risk and compliance management news may 