-opaque balance sheets. Consider the case of a very traditional life insurance company, which collects premiums from customers over a protracted period of time, while promising a payout to beneficiaries if the insured dies within the coverage period. The duration of the exposure, difficulties in evaluating the company's ability to pay, and the potentially high costs of changing coverage to another firm even if that evaluation can be done together provide a rationale for insurance company capital requirements. Here the motivation for capital regulation is likely oriented toward the capacity of the company to meet these long-term claims as they come due, presumably over a fairly extended span. Investors and counterparties from the financial sector might well be left to fend for themselves. Thus this rationale for capital regulation focuses only on assuring sufficient assets over time to satisfy the policyholders' claims should the company fail, with less attention to maintaining the company as a going concern. A second example of how the liability side of an intermediary's balance sheet suggests the appropriate form of capital regulation is presented by the familiar problem of deposit runs on banks. Like a policyholder, a depositor has difficulty gauging the health of the financial intermediary.

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But unlike a life insurance policyholder, a depositor can withdraw all or most of her funds if she has any fear--even an ill-founded fear--that the bank may be in trouble. Indeed, depositors have a rational incentive to act quickly, since the first to withdraw will have the best chance of getting all their money back. Experience with bank runs, and with the more-damaging cases of bank panics (in which problems at one bank are imputed to others on the basis of incomplete and possibly incorrect information), led to government -provided deposit insurance. While countering runs and panics and protecting depositors from loss, government deposit insurance creates different justifications for capital regulation--protecting the government insurance fund, which is now guaranteeing a significant portion of the bank's liabilities, and countering moral hazard, which may arise because insured depositors need no longer care whether the bank is adequately capitalized. The moral hazard issue leads us to a third example of how the liability side of the balance sheet of a financial intermediary reveals the need for capital regulation--the too-big-to-fail (TBTF) problem. As the size of an intermediary increases, its exposures to other market actors--including many other intermediaries--may become so extensive that its failure would threaten the financial system as a whole. Believing that the government will, for this reason, prevent such an intermediary from becoming insolvent, market actors may extend credit as if a guarantee similar to deposit insurance were in place. Thus the nature and extent of the firm's liabilities, taken as a whole, may warrant capital regulation to offset an implicit TBTF subsidy. Even if the distinct problem of TBTF could be countered through other means, such as a credible bankruptcy or resolution option, the failure of a financial intermediary with systemically significant liabilities raises the prospect of imposing very large negative externalities on the financial system. This prospect creates an additional argument for capital requirements--or, more precisely, an argument for progressively higher capital requirements

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that would reduce the probability of the failure of the systemically important intermediary. Note that this last discussion has moved us toward consideration of macroprudential reasons for capital requirements--specifically, for higher requirements aimed at reducing the probability of insolvency below that which would be warranted if the sole regulatory aim were to protect customers, depositors, or even a government deposit insurance fund. As has been much discussed in recent years, pre-crisis financial regulatory regimes had substantially undervalued systemwide considerations. Indeed, in the first instance the crisis spread not only because of the direct effects engendered by the insolvency of individual firms, but also because of the dramatic contraction of funding available throughout markets for widely held assets such as mortgage-backed securities. The pre-crisis explosion of short-term wholesale funding, both inside and outside traditional banks, left the entire financial system vulnerable to the disappearance of this market funding as real estate prices declined sharply and uncertainty spread about the value of the assets being funded. Concerns about solvency accelerated the run of wholesale funding from Bear Stearns and Lehman Brothers, raising the prospect of classic fire sales of their assets, with consequent depressing effects on the balance sheets of all firms holding these assets. Experience during the financial crisis vindicated the view of those who had argued that liquidity, as well as capital, in large intermediaries needed to be regulated. It also buttressed the view that capital and liquidity regulation are closely related and need to be developed in tandem, if not as part of the same regulatory framework. Much academic research prompted by the crisis has focused on the interrelationship between funding and solvency problems. Here, then, is another way in which the characteristics of the liability side of an intermediary's balance sheet should determine the form and stringency of capital regulation.

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Shorter duration and, if you will, increased "runnability" of its liabilities create greater threats to both its stability and that of the financial system as a whole. Where a firm is significantly dependent on this kind of funding, it may need more common equity to convince counterparties and investors of its solvency during periods in which assets are very volatile and to maintain its solvency should it need to sell assets at fire sale prices. This microprudential basis for higher capital requirements is complemented by the macroprudential rationale that intermediaries whose deleveraging could have a broad impact on market liquidity through fire sale or related effects should be required to hold still more capital. Let me make three additional points on this rationale for higher capital standards. First, a run that cuts off funding to widely held assets is a greater risk to the system than a conventional bank run in the absence of deposit insurance. A bank's whole loans would not usually be sold in great number even under stressed circumstances and, even to the degree they were, other banks' portfolios of loans are generally not marked down because of the stressed bank's sales. Second, the possible availability of central bank liquidity support does not obviate the need for higher capital for intermediaries reliant on short-term wholesale funding. The same factors that make market actors uncertain about the value of the intermediary's assets in times of stress will be relevant to the central bank's ability to assure itself that the recipient of temporary liquidity is in fact solvent. Third, because these risks to the firm and the financial system arise from of the composition of the liability side of the balance sheet, the concerns expressed here apply--though perhaps in somewhat different degrees--regardless of the particular form of intermediation in which the firm is engaged.

Tailoring Capital Regulation

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With only modest simplification of the always complex world of financial regulation, one can say that while capital requirements traditionally have differed significantly for different types of financial intermediaries, they have been relatively uniform for all firms classified as a particular type of intermediary. As I mentioned at the outset, the variations in capital requirements might run contrary to the intuition that the risk of loss of a given portfolio of assets is the same no matter who owns them. Of course, the direct explanation for the variations lies in part in institutional history, with different regulatory bodies having been given authority over different types of financial intermediaries. Still, as we have seen, differences in the liability side of the balance sheet can in fact provide a good policy justification for having varying capital requirements among different types of financial intermediaries. Yet, as I will suggest in a moment, even if conventional differences are at least broadly justifiable (which, of course, is not to say that certain differences in any particular jurisdiction have been well-formulated in all their specifics), the fact that so many intermediaries have moved well beyond their traditional practices, products, and scope may warrant some qualification of conventional practice. Conversely, the conventional regulatory principle of imposing more or less uniform capital requirements on a given form of intermediary might have seemed intuitively correct. But one lesson regulators around the world have drawn from the crisis is that macroprudential considerations can sometimes argue for varying capital requirements among the same kind of intermediaries. Let me address, then, some implications of the liability-side perspective on capital requirements for different forms of financial intermediaries. Despite the focus of this session of the conference on nonbanks, I want to begin by noting how post-crisis changes in the Basel regime reflected the characteristics of an intermediary's liabilities. Prior to the crisis, the Basel regime--though nominally applicable only to internationally active banks--in fact applied to most banks in many

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member jurisdictions, including the United States and the European Union (EU). There were no quantitative liquidity requirements, and capital requirements did not vary based on the liability side of the balance sheet. Indeed, the major departure from uniform application of capital rules was the opportunity afforded by Basel II for large banks to use their own internal models in determining their regulatory capital requirements, an opportunity that Basel II's proponents expected to result in slightly lower requirements than under a standardized approach. In the wake of the crisis, Basel III strengthened capital quality and levels across the board. In addition, capital surcharges were imposed on about thirty banks of global systemic importance (G-SIBs), based on criteria that roughly reflect TBTF concerns--that is, the size and interconnectedness of the firms' balance sheets. Neither the generally applicable Basel III changes nor the G-SIB surcharges were specifically tied to the stability of a bank's debt structure. However, minimum quantitative liquidity requirements have been developed in the form of the shorter-horizon Liquidity Coverage Ratio (LCR) and the longer-horizon Net Stable Funding Ratio, which together are intended to place some limits on excessive reliance on runnable liabilities. Important as these changes have been, the risks to the financial system posed by large amounts of short-term wholesale funding argue for closer regulatory linkage between capital and liquidity concerns. Conceptually, the cleanest approach might be to integrate capital and liquidity requirements in a single regulatory framework, which would establish minimum levels of capital and liquidity and then increase the capital requirement for intermediaries with more vulnerable funding structures. Higher capital levels would be especially warranted for intermediaries using large enough amounts of short-term debt that their response when funding liquidity is constrained--either selling assets or withholding funding from their own customers--could adversely affect the financial system as a whole.

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Realistically, though, the goal of full integration of capital and liquidity regulation seems unattainable for the foreseeable future. For one thing, it is hard to imagine all the relevant banking, market, and insurance regulators converging on such a novel approach anytime soon. In addition, though, without a more complete understanding of the precise relationship between liquidity and capital needs, placing so much weight on one form of regulation would be ill-advised. For the present, then, the Basel regime will maintain separate capital and liquidity regulations, which may differ among types of financial intermediaries. But we can at least strive to establish each set of regulations with reference to the other and to attain at least a rough consistency across regulatory regimes applicable to various intermediaries. In the United States, we have already taken one step in this direction. As you may know, in implementing the Basel G-SIB capital surcharge, we decided that surcharges somewhat higher than those finally agreed in Basel were appropriate. As we refashioned the Basel approach, we added a metric on short-term wholesale funding dependence to the formula for determining a firm's systemic significance, a factor that unfortunately had not been included in Basel. I hope that when it comes time for a review of the Basel methodology for identifying and grouping G-SIBs, funding practices and vulnerabilities will receive more attention. And there may be further steps that could increase that sensitivity. Exploring ideas along these lines seems to me far preferable to raising minimum liquidity requirements for all banks, even those with capital levels well above the regulatory minimum. For example, while stress testing has traditionally focused on risks to capital, some observers have suggested adding liquidity risks to the stress test.

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Turning now to some implications for other intermediaries, I will begin with broker-dealers, which pose perhaps the clearest case of the capital/funding relationship. Broker-dealers tend to hold large amounts of assets that are of longer duration, but that also are relatively liquid in normal times (in contrast, say, to whole loans by a bank). However, as seen most graphically in the case of mortgage-backed securities during the crisis, many of these assets can rapidly become quite illiquid in periods of stress. Since broker-dealers generally fund substantial portions of these assets with short-term liabilities, such as repurchase agreements (repos) rather than insured deposits, there is the potential, again seen in the crisis, for runs reminiscent of the bank runs of the era before the advent of deposit insurance. To a considerable extent, of course, the Basel framework covers these firms. In the EU, any broker-dealer is covered, whether as a stand-alone entity or as part of a universal bank. In the pre-crisis period in the United States, matters were less clear, since only broker-dealers affiliated with bank holding companies were covered by the full panoply of Basel requirements. There was partial coverage of the five largest freestanding broker-dealers that needed such oversight in order to operate within the EU. Because, during the crisis, those five firms either became bank holding companies or failed and had their continuing operations absorbed by bank holding companies, all sizeable domestically owned broker-dealers are now covered by Basel requirements. However, as I mentioned just a moment ago, the Basel framework itself has not gone as far as is desirable in making capital requirements at the largest institutions sensitive to macroprudential funding concerns, a circumstance underscored by the balance sheets typical of broker-dealers. Consideration of changes such as refinement of the formula for assigning surcharges to G-SIBs would be useful when Basel standards are revisited over time.

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In the interim, there are more near-term opportunities for supervisory measures that take account of the relationship between capital levels and funding vulnerabilities. Perhaps the most interesting application of a liability-side focus on capital regulation is the case of insurance companies. Given the ongoing discussions of capital standards in the International Association of Insurance Supervisors, the issue is also a timely one. Several relevant points can be derived from attention to the liability side of insurance company balance sheets. First, as shown in my earlier example of how liability structure affects capital needs, the largest segment of a traditional insurance company's liabilities is composed of contingent claims based on the occurrence of specified events, such as the death of an insured person or destruction of insured property. These claims cannot be accelerated at the discretion of the holders of the contracts so, unlike deposits in a bank, these liabilities cannot run in any meaningful sense. Unless customers decide to sever their relationship with the company, in which case the contingent liability will be reduced or eliminated, they will continue to provide funding to the firm. Life insurance, in particular, has an unusually predictable liability pattern, well-refined by actuaries over the years. Thus there is a relative absence of liquidity risk as compared with other kinds of intermediaries. Property and casualty insurance is somewhat more volatile but that volatility is not correlated with the broader economy. So, while higher capital levels may be needed for microprudential purposes, the traditional property-casualty insurance model does not appear to raise significant funding, fire sale, or other macroprudential concerns. These traditional insurance liabilities argue for lower capital requirements than might be required for a hypothetical bank holding a similar portfolio of assets.

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And, as noted earlier, in some respects they also argue for a gone-concern approach to capital regulation. However, a second observation is that the liability side of the balance sheets of many large insurance companies look quite different from this traditional picture. Many life insurers, for example, now offer wealth and retirement products with account values that can be withdrawn at the discretion of the policyholder, sometimes with little or no surrender penalty. Although these products are generally considered medium to long-term liabilities, the option to surrender or withdraw funds creates the potential for increased claims that could strain the liquidity of the firm. Recent history suggests that the surrender rates of fixed annuities are directly related to the path of interest rate rises. In the middle part of the last decade, as interest rates rose in the United States, the surrender rate for these products increased by about 75 percent in just a few years, before dropping precipitously after the rapid decline in rates following the onset of the financial crisis. Similarly, the move of some insurance firms into securities lending, repo, over-the-counter derivatives, and other capital market activities can work significant changes in the balance sheets of those firms, creating tighter connections to the rest of the financial system. As with other financial intermediaries, insurers then become subject to demands for posting additional collateral or closing out positions as unfavorable market conditions take hold. In addition, if the books of the insurance company are large enough, it then becomes a potential vehicle for transmitting distress at the company to other parts of the financial system. Thus the liability side of the balance sheets of firms that are all "insurance companies" can vary substantially, just as with firms that are called "banks" or "bank holding companies." Yet capital regulation currently applicable to insurance companies seems not to make some of the relevant distinctions.

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Traditional capital regulation, with an implicit aim of protecting only conventional policyholders over time, potentially through an orderly insolvency, does not reflect the balance sheet risks I have just described. Yet more recent measures, such as Solvency II, with its heavy emphasis on current market valuation, may not take account of the fact that liability and liquidity risks for genuinely traditional life insurance products are relatively limited compared to those of many other intermediaries. In some respects, Solvency II ignores the strength of conventional insurance funding--that assets can be held for the truly long-term, through multiple business cycles--even as it focuses directly on the fluctuations in asset values that are indeed relevant to many less conventional activities. This brief review illustrates the challenges in fashioning capital requirements for large insurance companies with a mix of traditional, nontraditional, and noninsurance activities that are sometimes quite intertwined in particular business lines or subsidiaries. And, even where these activities are reasonably segregated from one another, some of the policy devices suggested for differential capital treatment may be misplaced. For example, deciding on higher capital requirements based solely on whether an activity is "nontraditional" for an insurance company can be inappropriate. A "nontraditional" activity for an insurance company could embrace everything from the massive derivatives business maintained by the pre-crisis AIG to very sedate businesses outside the financial sphere entirely. In confronting these and similar challenges, I would suggest that a focus on the actual nature of liabilities associated with a firm's activities provides a good starting point for sound analysis. Finally, let me mention asset managers briefly. As they have garnered increasing shares of financial system assets, a trend that accelerated following the financial crisis, the question has arisen whether they too should hold capital buffers.

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Of course in most cases the asset manager itself does not have much of a balance sheet at all. The funds themselves are often not leveraged, in which case nearly all the liabilities are shares of the fund held by investors, the price of which varies to reflect the value of the assets purchased by the manager of the fund. While some commentators have suggested that liquidity challenges and consequent fire sale type behavior might develop if the structure of the fund places a premium on exiting first, these kinds of risks would support an argument less for capital buffers than for some form of prudential market regulation, such as rules on liquidity or redemptions. I would note in this regard that last week the SEC issued a proposed rulemaking that would require open-ended funds to have liquidity risk management controls in place for shareholder redemptions, including during times of stress. Likewise, to the degree that certain idiosyncratic risks might exist with respect to the decisions and operations of certain asset managers, their liability structure again suggests that some form of prudential market regulation would be better suited to address these risks.

Conclusion In conclusion, let me recapitulate one set of points and add another. To recapitulate--focusing on the characteristics of the liability side of a financial intermediary's balance sheet suggests that there are reasons to vary capital regulation across different forms of financial intermediation, but that significant shifts in the nature and scope of an intermediary's liabilities may in turn provide reasons for varying applicable capital regulation among firms that are primarily identified as a particular type of intermediary. Conceptual, institutional, and practical impediments to developing a single framework for capital regulation are doubtlessly insuperable for the foreseeable future. But regulators with mandates covering different kinds of intermediaries, including the Federal Reserve, must keep both sides of this perspective in mind.

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And, hopefully, regulators with a more focused responsibility will be sensitive to the ways in which their regulated entities have departed from their original liability structure. The additional point follows from the first. When concerns are raised about regulatory arbitrage or a level playing field, they are usually in the context of a similar asset being held, or a business activity conducted, by financial firms with different regulatory structures. My discussion today would suggest that attention must be paid to the liability structure of the different firms before deciding whether the asymmetric regulatory treatment is prudent or an invitation to the propagation of new financial risks. These two points underscore the fact that the question for regulators is not really whether capital rules developed for banks should be extended to nonbank actors. The Basel standards have already evolved to take account of different forms of intermediation in the financial firms subject to those rules. The Basel framework might itself be enhanced by further differentiation of capital and liquidity requirements based on the liability structures of firms. Similarly, capital rules for intermediaries not subject to Basel rules should be shaped by similar considerations.

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Digital Darwinism and the financial industry - a supervisor s perception Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Speech at the EBS (EBS University of Business and Law) Symposium, Oestrich-Winkel

1. Introduction Ladies and gentlemen Thank you for the opportunity to contribute to this EBS Symposium. As a banking supervisor, I am happy to share with you my thoughts on digital Darwinism in the financial industry.

2. Digital transition from an evolutionary perspective Dinosaurs are an often-used means of illustrating how "Darwinism" works. We still don't really know why those creatures - which ruled the earth for millions of years - suddenly became extinct. Some make volcanic eruptions responsible; others cite meteorites or a sharp drop in sea level as a possible explanation. In any case, the assumption is not that dinosaurs ceased to exist because they could not cope with their new environment or adapt quickly enough. Applying this diagnosis to the financial sector, where banks have reigned throughout the last few centuries, and supposing that the digital transition indeed constitutes a new environment for banks, one may pose a rather provocative question: are banks dinosaurs that will one day become extinct? You may guess that I do not share this doom scenario, so let me start out by describing my views on the evolution of the banking business. The digital era may indeed be considered a new environment for banks. Digitalisation of the financial sector is an irrevocable change that came about due to several factors.

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First, the digitalisation of the financial sector has been fuelled by the development of highly effective, state-of-the-art technologies like broadband networks, advances in data processing and the ubiquity of smartphones. And there is a premise that is common to virtually all technological advances in market economies in the last few centuries: when a product becomes available, sooner or later it creates its own demand and puts market forces into action. That means technological and social changes are intertwined. Bank customers are becoming increasingly open to digital banking. Think of innovative concepts such as online video consultation services, digital credit brokerage and the incorporation of social media into banking. Banking is still a "people business", but it's no longer reduced to proximate and personal relationships. So there is plenty of demand for use of the technological potential of digital banking: cheap and quick automatised processes, solutions for complex financial issues, service tailored to customers' individual needs. A fundamental challenge that banks now face is that in some business fields, we may expect a sudden and rapid change of the game that is being played. One rather obvious case in point is that of payment services. Service providers such as PayPal or Apple have implemented payment systems geared to consumers in a digital environment. Once customers become used to a new way of paying, competitors offering similar products will certainly have difficulties trying to convince customers to switch providers. The pioneer may have a decisive advantage. Now, in evolutionary terms, the question is whether banks can adapt quickly enough. Banks have used IT for decades, but these fast-moving times present wholly

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new possibilities for its use: P2P lending becomes feasible, internet and mobile applications are sprouting up and internet giants such as Google or Facebook are cultivating "big data" methods. These enterprises have grown up with - at times - entirely new perceptions of business, work and life. And they have the appropriate staff. That may be crucial. It is one thing to build new ideas, but quite another to incorporate them into the company DNA. Traditional banks, on the other hand, typically do not have a digital DNA. Theirs is an analogue world in which they have refined their knowledge about banking over decades and built up a customer relationship based on trust. Think of areas like investment advice and corporate finance as well as banks' own business of generating synergies between business strands. The question now is: what part of their knowledge is still valuable and what part do banks need to reframe? However, we cannot predict how the financial sector will look in ten years' time. There are just too many "unknown unknowns". Still, there is a recurring fallacy that reduces evolution to a narrow one-way street. If there are new market entrants whose businesses are well-adjusted to the digital environment, banks should be inclined to imitate their behaviour. But - to be clear - there is no one-size-fits-all strategy for digital banking. As in other industries, there will always be demand for more differentiated strategies, for example individual and personalised services as opposed to algorithm-based advice. Also, we should not be surprised to see the focus return to a key component of the banking business: establishing safety and trust.

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Furthermore, the digital age does not simply redistribute market shares of a fixed revenue pie: there are also entirely new opportunities for desirable businesses. Convenient banking is valuable. Banks could benefit from this, either through greater customer loyalty or through additional business volumes resulting from extra services. Win-win schemes are also conceivable in credit markets. "Big data" methods can generate highly informative individual risk profiles. This could enable banks to extend loans to private customers and small businesses which would otherwise not receive any financing. Even investment counselling could benefit. Video-based consulting, for example, does more than reflect modern life style of customers; it may also reduce costs for banks by rendering some branch offices unnecessary. Other keywords of digital openings are "co-creation", where customers participate in the development of products, and "multichannel banking". But my aim today is not to present an all-encompassing overview on digital bank business ideas. Instead, let us move one step back and look at the bigger picture. Reshaping the financial sector doesn't need to be left to new market entrants. This creative challenge can also be taken up by established banks. Supervisors, too, have an interest in seeing banks engage in innovation if this enhances the functionality of the financial sector and stabilises profitability in the medium and long run. To sum up, there is an "open end" to the evolution of the digital financial sector. If you ask diehard evolutionists for a forecast of the future, they will merely

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point to a trial-and-error process that should eventually give us an answer. For an individual company, that is of course not helpful. As a banking supervisor, I am not inclined to attempt a market forecast. Still, there is a bottom line for banks from the line of thought I outlined earlier, namely that it is appropriate neither to blindly imitate nor to stick to old habits. The message to every player in the financial industry is simple: rather than being caught off-guard, banks have to participate actively in shaping future banking services. A new game is being played, and new strategies need to be developed and executed decisively.

3. Cyber risks - an evolutionary attachment to the digital bank Along with the digitalisation of industries, there is another evolution that warrants our attention. It is a development that is neither intended by the visionaries and trailblazers of the digital world nor beneficial. I am referring to the evolution of cybercrime. While we cannot predict how banking will look in ten or twenty years' time, we can be almost certain that risks of fraud, theft and manipulation in banks through cyberspace will continue to rise. The reason is straightforward: digital channels can be used to steal a lot of assets with comparatively little effort today. Nowadays, a large proportion of banks' assets and value-generating capability is stored on hard drives and servers. The technical infrastructure facilitates the managing of bank accounts and grants access to money. But it also provides access to vast sources of data. There have been several incidents recently of truly large-scale data theft.

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Company secrets, too, are at stake. If, for example, the trading algorithms of your bank became known to others through illegal activities, they could be exploited in the market, causing huge losses to banks. In the same way, politically motivated acts of sabotage jeopardise trust in financial functions and integrity. Looking at those on the other side of cybercrime, the potential attackers - they often have access to far more powerful weapons than before and convenient access through the internet. Targeted attacks on IT systems can originate from anywhere in the world. Hackers often need little more than a laptop with internet access. Why do we have to expect a continuous evolution in this field? Attack vehicles like computer viruses differ widely and may target any chink in a bank's defence, rather as human viruses attack biological systems. Its logic follows the arms race between criminals and law enforcers that can be traced down through human history, but is now taking place with digital weapons. What makes this evolution more dangerous still is that we now face a highly complex digital world where progress is constantly being made in technologies and innovations. But, crucially, you cannot risk a trial-and-error process here. Once an easy point of attack is identified in the IT infrastructure, the word will quickly spread and criminals from all over the world will try to exploit the weakness. On top of this, we need to bear in mind that cyber and general IT risks are not only of a technical nature. The human factor often plays a crucial part. Employees may act in gross negligence, or they may be tricked by a Trojan

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horse or a phishing mail. In complex IT systems, even small system errors can quickly cause enormous damage. The error-prone human factor can only be eliminated by installing an appropriate system of controls and incentives. In today's world, this is an important management task.

4. Adaptation as a managerial task Before IT-related problems came to affect the very core of the digital economy, they were commonly shifted to the IT department. But this approach to IT risks is outdated. Awareness of digital risks and setting up a strategy are now a leader's duties. If your business crucially relies on digital processing, any strategic decision at the company level requires knowledge and understanding of risks. Besides, we frequently observe that banks find it difficult to reorganise their IT systems. While a complete, "big bang" overhaul may be preferable, it often meets with resistance from many parts of the company. To avoid being locked into more and more outdated structures, banks should not just consider the expected short-term benefits when designing their IT strategy. Furthermore, the digital world demands from banks' managers something I would describe as unbiased attentiveness towards new technologies. If banks don't think "digitally", they're going to find it difficult to compete for digital customers. They have to reassess their client relations and even rethink different lifestyles and social trends. The individual needs and wishes of customers are more pivotal than ever

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before. Take a look at social networks, at online shopping or even at information research - consumers are already used to having their own needs catered for. Consequently, banks will have to get into the habit of looking at things from the customer's perspective. Let us also bear in mind that competition is becoming more global and more transparent, the competitors more diverse. In addition to FinTech companies, other industries with a strong IT focus are only one step away from the banking world. This means that the lines between industries are becoming blurred. Now more than ever, banks need to be aware of what the competition is doing so that they can review and refine their own strategies. From an evolutionary perspective, adaptability is another essential attribute. The digital world welcomes experimentation, is prone to sudden trends, and is constantly changing. Although the banking industry may not always be subject to all of this constant movement, adaptability is definitely becoming more important. So a flexible IT infrastructure that supports adaptability, for example, will be vital. Business models can also be more open and flexible in structure. Just think of the "digital ecosystem" strategies banks are now deploying.

5. Towards a resilient sector As a banking supervisor, I am wholeheartedly in favour of the goal of a stable sector. But this should not be understood as adopting a static view towards stability.

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For a workable financial industry, it is not decisive whether services are provided offline or online, by humans or by automated services. Our yardstick needs to measure whether the sector continues to fulfil its duty towards the real economy, which is to transform risks and provide payment and other financial services. That's what is meant by a resilient financial sector. To that end, we have to ensure there are no "dead ends" to the digital evolution in the financial industry. I refer to IT-related risks in particular. If we rely on computers and digitalised processes, we have to make sure that they are reliable and trustworthy. Sector-wide reputation and functionality are at stake. Nowadays, a customer's personal payment information is stored not only at the bank but at a multitude of service providers and retailers as well. How can a bank ensure the safety of its payment services against a cyber-attack on a retailer's network or on that of a third-party vendor? Combined efforts should be seen as insurance. You never know who will be the next victim of an attack. And attacks don't stop at borders, so cooperation of this kind is also needed at the global level. In an interconnected and therefore interdependent financial sector, strengthening the common defence should also be in the banks' very own interest.

6. Conclusion Let me restate my views on "digital Darwinism". Adaptation to a digitalised financial world does not simply require banks to develop new and ground-breaking ideas.

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It has more to do with a well-adjusted strategy - which means that it's not just a race between development departments, but between leaders. As a supervisor, I therefore urge that we do not interpret digital competition as a race merely for the most advanced technologies, but for the right mix. This is why I am not in favour of comparing banks to dinosaurs. Traditional banks may typically have a pre-digital DNA, but they are capable of learning, adapting to a digital landscape and cooperating with technological pioneers. And each bank needs to find its own strategy. Banking business itself is as irreplaceable as ever before. So what will not change? Business success will continue to hinge on entrepreneurial skills. In an increasingly digital finance sector, the role of banking will still be to serve the real economy. And banking is based on trust. To keep this in mind will be key to ensuring a thriving and stable financial sector.

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Reintegrating the banking sector into society - earning and re-establishing trust Speech by Ms Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the Single Supervisory Mechanism, at the 7th International Banking Conference "Tomorrow's bank business model - How far are we from the new equilibrium", organised by Bocconi University, Milan

Introduction Ladies and Gentlemen, esteemed audience, First of all let me thank the organisers of this conference, and especially Andrea Sironi, for their kind invitation. I very much welcome this opportunity to elaborate on what I think are currently some of the most important questions in banking: How can bankers regain the trust that was lost during the crisis? How can the banking sector be reintegrated into society? There is no doubt that banks, bankers and the whole industry are experiencing one of the worst crises of confidence ever. The turmoil of 2008 and 2009 played a major role in this loss of public trust, but the problem did not end after the most acute phase of the crisis. Even seven years later, confidence in the banking sector is still very low. Numerous scandals, like the manipulation of LIBOR rates, large-scale tax evasion, the fraudulent behaviour of rogue traders, misconduct in the selling of mortgages, and large taxpayer bailouts of banks, have reinforced the perception that wrongdoing is widespread in the banking sector. But mistrust is not only confined to banks themselves. Investors and clients also have less confidence in the correct functioning of the banking sector and in the ability of supervisors and regulators to prevent excessive risk-taking.

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We should worry about this loss of trust in the banking sector: It impairs the proper functioning of banks to reallocate resources. It hampers growth. It leads to instability and costly crises. In a recent paper, Gennaioli illustrated the role that trust plays in banking by comparing finance to medicine. Banking, is a service like healthcare, in which "transactions" take place between two parties that differ in terms of information, knowledge and technical competence. Patients put themselves in the hands of their doctor, and investors, like patients, would like to be in good hands and not be taken advantage of. But how can trust in the banking sector be restored? Who are the key players in this process? Is it enough to reform the regulatory and supervisory framework, as we have done in recent years?

Banks, intermediation and trust Let me start by using a simplification of the activities of banks to explain why it is worthwhile investing in regaining trust. Traditionally, the core activity of a commercial bank is to take deposits from individuals who have a surplus of resources and to allocate those resources to productive activities. Banks thereby perform three main functions. First, they provide payment and settlement services to households, entrepreneurs, companies and other financial institutions. Second, they enable savers to reap the full benefits of long-term investments, while still being able to access liquidity when needed. Third, they assess and monitor the creditworthiness and payment

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behaviour of borrowers more efficiently than an individual investor could. Through these activities, banks reduce the inefficiencies caused by asymmetric information and incentive problems between those who save and those who borrow. It is mainly via this channel, that banks create value and contribute to economic growth. However, even though banks assess and monitor borrowers' creditworthiness, savers may still be concerned about whether banks - and their managements - have the necessary skills and will make the required effort to protect their savings. Asymmetric information and incentive problems are still present, but arise at new, different levels: no longer between savers and borrowers, but between savers, bankers and supervisors. In the relationship between banks and their creditors, incentive conflicts may arise between managers on one side (who set the bank's strategy, make investment decisions and monitor the performance of investment projects and the payment behaviour of debtors) and shareholders and debt holders on the other side (who provide the bank's funding and who bear the ultimate risks and receive the benefits of the bank's activities). Information problems may also occur among banks that are linked by mutual business relationships or collective vulnerabilities to systemic events. Asymmetric information and incentive problems can be addressed through contracts, institutions and appropriate regulatory and supervisory frameworks. But this is a rather abstract and idealised view. In reality, more is needed: trust is needed. The medical analogy is a handy way to illustrate this. Patients can always sue doctors for malpractice. They could always enforce the "contract" with their doctor. However, no patient will ever consult a doctor whom he does not trust, even

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though he can sue him. The same applies to banking. In general, creditors will not deposit money in a bank whose integrity and soundness they do not trust. Shareholders can set up remuneration schemes to incentivise managers whose activities they cannot monitor full time. But shareholders also need to trust their managers, because not all of their activities are perfectly contractible and, even if they were, it could be difficult and time-consuming to enforce the incentive contract in court. At this point, one could interject that, while trust may have been essential for banking in the past, this is no longer the case today. Our economy and society have undergone dramatic changes in recent decades, which have also affected banks. Innovation and technological progress have reduced the need for trust in some situations. Computerisation has allowed banks to use data-driven applications rather than rely on expert judgement for the evaluation of creditworthiness of borrowers or the pricing of financial products. However, banks and their business have become much more complex than they used to be, which increases the asymmetry of information and, hence, the need for trust. For example, it is not now uncommon for banks now to have multiple parent-subsidiary structures operating in different jurisdictions across the globe. Some banking products have become so sophisticated that most people, even some bankers, no longer fully understand them. By the way, I expect every CEO or Board member to do without products which they do not understand. Today, banks are more complex to manage harder to monitor and their activities are more difficult to understand than was previously the case, and

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the asymmetric information and incentive problems I mentioned earlier are more prominent than ever. In short, trust is and has always been essential for banks to carry out their activities, foster economic growth and add value to society. Banking is and always has been trusting. What can be done to restore trust? Given the currently low level of confidence in, and within, banks, what needs to be done to rebuild trust?

The role of regulatory reform First, whose job is it to regain trust? In the aftermath of the crisis, significant changes have been made in the regulatory and supervisory framework. Reforms of capital and liquidity regulation, risk management, governance and resolution regimes have been introduced. Moreover, consumer protection has been enhanced. The regulatory framework now has a better and broader base, and is less vulnerable to arbitrage. While much has been achieved, I would like to highlight one piece of work in particular. Last year, the Financial Stability Board published a set of guidelines on supervisory interaction with banks on risk culture. The guidelines are aimed at assisting supervisors in their assessment of risk culture by listing a number of indicators or practices that can be indicative of an overall sound and well-balanced approach. These include an appropriate "tone from the top" within a bank and other key factors, such as accountability, effective internal communication, the existence of challenge mechanisms within the decision-making process, and incentives for employees.

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Supervisors themselves have also changed since the crisis. They are now stricter, more pro-active and assess banks in a much more holistic way. Topics such as governance, remuneration and risk appetite are among the key priorities on every supervisor's agenda this year. In the Single Supervisory Mechanism (SSM) for example, we are in the final stages of a thematic review of governance and risk appetite in the 123 institutions directly supervised by us which will feed into this year's assessments of the capital and liquidity adequacy of banks. Our initial findings indicate that a number of banks, while meeting national requirements, do not comply with international best practices with regard to governance. Our key observations include examples of power concentration in individual board members (e.g. holding multiple offices or chairmanships within the same group), a lack of separation between a bank's risk and audit functions, information asymmetries among board members, and instances where the board simply does not take enough time to discuss and reflect on individual issues. It is also apparent that some banks are still in the early stages of implementing their risk appetite framework and therefore still have a lot of work to do to ensure its consistent application throughout the entire organisation. All of these issues reduce the quality of decision-making and risk awareness within a bank and can obscure or even encourage malpractice. Therefore, we will require banks to follow up on these findings. But are the efforts of regulators and supervisors enough? Can trust be rebuilt simply by having better and more credible rules? Our finance-medicine analogy suggests that the answer to these questions is no. It is the doctor who holds the key to earning the trust of his patients. Likewise, rebuilding trust in the banking sector requires the active

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engagement of bankers and their stakeholders. Regulatory and supervisory reforms are necessary, but not sufficient to restore people's trust in banks. My view is that, while regulatory reform and supervisory action were certainly necessary to lay the foundations on which banks can restore trust, regulators and supervisors are not the key players in this process. The main effort to regain trust must come from bankers, in particular from banks' management and their boards as the tone from the top as well as the accountability of banks' top management are key for risk culture and staff's behaviour. Without their active effort, society will not start to trust again. The necessary process will be laborious and time-consuming; and it will not be one measure or action that does the job, but rather a complex mixture of governance, risk appetite, risk culture and behaviour from the top. The role of banks and their stakeholders in restoring trust So what must bankers do to rebuild trust? First, bank's management should develop viable business models with a clear long-term perspective. Many of the recent crises have been the consequence of banks targeting high, but risky, short-term gains rather than pursuing lower, but more stable, long-term returns. Banks should refocus on their core functions: providing valuable investment opportunities to savers, while shielding them from liquidity risk, and providing funds to those who need them, while assessing and monitoring their creditworthiness. Financial intermediation is not simply a way to garner revenues; it also supports economic growth and thus, ultimately, provides an important service to society. Significant changes in the economic environment in recent decades have diverted banks from these core functions.

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It seems that the combination of an increased range of investment opportunities and funding sources, a trend towards more liberal regulation, and an increasingly competitive environment caused banks to reshuffle their priorities towards maximising short-term corporate and often also personal gain. The change in banks' business models from "originate to hold" to "originate to repackage and sell", which was the proverbial spark in the tinder box that set off the financial crisis, can be seen as a prime example of losing sight of the goal of maximising long-term value. Second, a bank's management and board must have a sense of responsibility for developing the bank's individual risk culture, thus enabling it to deal with risk in a way that supports this long-term business perspective and fosters transparency and accountability. Every bank needs a strong cultural base, which should embody the bank's essence and aspirations and embrace its role as a profit-oriented organisation without neglecting its relevance for the well-being of national economies and for the finances of both individuals and corporations. This strong cultural base should serve as a shared value framework throughout the organisation. On top of these foundations, every bank needs clear risk-taking policies, allowing it to reach its business objectives, while ensuring that risk-taking activities beyond the institution's risk appetite can be identified and addressed in a timely manner. To complement this, there must be clear governance arrangements defining processes and responsibilities for decision-making, risk management, control and audit. Lastly, a bank requires well-functioning communication mechanisms and IT systems to link the bank's decision-making, risk management and control organs together, to convey information to where it is needed, and to help create awareness and transparency about the bank's objectives, policies and values throughout the organisation. Changing an existing culture and the way an organisation thinks about its business is clearly a major challenge. In particular, at a time when the banking sector as a whole is having to

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comprehensively rethink the values it embodies and the culture it lives. Although some progress has been achieved recently, much more is still needed. In this context, I welcome the continued initiative of policy-makers to stimulate further progress in this area. For example, in May this year, the G finance ministers and central bank governors urged the Financial Stability Board to begin developing a bankers' "code of conduct" to complement the existing guidance. Third, banks' senior management and boards have to create adequate incentive schemes, including remuneration policies, to promote long-term perspectives within their organisation. We have witnessed too many scandals over recent years, too many cases of misconduct where responsible parties were not sufficiently held accountable. We have witnessed banks cooperating only reluctantly in criminal investigations, and we have seen interest groups rejecting outright any attempt to reform remuneration in the banking sector. Regaining trust will not be easy. Bank managers must convince the public that they will reward socially beneficial behaviour, while unacceptable behaviour will be credibly sanctioned, up to the top. Most importantly, people need to believe that managers will be truly responsible for the conduct of those who report to them. To achieve a turnaround in public sentiment, those working in banks must believe in the value of sustainable business models and ethical behaviour. The tone from the top is key in this endeavour - the message must be that not everything that is legal is also legitimate and that the bank is only interested in legitimate business. This may require a considerable revision of human resources policies, too. For a start, senior management could think about introducing new

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recruitment and training guidelines that indicate what sort of talent and personalities should be hired and how the bank's values should be taught to employees. A well-balanced combination of monetary and non-monetary incentives should be in place. Staff should have reasonable compensation and development options aligned with the behaviour they exhibit in implementing the bank's desired values and culture. Remuneration, performance evaluation and promotion systems should be calibrated in such a way that they reward client orientation, long-term value creation and sound risk management practices rather than short-term revenues. One possibility could be to extend even further the existing claw-back times for bonuses to discourage unacceptable behaviour, possibly up to seven years. Staff should face clear rules on responsibility, liability and integrity and be subject to proportionate follow-up or disciplinary measures in the case of infringements. Last, but not least, the expectations of bank shareholders are critical and key to re-establishing trust. Their demand for higher returns puts pressure on banks and induces them to embark on risky business activities. Hence, efforts to restore trust cannot be successful without a corresponding change in attitude among shareholders. They must understand that there is no such thing as a "free lunch". Properly adjusting for risk, shareholders may actually be better off when banks behave cooperatively and achieve a high level of trust.

The role of bankers' self-interest Having identified possible actions bankers can take to restore trust, an important question remains.

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Why should bankers ever take such actions? Is it in their own interest? As I stressed before, trust is essential for the functioning of the banking sector. Without trust, banks cannot function properly. This not only has negative consequences for the rest of the economy, but also negatively affects banks themselves. There are several channels through which a lack of trust negatively affects banks. First, it is a potential root cause of crises. Crises usually lead to a significant and often long-lasting contraction in bank profits, as can be seen, for instance, from the large drop in the S&P 500 index for the banking sector. Moreover, they are usually followed by an "aggressive" regulatory response to constrain banking activities. Second, a lack of trust negatively impacts on the relationship between regulators and banks. The interaction tends to become more adversarial. Regulators become less willing to listen to bankers and to take their views on how to do business into account. Third, a lack of trust in some banks and bankers usually translates into a negative sentiment towards the entire industry. This, in turn, has negative implications for business. Customers may leave, and it is more difficult to recruit talent. But this negative sentiment not only has repercussions for banks' business prospects, it also affects the social standing of bankers, whose image is often tarnished in society.

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Concluding remarks Let me conclude. The recent crisis is a stark reminder that banking is trusting. The dramatic changes in the banking environment brought about by financial innovation and technological progress have not diminished the role of trust in banking. Any lack of trust significantly impairs the functioning of the banking sector and prevents banks from contributing to economic growth. A lack of trust also negatively affects banks' business and profitability. It is in the banks' collective interest to restore and preserve a high level of trust in, and within, the banking sector. Rebuilding trust is a long and complex process. It certainly requires effort on the part of regulators and supervisors, and a lot has been achieved there. But, ultimately, as the analogy with the trust between doctors and patients makes clear, most of the heavy lifting will have to be done by the banks - their senior managements, boards and shareholders - themselves. There is plenty that they can do and should be doing.

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Hearing at the Committee on Economic and Monetary Affairs of the European Parliament Introductory statement by Mr Mario Draghi, President of the European Central Bank, before the Hearing at the Committee on Economic and Monetary Affairs of the European Parliament, Brussels Mr Chairman, Honourable Members of the Economic and Monetary Affairs Committee, Ladies and gentlemen, During the summer break, our Union faced exceptional challenges. First, there was the long and complicated discussion on the new adjustment programme for Greece. And now, in an area very much outside the ECB's competence, there is the challenge of harbouring a large number of refugees that had to leave their homes behind. Both these events - although very different in nature - have shown again that Europe can only be strong if it acts in unity on the basis of solidarity and cooperation. This is a lesson we should draw also for the challenges to come. In my remarks today, I would like to discuss two main topics: First, our assessment of the latest economic developments and its implications for our monetary policy stance; Second, the proposals my colleagues and I presented in the Five Presidents' Report.

Economic developments and monetary policy Turning to the first topic, let me give you an overview of the economic developments since the last hearing in June. Over the summer, industrial production and other indicators of economic activity showed signs of resilience.

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At the same time, the macroeconomic environment has become more challenging. Our September macroeconomic projections indicated a weaker economic recovery and a slower increase in inflation rates than we had expected earlier this year. The inflation rate will remain close to zero in the very near term, before rising again towards the end of the year. It will take somewhat longer than previously anticipated for it to converge back to and stabilise around levels that we consider sufficiently close to 2%. Slowing growth in emerging market economies, a stronger euro and the fall in oil prices and in commodity prices more generally are the main causes for these developments. As a result, renewed downside risks to the outlook for growth and inflation have emerged. For many of these changes, it is too early to judge with sufficient confidence whether they will cause lasting slippage from the trajectory that we initially expected inflation to follow when we decided to expand our asset purchase programme in January. More time is needed to determine in particular whether the loss of growth momentum in emerging markets is of a temporary or permanent nature and to assess the driving forces behind the drop in the international price of commodities and behind the recent episodes of severe financial turbulence. We will therefore monitor closely all relevant incoming information and its impact on the outlook for price stability. Our monetary policy measures in place, including the TLTROs, continue to have a favourable impact on the cost and availability of credit for firms and households. They have so far prevented a measurable tightening in financial conditions for the real economy despite the recent surge in financial volatility. The sustained decline in the cost of borrowing is strengthening domestic demand, by supporting durable goods consumption and stimulating investment particularly by small and medium-sized businesses.

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This is making the euro area economy more resistant to external shocks. Should some of the downwards risks weaken the inflation outlook over the medium term more fundamentally than we project at present, we would not hesitate to act. The asset purchase programme has sufficient in-built flexibility. We will adjust its size, composition and duration as appropriate, if more monetary policy impulse should become necessary. I am aware that many of you closely scrutinise the potential effect of the low interest rate environment on financial stability; ECON coordinators chose this as one of the topics for today. Building on what I said during the hearing in March, let me underline that we are closely monitoring risks to financial stability, but we do not see them materialising for the moment. Should this be the case, macroprudential policy - not monetary policy - would be the tool of choice to address these risks. Here, we can build on the recent experience in developing these tools: over the last two years, national authorities in Europe have been active in introducing macroprudential policies, such as caps on loan-to-value or debt-to-income ratios to structurally strengthen the mortgage market and to counter growth in real estate prices as well as mortgage loans. Similarly, to strengthen the banking system, countries have introduced systemic risk buffers, in addition to the buffers for globally systemic banks and other important institutions. However, these macroprudential instruments mainly cover lending through the banking sector. As there are signs that the financing of the euro area economy has tended to shift to non-banks, the coverage of the macroprudential framework needs to start being extended to the shadow banking sector so as to address risks in the financial sector as a whole. I would also like to say a few words about Greece. During the last hearing in June, I called for a comprehensive and fair agreement with Greece.

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In the following weeks, coming to such an agreement was very difficult and necessitated tremendous efforts from all those involved. But I am grateful that in the end, an agreement was reached. If it is completely implemented, the new programme will put Greece in a position to grow again and to reap the full benefits of participating in our common currency. The ECB contributed, in line with the provisions laid out in the legal framework, to the negotiation of the programme. In addition, the ECB closely monitored the provision of emergency liquidity assistance by the Bank of Greece according to our rules, taking into account the prospect of a successful completion of the negotiations at any point in time.

Completing EMU: following up on the Five Presidents' Report The negotiations over the summer revealed again the fact that our institutional framework is still not commensurate with the requirements of sharing one currency. In the Five Presidents' Report that we published shortly after the last hearing, the five authors shared one common conviction, namely that to make monetary union stable and prosperous, a more complete union is necessary. But we did not only outline this common conviction; we also presented a concrete roadmap showing how to attain this objective. This roadmap should now guide our discussions in the months to come. From our perspective, two elements are of particular importance. First, despite the best efforts of all actors involved, the crisis has shown that monetary union requires a political centre; a centre that can take the relevant fiscal, economic and financial decisions for the euro area as a whole in a swift and transparent manner with full democratic legitimacy and a clear set of responsibilities given to it by the legislators. It is in this spirit that I have called repeatedly for a move from rules-based coordination to sharing of sovereignty within common institutions.

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The report proposes a euro area treasury as one example. Such ideas now need to be spelled out. But we should also go further with regard to our policies. The report makes clear that EMU will also need to strengthen its tools to manage and prevent the build-up of fiscal, financial and other macroeconomic risks. In the last few years, notably with the reforms strengthening the economic governance framework and setting up the ESM, SSM and SRM, we have made important first steps in improving our crisis prevention and crisis management toolkit. But we are not there yet. Most imminently, we should move towards completing banking union through a common backstop for the Single Resolution Fund and through a European deposit insurance scheme. Both are essential to create a truly single banking system to mirror our single currency, and both are crucial to underpin the credibility of banking union and finally achieve its initial promise, namely breaking the bank-sovereign nexus, making the financial system more resilient, and protecting the interests of taxpayers. At the same time - going beyond the confines of the banking sector and banking union - we must make progress in developing a capital markets union to enhance further the scope for cross-border private risk-sharing. In addition, we need to prevent imbalances - whatever their nature - from developing into a crisis environment. Therefore, we need a new convergence process based on the capacity of our economies to withstand shocks and grow out of them quickly. This would imply not only a more robust financial system as just described, but also stronger governance over structural reforms and a tighter control of national fiscal policies. To ensure that Member States can adjust to shocks, whatever their size, we will also need to add a layer of fiscal stabilisation at the European level.

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Taken together, these steps towards completing EMU would help to make the euro area not only survive, but thrive and prosper. On that note, I am now looking forward to your questions.

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NEW MICROCHIP-ENABLED CREDIT CARDS MAY STILL BE VULNERABLE TO EXPLOITATION BY FRAUDSTERS

By October 2015, many U.S. banks will have replaced hundreds of millions of traditional credit and debit cards, which rely on data stored on magnetic strips, with new payment cards containing a microchip known as an EMV chip. While EMV cards offer enhanced security, the FBI is warning law enforcement, merchants, and the general public that no one technology eliminates fraud and cybercriminals will continue to look for opportunities to steal payment information.

Note What is an EMV credit card?

EMV Chip The small gold chip found in many credit cards is most often referred to as an EMV chip. Cards containing this chip are known as EMV cards, as well as “chip-and-signature,” “chip-and-pin,” or “smart” cards. The name “EMV” refers to the three originators of chip-enabled cards: Europay, MasterCard, and Visa. EMV chips are now the global standard for credit card security.

TECHNICAL DETAILS With traditional credit cards, the magnetic strip on the back of the card contains static personal information about the cardholder. This information is used to authenticate the card at the point of sale (PoS) terminal, before the purchase is authorized.

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When a consumer uses an EMV card at a chip PoS terminal, that transaction is protected using the technology in the microchip. Additionally, consumers will be able to continue to use the magnetic strip on the EMV card at retailers who have not yet implemented chip PoS terminals. When the card is equipped with a personal identification number (PIN), which is known only to the cardholder and the issuing financial institution, issuers will be able to verify the user’s identity. Currently, not all EMV cards are issued to consumers with the PIN capability and not all merchant PoS terminals can accept PIN entry. EMV transactions at chip PoS terminals provide more security of consumers' personal data than magnetic strip PoS transactions. In addition, EMV card transactions transmit data between the merchant and the issuing bank with a special code that is unique to each individual transaction. This provides the cardholder greater security and makes the EMV card less vulnerable to criminal activity while the data is transmitted from the chip enabled PoS to the issuing bank.

THREAT Although EMV cards provide greater security than traditional magnetic strip cards, an EMV chip does not stop lost and stolen cards from being used in stores, or for online or telephone purchases when the chip is not physically provided to the merchant, referred to as a card-not-present transaction. Additionally, the data on the magnetic strip of an EMV card can still be stolen if the merchant has not upgraded to an EMV terminal and it becomes infected with data-capturing malware. Consumers are urged to use the EMV feature of their new card wherever merchants accept it to limit the exposure of their sensitive payment data.

DEFENSE

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Consumers should closely safeguard the security of their EMV cards and PINs. This includes being vigilant in handling, signing, and activating a card as soon as it arrives in the mail, reviewing statements for irregularities, and promptly reporting lost or stolen credit cards to the issuing bank. Consumers should also shield the keypad from bystanders when entering a PIN, as PINs are vulnerable to cybercriminals who work to steal these numbers to commit ATM and cash-back crimes. The FBI encourages merchants to handle the EMV card and its data with the same security precautions they use for standard credit cards. Merchants handling sales over the telephone or via the Internet are encouraged to adopt additional security measures to ensure the authenticity of cards used for transactions. At a minimum, merchants should use secure servers and payment links for all Internet transactions with credit and debit cards, and information should be encrypted, if possible, to avert hackers from compromising card information provided by consumers. Credit card information taken over the telephone or through online means should be protected by the retailer to include encrypting digital information and securely disposing written credit card information. If you believe you have been a victim of credit card fraud, reach out to your local law enforcement or FBI field office, and file a complaint with the Internet Crime Complaint Center (IC3) at www.IC3.gov

About the Internet Crime Complaint Center (IC3) Since 2000, the IC3 has received complaints crossing the spectrum of cyber crime matters, to include online fraud in its many forms including Intellectual Property Rights (IPR) matters, Computer Intrusions (hacking), Economic Espionage (Theft of Trade Secrets), Online Extortion, International Money Laundering, Identity Theft, and a growing list of Internet facilitated crimes. It has become increasingly evident that, regardless of the label placed on a cyber crime matter, the potential for it to overlap with another referred matter is substantial.

http://www.ic3.gov/

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Therefore, the IC3, formerly known as the Internet Fraud Complaint Center (Internet Fraud Complaint Center), was renamed in October 2003 to better reflect the broad character of such matters having an Internet, or cyber, nexus referred to the IC3, and to minimize the need for one to distinguish "Internet Fraud" from other potentially overlapping cyber crimes.

Internet Crime Complaint Center (IC3) - Mission Statement The mission of the Internet Crime Complaint Center is to provide the public with a reliable and convenient reporting mechanism to submit information to the Federal Bureau of Investigation concerning suspected Internet - facilitated criminal activity and to develop effective alliances with law enforcement and industry partners. Information is analyzed and disseminated for investigative and intelligence purposes to law enforcement and for public awareness.

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Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III, Liquidity Coverage Ratio regulations – Saudi Arabia Preface The Basel Committee on Banking Supervision sets a high priority on the implementation of regulatory standards underpinning the Basel III framework. The prudential benefits from adopting Basel standards can only fully accrue if these are implemented appropriately and consistently by all member jurisdictions. The Committee established the Regulatory Consistency Assessment Programme (RCAP) to monitor, assess and evaluate its members’ implementation of the Basel framework. This report presents the findings of the RCAP Assessment Team (the Assessment Team) on the domestic adoption of the Basel Liquidity Coverage Ratio (LCR) standards in the Kingdom of Saudi Arabia (KSA). The assessment focuses on the regulatory adoption of Basel LCR standards applied to KSA banks that are internationally or regionally active and of significance to its domestic financial stability. The RCAP LCR assessment was based primarily on the LCR rules that were issued by the Saudi Arabian Monetary Agency (SAMA) in July 2013. In the course of the assessment, the authorities made a number of revisions to the rules based on issues identified by the Assessment Team. This report has been updated where relevant, to reflect the progress made by SAMA to align the regulations with Basel LCR standards. The RCAP Assessment Team was led by Mr Stephen Bland, Director, Strategic Policy Adviser of the United Kingdom Prudential Regulation Authority (UK PRA).

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The Assessment Team comprised seven technical experts drawn from China, the Financial Stability Institute, Germany, New Zealand, South Africa, Sweden and Turkey. The main counterpart for the assessment was SAMA. The assessment relied upon the data, information and materiality computations provided by SAMA up to 31 July 2015. The assessment findings are based primarily on an understanding of the current processes in the KSA as explained by the counterpart staff and the expert view of the Assessment Team on the documents and data reviewed. The overall work was coordinated by the Basel Committee Secretariat. The assessment began in February 2015 and consisted of three phases: (i) completion of an RCAP questionnaire (a self-assessment) by SAMA; (ii) an off- and on-site assessment phase (February to May 2015); and (iii) a post-assessment review phase (June to August 2015). The off- and on-site phases included an on-site visit for discussions with SAMA and representatives of KSA banks (which were used as the RCAP sample banks for the purpose of impact assessment) and external audit firms. These exchanges provided the Assessment Team with a deeper understanding of the implementation of the Basel LCR standards in the KSA. The third phase consisted of a two-stage technical review of the assessment findings: first by a separate RCAP Review Team and feedback from the Basel Committee’s Supervision and Implementation Group; and secondly, by the RCAP Peer Review Board and the Basel Committee. This two-step review process is a key instrument of the RCAP process to provide quality control and ensure integrity of the assessment findings. The focus of the assessment was on the consistency and completeness of the domestic regulations in the KSA with the Basel minimum requirements.

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Issues relating to prudential outcomes, adequacy of liquidity ratios at individual banks or the effectiveness of the Saudi authorities’ liquidity risk management supervision were not in the scope of this RCAP assessment exercise. Where domestic regulations and provisions were identified to be not in conformity with the Basel framework, those deviations were evaluated for their current and potential impact (or non-impact) on the reported liquidity ratios for a sample of internationally and regionally active KSA banks. Some findings were evaluated on a qualitative basis. The overall assessment outcome was based on the materiality of findings and the use of expert judgment. The report has two sections and a set of annexes: (i) an executive summary with a statement from SAMA on the material findings; (ii) the context, scope and methodology and the main set of assessment findings; and (iii) details of the deviations and their materiality along with other assessmentrelated observations. The RCAP Assessment Team acknowledges the professional cooperation received from SAMA counterparts throughout the assessment process. In particular, the team sincerely thanks the staff of SAMA for playing an instrumental role in coordinating the assessment exercise. The series of comprehensive briefings and clarifications provided by SAMA enabled the RCAP assessors to arrive at their expert assessment. The Assessment Team is hopeful that the RCAP assessment exercise will contribute towards strengthening prudential effectiveness and full implementation of the recent reform measures in the KSA.

Executive summary SAMA has implemented the Basel LCR requirements consistently with the internationally agreed standards with the exception of one material finding with regard to the definition of high-quality liquid assets (HQLA).

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SAMA has implemented the Basel LCR requirements consistently with the internationally agreed timeline and has also applied the transitional arrangements in line with the Basel LCR standard. The LCR applies to all 12 licensed banks on a consolidated basis, while KSA foreign bank branches are so far exempted from the LCR. In February 2015, SAMA completed an extensive self-assessment of the KSA LCR rules as part of the preparation for the RCAP exercise. In its review of the KSA regulations and the self-assessment by SAMA, the Assessment Team identified a few deviations in the LCR rules from the Basel framework. SAMA used the RCAP findings to amend the rules where feasible and consistent with the KSA’s national interests. This has resulted in a significant strengthening of the KSA’s liquidity regime. Overall, for the reasons set out below, as on the cut-off date for the RCAP assessment, the final LCR requirements in the KSA are assessed as largely compliant with the minimum Basel liquidity standards. The two graded components of the LCR framework, the LCR standard and the LCR disclosure requirements, are assessed as largely compliant and compliant with the Basel standard, respectively. Following the issuance of the revisions to the KSA LCR rules, one finding remains on the definition of HQLA, which has a material effect on the LCR results of KSA banks. In order to qualify as Level 1 HQLA securities, the Basel LCR standard requires that assets fulfil a number of conditions, which include a requirement for such assets to be traded in large, deep and active markets characterised by a low level of concentration. Currently there is no liquid market in KSA for domestic Level 1-type assets. Therefore, in the local KSA context, the LCR rules specify that the ability to engage in a repurchase agreement with the central bank is a sufficient determining criterion for a local asset to be considered as satisfying this condition and, thus, to be eligible for inclusion as Level 1 HQLA.

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Accordingly, local government bonds and central bank treasury bills are accepted as Level 1 HQLA for the purpose of calculating the LCR, although they do not fulfil the requirements set out in the Basel LCR standard. In the Assessment Team’s view, the reliance on this criterion (repo-ability with the central bank), as well as the inclusion of the illiquid local government bonds as Level 1 HQLA deviates from the Basel LCR standard. This deviation has a material impact on the LCR and reduces its international comparability. The Assessment Team understands the rationale for such deviation in the local KSA context. However, based on quantitative and qualitative judgment, the Assessment Team is of the view that the finding constitutes a material deviation from the Basel LCR standard. Some jurisdictions may have an insufficient supply of Level 1 assets (or both Level 1 and Level 2 assets) in their domestic currency to meet the aggregate demand of banks with significant exposures in this currency. To address this situation, the LCR allows alternative treatments, the Alternative Liquidity Approaches (ALA) for holdings in the stock of HQLA. SAMA decided to not make use of these alternatives. The Assessment Team recognises that all ALA options come with a cost and that it is possible, or even likely, that the ALA would not provide an unambiguously better solution for SAMA. If SAMA were to adopt an ALA, it is likely it would be considered compliant with Basel III’s LCR standard, which would align SAMA’s implementation with that of other jurisdictions with insufficient Level 1 HQLA and improve comparability across jurisdictions. Similar to the capital assessment, the Assessment Team notes that SAMA regulates Sharia compliant banks in the same way as other conventional banks in the KSA. Thus, the way in which it does so does not currently lead to any deviation from Basel standards.

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Nevertheless, if there were to be a greater variety of Sharia-compliant activities and/or if the International Financial Reporting Standards were differently applied to Sharia-compliant activities in the KSA, this could change. More generally, it would seem sensible for the Basel Committee to consider whether the application of its standards in practice fully captures the risk emanating from the variety of Sharia-compliant banks and activities. In addition to the formal assessment of the LCR standard and disclosure requirements, this report also summarises SAMA’s implementation of the Basel Principles for sound liquidity risk management (Sound Principles) and the LCR monitoring tools. The Sound Principles have been implemented in the KSA’s regulation through the issuance of a circular to the banks. The liquidity monitoring tools were introduced in the KSA on 24 September 2014 through the issuance of a circular which became effective from 1 January 2015. Further, a summary is provided of the key national discretions and approaches that SAMA has adopted in their implementation of the LCR standard. The Assessment Team recognises the efforts made by SAMA to strengthen and align its LCR rules to the Basel LCR framework throughout the course of the assessment process. These amendments became effective prior to 31 July 2015 (see Annex 5 for a complete list of the amendments).

Response from SAMA SAMA welcomes this opportunity to respond to the findings and comments of the RCAP Assessment Team on the implementation of Basel Liquidity Coverage Ratio in Saudi Arabia. SAMA also wishes to acknowledge and appreciate the commitment, professionalism and expertise of the RCAP Assessment Team, under the leadership of Mr Stephen Bland, and would like to thank the Team for the proficiency with which the entire RCAP exercise for Saudi Arabia was completed.

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The RCAP exercise has provided a comprehensive and thorough review of the implementation of the Basel LCR framework in Saudi Arabia, although we are disappointed that Saudi Arabia has received an overall largely compliant rating. We believe that this was perhaps the first time that an RCAP Assessment Team faced a situation of a zero (0%) risk weight country which does not have a "large, deep and active market". In our view, this assessment arose from a narrow and selective use and interpretation of the LCR rules, particularly paragraph 50(c), which requires HQLA to be traded in “large, deep and active markets”, characterised by low levels of concentration. Also the AT has used paragraph 27 that states that central bank eligibility “does not by itself constitute the basis of HQLA”. We believe that this narrow and selective use of LCR Rules ignores other relevant paragraphs including 24, 25, 26, 44, 45 and 50(a), (b) and (d). For example, paragraph 45 states that “the stock of HQLA should comprise assets with characteristics outlined in paragraphs 24 to 27”. In our view the Level 1 HQLA defined by SAMA meets the requirements of these paragraphs. To put our comments in perspective, it is important to explain that Level 1 HQLA in Saudi Arabia are well diversified and include the following (percentage of total HQLA as at 31 December 2014):

In our view, all of the above assets qualify as Level 1 HQLA as they meet the requirements of paragraph 24 that states “Assets are considered to be

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HQLA if they can be easily and immediately converted into cash at little or no loss in value”. The above assets can be easily liquidated in international markets or repo’d with central banks to raise cash quickly without loss in value. The assets also meet the requirements of paragraph 25, which states “that the test of whether assets are liquid or of high quality is that by way of sale or repo their liquidity generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress”. This has been successfully tested several times in Saudi Arabia in the last few decades, most recently during the 2007–09 global financial crisis. In paragraph 26, the Basel LCR rules state that HQLA should “ideally be eligible at central bank for intraday liquidity needs and overnight liquidity facilities”. Again, the KSA government bonds and SAMA bills, as well as most of foreign securities meet these requirements. In our view, a broader interpretation of the Basel LCR rules including all relevant paragraphs (paragraphs 24 to 27, 44, 45 and 50) could lead to a more pragmatic conclusion, keeping in perspective the on-the-ground realities and the special characteristics of a market. On the other hand, a narrow interpretation of LCR rules would mean that only a few advanced markets in Europe, North America and Asia would qualify as “large, deep and liquid” while most emerging markets would not meet these requirements, despite a large stock of domestic government securities and T-bills, and would never be LCR-compliant. It is counter intuitive to note that had the KSA been a non-zero risk weight market, it would have been fully compliant to Basel LCR standards due to the provision of paragraph 50(d). We would like to draw your attention to the fact that the KSA banking system has had a legal liquidity ratio that is more stringent than the LCR and a loan-to-deposit ratio since the 1966 Banking Control Law (BCL) was put into effect. Also, for several decades, the KSA banking system and SAMA have been net providers of liquidity to the global financial markets.

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Over these decades, despite wars, conflicts and global and regional financial crises, no bank has ever failed in Saudi Arabia nor has there been a liquidity crisis. Today, the banking system continues to be highly liquid with an average LCR of 180% (three times the Basel requirements) and among the most liquid jurisdictions in the BCBS QIS exercise since 2013. We believe that, with such a long history of ample liquidity and the current strong liquidity position, the assessment should have been “compliant”, as what matters is the ability of SAMA and the banking system to meet the substance of the LCR requirements as envisaged in paragraphs 2 and 4 of the Basel LCR rules under stress scenarios. Turning to the proposed suggestion of the Assessment Team that SAMA should explore the ALA option, SAMA foresees several difficulties: • The KSA’s banking system has no shortage of HQLA, as outlined earlier, and the banking system does easily meet the Basel requirements. For KSA to seek an ALA solution would be a contradiction of the first criteria in paragraph 56 of the Basel LCR standards. • To exclude government securities and replace it by an ALA arrangement would send a wrong signal on the liquidity of such securities and thus could have a negative impact on the government’s plan for debt issuance. • It will send a message that banks should invest in foreign securities of other 0% risk-weighted countries instead of domestic securities. We are not aware of any other government issuing such instructions to its banks. • It would add to the cost for the banking system as the ALA facilities come with a fee. • The ALA arrangements would add a significant operational burden on the banks and SAMA, as the ALA is far more complex than the current simple repo arrangements. In view of the above, SAMA has made an assessment that the use of the ALA cannot be justified, and the KSA should not embark on it at this stage.

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Given the somewhat different and unique liquidity circumstances in the KSA, an assessment needed to focus on a careful understanding of the ability of a banking system to meet the Basel requirements, rather than a simplistic application of the wording of the Basel requirements. It is noteworthy that a few different findings and observations were presented by the RCAP Assessment Team at different stages of the Assessment and Review process, with different suggestions. However, the solutions that were offered for full compliance did not seem to have any precedents, and were impractical given the ample liquidity position of the KSA banking system. Consequently, we believe that there is a need for the Basel Committee to provide additional guidance to banking supervisors and the RCAP teams on the correct interpretation of paragraphs 24 to 27, 44, 45 and 50 of the LCR rules, keeping in perspective that the Basel LCR rules apply to not only few advanced markets but also to a large number of zero risk weight emerging markets, which may lack some aspects of “large, deep and active markets” but may have equally sound solutions to provide their institutions with sufficient liquidity over a short period. Based on SAMA’s self-assessment and as identified by the Assessment Team, SAMA has carried out 14 modifications to the existing regulations and guidelines before the agreed cut-off date 31 July 2015. We believe that these modifications will further strengthen the implementation of the Basel liquidity framework in Saudi Arabia. Overall, SAMA considers the RCAP process to have been a very useful exercise, and is supportive of the Basel objectives to promote consistency of implementation of rules among member countries. SAMA also concurs that the RCAP process promotes a level playing field among Basel member jurisdictions, which reduces regulatory arbitrage and promotes safety, soundness and stability in the global financial system.

1 Assessment context and main findings 1.1 Context Status of implementation The Saudi Arabian Monetary Agency (SAMA), the KSA’s central bank, is responsible for the regulation and supervision of the banking sector.

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SAMA is empowered by the Banking Control Law (BCL) 1966 and SAMA Charter 1957 to issue banking regulations, rules and guidance to licensed banks in the KSA. The Basel LCR standards have been in effect from 1 January 2015, implemented via the issuance of regulations and circulars. Regulations are published in English. The LCR standard was first introduced through Circular #BCS 7390 of 8 February 2012. Subsequently, SAMA issued revisions of the LCR regulation and LCR disclosure requirements, on 10 July 2013 and 25 August 2014, respectively. These regulations came into force on 1 January 2015. Final revisions entered into force on 9 July 2015. Along with the LCR regulations, SAMA has also implemented the LCR monitoring tools (31 January 2015) and the Basel Principles for sound liquidity risk management and supervision (5 December 2008). A factual description of how each of these frameworks has been implemented is provided in Annexes 9 and 10, respectively. Regulatory system and model of supervision In the KSA, all commercial banking institutions are subject to the Basel III LCR standards. SAMA is responsible for issuing and enforcing the LCR regulation in the KSA. In case of breaches of the LCR regulation, SAMA has powers to impose corrective measures, as detailed in the LCR regulation and BCL. In periods of systemic stress, SAMA may also determine whether to relax or lower the LCR requirements. Further, SAMA has issued a data collection template with the information required to calculate the LCR for each bank. The submitted LCR and accompanying data are reviewed monthly.

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Given the amount of information needed, and the need for homogeneous and consistent reporting, banks are also provided with technical guidance on completing the data template and computing the LCR. This technical guidance is explicitly referenced in the KSA’s LCR regulation.

1.2 Structure, enforceability and binding nature of prudential regulations The liquidity regulation is subject to the same well defined regulatory process as for capital regulation. The following table provides an overview of the legal hierarchy of prudential regulations in the KSA (details on the structure and binding nature of prudential regulations in the KSA are outlined in the RCAP assessment report on the KSA risk-based capital requirements for banks). The LCR requirements, as issued in final form on 9 July 2015, meet the RCAP criterion of being enforceable and binding in nature.

1.3 Scope of the assessment The assessment was made of the LCR requirements as applicable to all of the 12 locally incorporated banks in the KSA. In evaluating the materiality of the findings, the quantification was limited to the agreed five banks subject to the RCAP review (see Annex 8). These banks hold more than 63% of the assets in the KSA banking system.

Assessment grading and methodology

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As per the RCAP methodology approved by the Basel Committee, the outcome of the assessment was summarised using a four-grade scale, at the level of both the twin components of the Basel LCR framework (LCR and LCR disclosure requirements) and the overall assessment of compliance: compliant, largely compliant, materially non-compliant and non-compliant. The materiality of the deviations was assessed in terms of their current or, where applicable, potential future impact (or non-impact) on the liquidity coverage ratios of the banks. Wherever relevant and feasible, the Assessment Team, together with SAMA, attempted to quantify the impact based on data collected from KSA banks in the agreed sample of banks. The non-quantifiable aspects of identified deviations were discussed and reviewed with SAMA, in the context of the prevailing regulatory practices and processes. Ultimately, the assignment of the assessment grades was guided by the collective expert judgment of the Assessment Team. In doing so, the Assessment Team relied on the general principle that the burden of proof rests with the assessed jurisdiction to show that a finding is not material or not potentially material. In a few cases, KSA liquidity requirements go beyond the minimum Basel standards. Although these elements provide for a more rigorous implementation of the Basel framework in some aspects, they have not been taken into account for the assessment of compliance under the RCAP methodology as per the agreed assessment methodology (see Annex 12 for a listing of areas of super-equivalence).

1.4 Main findings A summary of the main findings is given below. Overall, the Assessment Team considers the LCR regulation issued in July 2015 as largely compliant with the Basel standard.

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The LCR regulation and the disclosure standards are assessed by the RCAP Assessment Team as largely compliant and compliant with the minimum Basel liquidity standard, respectively. More detail is provided below.

Main findings by component Scope of application and transitional arrangements The Basel LCR standard is applicable to all internationally active banks on a consolidated basis. According to SAMA, the regulation applies to all commercial banks and regulated entities in the KSA on a consolidated level, with the exception of foreign bank branches in the KSA. Currently there are 12 locally incorporated banks and 12 foreign branches registered in the KSA. The regulation does not apply to investment entities that are not subsidiaries, not registered as banks and not consolidated in a banking group. However, SAMA has the authority to require banks to include investment firms in their LCR calculation, specifically when a bank has a minority interest in an entity and carries a significant liquidity risk with respect to that entity.

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At present, SAMA has not enforced such requirement to any banking institution. It does not require insurance companies to be consolidated for LCR purposes due to the ownership restrictions imposed on banks.

High-quality liquid assets (numerator) The definition of high-quality liquid assets (HQLA) is a key element of the Basel LCR standard. SAMA has generally implemented the HQLA component of the LCR consistently with the Basel standard, with one exception which materially affects the implementation of the HQLA requirement. As such, the Assessment Team assesses the implementation of the HQLA requirement as being largely compliant. The finding relates to the conditions set up in the Basel standard that assets need to fulfil in order to qualify as Level 1 HQLA. According to the Basel LCR standard, marketable securities can be included to an unlimited amount in Level 1 HQLA provided that they satisfy all of the conditions set out in paragraph 50(c) of the Basel III text. These conditions include: (i) assigned a 0% risk-weight under the Basel II Standardised Approach for credit risk, (ii) traded in large, deep and active repo or cash markets characterised by a low level of concentration, (iii) have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions and (iv) not an obligation of a financial institution or any of its affiliated entities. Additionally, paragraph 27 of the Basel LCR standard states that central bank eligibility is not a sufficient condition for an asset to be classified as HQLA.

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The KSA government debt securities are internationally rated as AA8 and therefore have a 0% risk weight under the Basel II credit risk standardised approach. Despite the excellent credit quality, there are no large, deep and active local markets for these securities in the KSA. According to SAMA, this is due to several factors, including (i) the limited supply of government securities (only 2% of the KSA’s GDP), (ii) banks and other investors typically hold the securities until maturity and (iii) a lack of foreign and institutional investors (pension funds or insurance companies) in the market. This is also true for other domestic Level 1-type securities such as central bank claims. The only reliable way for banks to monetise these assets is therefore through repos with SAMA. For this reason, SAMA has made repoability with the central bank a sufficient requirement to satisfy the “large, deep and active market” condition in the LCR. As a consequence, the local government bonds (and other local Level 1-type assets) are accepted as Level 1 HQLA for the purpose of calculating the LCR, despite the absence of a large, deep and active private market. In the view of the Assessment Team, this is a deviation from the requirement stipulated in paragraphs 27 and 50(c) of the Basel LCR standard. Notwithstanding this deviation, the Assessment Team considers that KSA’s situation is challenging. For jurisdictions with an insufficient supply of Level 1 HQLA assets in their domestic currency, the LCR provides for Alternative Liquidity Approaches (ALA). Such jurisdictions could consider exploring the possibility of using ALA’s Option 1 – the Committed Liquidity Facility (CLF) – and/or, Option 2 – the

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use of foreign currency HQLA – and/or Option 3 – additional use of Level 2 assets with a higher haircut. The team also notes SAMA’s earlier decision not to adopt the ALA due to an internal assessment it conducted. This assessment concluded that the KSA has sufficient domestic assets (mainly government debt securities and SAMA Bills) to meet the HQLA requirement and expressed concern that adopting the ALA might also induce banking institutions to heavily invest in foreign assets, which could lead to capital outflows. It is possible, or even likely, that the ALA would not provide an unambiguously better solution for SAMA as these solutions come with costs, in terms of increased operational challenges, eg determining the conditions of a CLF (ALA Option 1) and implementing additional mechanisms to control the FX risks (ALA Option 2). Adopting the ALA would, however, bring the domestic LCR rule fully in line with the Basel LCR standard (subject to meeting the ALA eligibility criteria) and rectify the deviation with respect to paragraphs 27 and 50(c). Additionally, this could also align SAMA’s implementation with other jurisdictions with insufficient Level 1 HQLA and improve comparability across jurisdictions. In addition, SAMA also relies on central bank repo-ability as a sufficient condition when classifying HQLA Level 1 assets in other jurisdictions where markets are not liquid, eg the other Gulf Cooperative Council (GCC) jurisdictions. However, this deviation from paragraphs 27 and 50(c) has been assessed as not material. The Assessment Team also made one observation with respect to SAMA’s implementation of paragraph 50(c). The team notes that a 25% haircut was imposed by SAMA as part of its central banking operation on the local government securities but this was not taken into account in the banks’ LCR calculation.

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As a result, banks may have overstated the amount of HQLA in the LCR calculation relative to the amount of liquidity these can generate for the banks (as central bank repos are the only way of monetising the assets). SAMA has aligned their central bank haircut (from 25% to 0%) with that of the LCR, following the RCAP assessment, meaning there is no longer a risk of overstatement of banks’ LCR. This has been listed as part of the rectifications made by SAMA in Annex 5 of this report. Also with respect to HQLA, the Assessment Team noted that SAMA has implemented a murabaha facility for Sharia-compliant banks that is treated as a central bank reserve. It therefore qualifies as a Level 1 asset. The facility is de facto a cash placement with the central bank and replicates a treasury bill. Banks are allowed to use this product as collateral for central bank operations (a 0% haircut applies as of 8 July 2015) and could therefore generate liquidity when needed. The Assessment Team considered the treatment of this product by SAMA in the LCR to be adequate. Level 2A assets are generally HQLA-eligible in the KSA but locally this type of asset does not exist due to market illiquidity. SAMA disallows Level 2B assets generally, even for foreign operations of the KSA banks where the host supervisors allow Level 2B assets to be included as HQLA.

Outflows (denominator) SAMA has implemented the LCR outflow requirement consistently with the run-off factors (outflows) specified by the Basel LCR standard. (In some cases, SAMA’s LCR rules are more conservative than the Basel LCR requirements.) In this regard, the Assessment Team considered the implementation of the outflows requirement as being compliant.

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Inflows (denominator) SAMA has implemented the inflows requirements consistently with the Basel LCR standard and it is assessed as compliant.

Disclosure requirements The Basel standard requires disclosure of the LCR at a consolidated level and at the same frequency, and concurrently with, the publication of financial statements. The KSA’s implementation of the LCR disclosure requirements is assessed as compliant with the Basel standard. In the KSA, LCR disclosure started from 1 January 2015. With respect to the phase-in period, SAMA will allow banks to calculate their average LCR based on three end-of-month observations until 2017. From 1 January 2017, the numbers must be based on daily data. SAMA also requires banks to report both quantitative and qualitative LCR disclosures according to the Basel disclosure template on a quarterly basis and no later than 30 days after the quarter-end.

2 Detailed assessment findings The component-by-component details of the assessment of compliance with the LCR standards of the Basel framework are detailed below. The focus of Sections 2.1 to 2.2 is on findings that were assessed to be deviating from the Basel minimum standards and their materiality. Section 2.3 lists some observations and other findings specific to the implementation practices in the KSA.

2.1 LCR requirement

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2.2 LCR disclosure requirements

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2.3 Observations and other findings specific to the implementation practices in The KSA The following list includes observations made by the Assessment Team regarding the KSA’s implementation of the LCR standard. These observations are assessed as consistent with the Basel standard and are provided here for background information only.

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Annex 2: List of LCR standards under the Basel framework used for the assessment

Basel documents in scope of the assessment (i) The Liquidity Coverage Ratio (January 2013), including the frequently asked questions on Basel III’s January 2013 Liquidity Coverage Ratio (April 2014);

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(ii) Liquidity Coverage Ratio disclosure standards (January 2014);

Basel documents reviewed for information purposes (iii) Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools (January 2013) (part of liquidity risk monitoring tools); (iv) Monitoring tools for intraday liquidity management (April 2013); and, (iv) Principles for sound liquidity risk management and supervision (September 2008).

Annex 3: Local regulations issued by SAMA for implementing Basel LCR standards The BCL of 1966 and SAMA Charter of 1957 have conferred powers on SAMA to issue regulations, rules and guidance to licensed banks in the Kingdom of Saudi Arabia. Under these laws, SAMA has used its powers to issue regulations related to the Basel II, II.5 and III Rules standards. All of the regulations issued by SAMA are legally enforceable and none has never been challenged in a court of law. In certain instances, regulations have been supplemented by additional Guidance Notes; however, all additional guidance is legally enforceable. Basel III Regulations, Rules and Guidance Notes are in final form and the text in English is available on SAMA website.

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Annex 4: Details of the RCAP assessment process A. Off-site evaluation (i) Completion of a self-assessment questionnaire by SAMA (ii) Evaluation of the self-assessment by the RCAP Assessment Team (iii) Independent comparison and evaluation of the domestic regulations issued by SAMA with corresponding Basel III standards issued by the BCBS (iv) Identification of observations (v) Refinement of the list of observations based on clarifications provided by SAMA

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(vi) Assessment of materiality of deviations for all quantifiable deviations based on data and nonquantifiable deviations based on expert judgment (vii) Forwarding of the list of observations to SAMA

B. On-site assessment (viii) Discussion of individual observations with SAMA (ix) Meeting with selected KSA banks, accounting firms (x) Discussion with SAMA and revision of findings to reflect additional information received (xi) Assignment of component grades and overall grade (xii) Submission of the detailed findings to SAMA with grades (xiii) Receipt of comments on the detailed findings from SAMA

C. Review and finalisation of the RCAP report (xiv) Review of comments by the RCAP Assessment Team, finalisation of the draft report and forwarding to SAMA for comments (xv) Review of SAMA’s comments by the RCAP Assessment Team (xvi) Review of the draft report by the RCAP Review Team (xvii) Review of the draft report by the Peer Review Board (xviii) Reporting of findings to SIG by the team leader

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Annex 6: Assessment of the binding nature of regulatory documents The following table summarises the assessment of the seven criteria used by the Assessment Team to determine the eligibility of KSA’s regulatory documents. Based on this, the Assessment Team concluded that the regulatory instruments issued and used by SAMA as set out in Annex 3 are eligible for the RCAP assessment.

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Annex 8: A summary of the materiality assessment As a general principle, and mirroring the established RCAP assessment methodology for risk-based capital standards, the RCAP-LCR materiality assessment is based on both quantitative and qualitative information with an overlay of expert judgment.

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Where possible, teams also take into account the dynamic nature of liquidity risks and seek to assess the materiality of deviation at different points in time. In line with underlying RCAP principles, the quantitative materiality assessment for the LCR is based on a determination of the cumulative impact of all identified deviations (both quantifiable and non-quantifiable deviations). Where deviations are quantifiable, the Assessment Team will generally base the assessment on the highest impact that has been reported across three data points. The collection of data across different dates is agreed upon between the team leader and the assessed jurisdiction. In the case of the KSA LCR assessment, two deviations were assessed on both a quantifiable and qualitative basis, taking into account the amendments made by SAMA during the course of the RCAP. The following table summarises the number of deviations according to their materiality.

Annex 9: The KSA’s implementation of the liquidity monitoring tools In addition to the minimum standard for the LCR, the LCR framework also outlines metrics to be used as consistent liquidity monitoring tools (“the monitoring tools”).

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The monitoring tools capture specific information related to a bank’s cash flows, balance sheet structure, available unencumbered collateral and certain market indicators. The monitoring tools supplement the LCR standard and are meant to provide the cornerstone of information that aids supervisors in assessing a bank’s liquidity risk. This part of the annex provides a qualitative overview of the implementation of the monitoring tools in the KSA.

Method of implementing the Basel liquidity monitoring tools The liquidity monitoring tools were introduced in the KSA on 24 September 2014 by means of Circular # 351000147086, which outlines the considerations that banks must observe when managing their liquidity risk and the specific risk management process that banks must follow. This circular took effect on 1 January 2015. 1. Contractual maturity mismatch 2. Concentration of funding 3. Available unencumbered assets 4. LCR by currency 5. Market-related monitoring tool: already implemented by SAMA as described in Item II below.

How are the tools used by supervisors? Banks have been required to calculate the monitoring tools (returns) as part of their liquidity risk management process and practices, and to submit the returns monthly since 1 January 2015. The returns are standard reporting templates for banks to report their positions in respect of (i) concentration of funding; (ii) available unencumbered assets; and (iii) LCR by significant currency; and (iv) maturity mismatch.

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Failure to submit the returns could trigger the use of other supervisory actions by SAMA, which includes fines and penalties. Description of how the monitoring tools in SAMA regulation will be implemented

I. Contractual maturity mismatch SAMA’s monitoring tool on the contractual maturity mismatch profile identifies the gaps between the contractual inflows and outflows of liquidity for defined time bands. These maturity gaps indicate how much liquidity a bank would potentially need to raise in each of these time bands. This metric provides insight into how far the bank relies on maturity transformation under its current contracts.

II. Concentration of funding This Basel standard tool is designed to identify sources of wholesale funding that are of such significance that withdrawal of this funding could trigger liquidity problems. For this purpose, banks should manage funding concentration by counterparty, significant instrument as well as list assets and liabilities by significant currency.

III. Available unencumbered assets This monitoring tool is designed to provide supervisors with data on their available unencumbered assets in terms of quantity and key characteristics, including currency denomination and location.

IV. LCR by significant currency While compliance with the LCR is required in one single currency, the Basel liquidity standard states that banks and supervisors should also monitor the LCR in other significant currencies. This will allow the bank and the supervisor to track potential currency mismatch issues that could arise.

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The KSA regulation requires banks to define and monitor their Liquidity Coverage Ratio for each relevant currency.

V. Market-related monitoring tools It is evident that the “market-related monitoring tools” requirement includes a wide range of information on the financial sector; bank-specific information and related market development. It is currently available in SAMA through the following channels, which are adequate in terms of frequency of information as an early warning system for SAMA purposes. (a) SAMA regularly publishes its weekly report on market developments and other investment information covering the following aspects: • Foreign exchange and money market rates • Status of eight stock exchanges including that of the KSA • US Treasury yields • International government bond yields • LIBOR and SIBOR rates • For nine major economies o Oil prices o Interest rates o Price/earnings ratio o Dividend yields o Market capitalisation (b) This information is also available in SAMA’s annual, quarterly, and monthly reports. The information provided is quantitative and qualitative and comprises various quarterly financial ratios and other financial information.

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Basel guidance on monitoring tools for intraday liquidity management The BCBS in April 2013 issued a document entitled “Monitoring tools for intraday liquidity management”. SAMA circulated this document to banks through its Circular # 341000085566 dated 20 May 2013, which required banks to incorporate this guidance in their internal risk management systems concerning liquidity risk. Meetings and teleconferences have taken place between SAMA, the Saudi Arabian Riyal Interbank Express (SARIE) and the banks to discuss the implementation of this circular. Consequently, SAMA is aiming to implement the intraday liquidity management in Saudi Arabia before the end of 2016, prior to the time limit set by the BCBS of January 2017.

Annex 10: The KSA’s implementation of the Principles for sound liquidity risk management and supervision This annex outlines the implementation of the Basel Committee’s Principles for sound liquidity risk management and supervision (Sound Principles) in the KSA’s regulation. The principles are not part of the formal RCAP assessment and no grade is assigned. This annex serves for information purposes only. The Sound Principles were published in September 2008. SAMA issued this document to the banks through its Circular # 771 of 5 December 2008, which instructed banks to audit the level of their compliance with the Sound Principles. It required this assessment to be made on a principle-by-principle basis as follows: 1. Compliant 2. Largely compliant

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3. Largely not compliant 4. Not compliant These results were received by SAMA in the first half of 2009. SAMA subsequently issued Circular # 351000147075 of 25 September 2014 to require the banks to conduct a further internal audit to assess the current level of compliance with the Sound Principles. Principles 1–13 are applicable to all regulated entities. Principles 14–17, which give guidance for supervisors assessing liquidity risk management in banks, are implemented through the BCL.

Fundamental principle for the management and supervision of liquidity risk – Principle 1 The first principle states the overall purpose: banks are responsible for having processes in place to actively monitor and manage liquidity risk. In terms of implementation, SAMA requirements mirror the BCBS requirements, which include requirements for sound risk management overall as well as a specific requirement concerning liquidity risk. SAMA’s expectations have been outlined in various complementary guidelines relating to Basel II Pillar II, stress-testing and ICAAP which require banks to establish mechanisms that allow them to operate at liquidity risk levels commensurate with their liquidity profile. SAMA’s expectations are that the liquidity risk profile of a regulated entity needs to be considered on both a group and a standalone basis, and compliance is enforced through on-site and off-site monitoring. Further, the requirement to maintain an adequate level of liquid assets has been augmented by the introduction of the LCR guidelines, with their emphasis on explicitly defined HQLA assets. It is noteworthy that the LCR coverage with respect to the overall system indicates a liquidity buffer substantially above (currently more than three times) the minimum regulatory requirement for the year 2015 as prescribed by the BCBS.

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SAMA believes that the liquidity profile of the regulated entities within the KSA is at a level that would enable them to cope with any reasonably foreseeable liquidity contingency.

Governance of liquidity risk management – Principles 2–4 These principles require that a bank clearly spells out its liquidity risk tolerance and strategy to maintain the bank’s stability and consequently that of the financial system. Senior management needs to ensure that the policies, procedures and practices are commensurate with the risk tolerance set by the bank. For its part, the board should take ownership of the bank’s policies, practices and risk tolerance, and ensure that liquidity risk is effectively managed. For this purpose, liquidity costs, benefits and risks should be incorporated into the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures that their activities create for the bank as a whole. SAMA requirements are identical to those outlined by BCBS, so that senior management together with the board of directors are obliged to be involved in the process of defining, approving and monitoring the bank’s liquidity risk tolerance. In most banks in the KSA, the assets and liabilities committee plays an instrumental role in identifying an appropriate liquidity profile and associated tolerance with due oversight from the risk management function. These recommendations form part of the financial forecasts and the ICAAP process, both of which are thoroughly reviewed by the respective bank’s board. From a governance perspective, both the senior management and the board are held responsible for maintaining the bank’s liquidity profile at a safe level.

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SAMA requires that banks disclose in their ICAAP submissions the governance process for liquidity management. All local banks are expected to institute a liquidity risk management process that allocates the liquidity costs, benefits and risks of the various business units appropriately, taking a holistic approach to liquidity risk measurement for the entire bank. SAMA is cognisant of the high correlation liquidity risk can have at times with other risk categories and expects banks to manage risks on an integrated basis.

Measurement and management of liquidity risk – Principles 5–12 The aim of these Basel principles is that banks should have adequate tools in place to capture all material sources of liquidity, whether current or those arising as a result of the bank’s strategic plan. Liquidity risk is expected to be managed holistically at a group level and banks are expected to maintain a robust funding strategy, covering short- to long-term horizons, including intraday. Further, collateral management, stress testing and liquidity contingency should form an integral part of a bank’s risk management mechanisms. SAMA requires banks to comply with their obligations, while considering the possibility of adverse conditions, and to maintain a level of liquid assets that is sufficient to cover outflows, even in stress situations. SAMA expects to see adequate linkage between the stress testing undertaken and liquidity contingency planning. In addition, all measurement tools are required to capture all material aspects of a bank’s balance sheet, including, derivatives and structured products, and traditional off balance sheet items. SAMA annually reviews the same as part of the bank’s stress-testing framework and the ICAAP process. As part of the implementation, SAMA imposes additional capital which varies from bank to bank based on its Pillar II risk profile, a material part of which is based on an assessment of the bank’s liquidity risk profile.

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SAMA’s LCR guidelines further complement the principles laid out in the Sound Principles and require banks to differentiate between encumbered and unencumbered assets and take into account which are part of their hedging strategies. SAMA also requires banks to proactively manage their liquidity positions and their intraday risks and is in the process of implementing the BCBS requirement on intraday liquidity monitoring to further strengthen the resilience of the banking system in terms of meeting its payment and settlement obligations in a timely fashion, both in normal and stress conditions. SAMA regulations require that regulated entities must have a documented Liquidity Contingency Plan (LCP), which addresses all material threats to liquidity and is annually reviewed and approved by the bank’s board. SAMA also requires an adequate linkage between business continuity planning and the LCP; and the LCP needs to reflect the bank’s strategy and its business profile.

Public disclosure – Principle 13 Principle 13 requires regular public disclosure of liquidity-related information to enable market participants make an informed judgment about the soundness of an institution’s liquidity risk management framework and liquidity position. SAMA formed a subcommittee of its committee for bank CFOs. The committee recommended an Illustrative Financial Statement template covering the key elements of a bank’s methodologies for the management of liquidity risks, including: • brief description of the methodology used to identify and quantify liquidity risk; and • exposures and portfolios being assessed for liquidity risk. In addition, the CFO Committee is actively working on the Enhanced Disclosures Task Force’s recommendations, including those pertaining to liquidity risk, which aim at bringing the quality of local banks’ disclosures on liquidity and other financial risks into line with global best practice.

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The role of supervisors – Principles 14–17 According to these principles, the supervisor should regularly assess a bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank’s role in the financial system. This comprehensive assessment should be supplemented by monitoring a combination of internal reports, prudential reports and market information. In the case of deficiencies in a bank’s liquidity risk management processes, the supervisor should intervene to require effective and timely remedial action by the bank. Based on the BCL, SAMA can make regular on-site inspections to regulated entities to assess if their operations, organisation, processes and systems of internal control and risk management comply with the provisions regarding liquidity risk. For this purpose, SAMA assesses the risks to which the banks are exposed, their control systems and the quality of management, to ensure that they maintain adequate liquidity. Additionally, the regulated institutions must provide the inspection team with the information it requires for its liquidity risk assessments.

Annex 11: Areas for further guidance from the Basel Committee The Assessment Team listed the following issues for further guidance from the Basel Committee.

Illiquid 0% risk-weighted government securities To ensure a consistent implementation of the LCR across jurisdictions, the Assessment Team believes it would be helpful if the Committee clarifies the treatment of 0% risk-weighted Level 1 securities that are not traded on large, deep, active and liquid markets and how to deal with central bank haircuts where banks have to rely on central banks to monetise these assets due to illiquid markets. Paragraph 50(c) of the Basel LCR rules is explicit only on tradability as a condition required for 0% risk-weighted securities.

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Non-0% risk-weighted government securities, as stipulated in paragraph 50(d) and 50(e), on the other hand do not have to meet this criteria but can be included without any restriction if they comprise domestic securities and non-domestic securities, limited to the amount of net cash outflows in that currency. In the case of non-0% risk-weighted government securities, there seems to be a presumption that these may not be liquid and that therefore a (constrained) exemption is proposed for these. In practice, countries such as the KSA could have allowed for more of their local government bonds to be included in the LCR if the bonds were to have a lower credit rating. This does not seem to be a fully consistent or intended outcome.

Sharia-specific requirements SAMA regulates Sharia-compliant banks in the same way as it does other banks in the KSA. Thus, this does not currently lead to any deviation from Basel standards. Nevertheless, if there were to be a greater variety of Sharia-compliant activities and/or if the International Financial Reporting Standards were differently applied to Sharia-compliant activities in the KSA, this could change. More generally, it would seem sensible for the Basel Committee to consider whether the application of its standards in practice fully captures the risk emanating from the variety of Sharia-compliant banks and their activities.

Annex 12: Areas where SAMA rules are stricter than the Basel standards In several places, SAMA has adopted a stricter approach than the minimum standards prescribed by Basel or has simplified or generalised an approach in a way that does not necessarily result in stricter requirements under all circumstances but which never results in less rigorous requirements than the Basel standards. The following list provides an overview of these areas.

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It should be noted that these areas have not been taken into account as mitigants for the overall assessment of compliance. • Currently, SAMA does not permit the use of Level 2B assets for the purpose of the LCR. • For the overseas branches and subsidiaries of KSA banks, on a consolidated basis, SAMA applies a run-off rate of 10% for their retail deposits, although the host country may have a deposit insurance scheme and could be applying a lower run-off rate. • Although a deposit insurance scheme is in place in the KSA, which takes effect on 1 Jan 2016, SAMA does not allow the category of stable deposits. Hence, a run-off rate of 10% is applied. This also applies to all deposits outside the KSA.

Annex 13: Implementation of LCR elements subject to prudential judgment or discretion in the KSA The following tables provide information on elements of LCR implementation that are subject to prudential judgment and national discretion. The information provided helps the Basel Committee to identify implementation issues where clarifications and (additional) FAQs could improve the quality and consistency of implementation. It should also inform the preliminary design of any peer comparison of consistency across the membership that the Committee may decide to conduct, in similar fashion to the studies on risk-weighted asset variation for the capital standards.

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Glossary ALA Alternative Liquidity Approaches BCBS Basel Committee on Banking Supervision BCL Banking Control Law BDR Banking Disclosure Rules BLR Banking Liquidity Rules CFO Chief financial officer CLF Committed liquidity facility D-SIBs Domestic systemically important banks FAQs Frequently asked questions FSAP Financial Sector Assessment Program FX Foreign exchange GCC Gulf Cooperation Council HQLA High-quality liquid assets ICAAP Internal Liquidity Adequacy Assessment Programme KSA Kingdom of Saudi Arabia LCP Liquidity Contingency Plan LCR Liquidity Coverage Ratio LIBOR London Interbank Offer Rate MDB Multilateral development bank RCAP Regulatory Consistency Assessment Programme SAMA Saudi Arabian Monetary Agency SAR Saudi Arabian riyal SARIE Saudi Arabian Riyal Interbank Express SIBOR Saudi Interbank Offer Rate SMEs Small and medium-sized enterprises SREP Supervisory Review and Evaluation Process UK PRA United Kingdom Prudential Regulation Authority

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RiskMinds International is the world’s largest and most prestigious risk management conference and is fully established as the most senior gathering of the global risk management community. 600+ CROs, global supervisors, renowned academics and expert industry practitioners will gather together this December to discuss strategic risk management, capital allocation and practical risk modelling. I will be providing information about the CRCMP training course during the event. I am pleased to be able to offer you a special 15% discount off the booking fee for RiskMinds International. Just quote the discount VIP Code: FKN2436IARCPE to claim your discount. The latest agenda can be found on the website here, as well as the speaker line-up to date. For more information or to register for the 22nd annual RiskMinds, please contact the ICBI team on: Tel: +44 (0) 20 7017 7200 Fax: + 44 (0) 20 7017 7806 Email: [email protected] Web: http://www.riskmindsinternational.com/FKN2436IARCPE Please note: you can save up to £1800 in early bird savings on top of the 15% discount. I look forward to meeting those of you attending this conference. Best Regards, George Lekatis President of the IARCP 1200 G Street NW Suite 800, Washington DC 20005, USA Tel: (202) 449-9750 Email: [email protected] Web: www.risk-compliance-association.com HQ: 1220 N. Market Street Suite 804, Wilmington DE 19801, USA Tel: (302) 342-8828

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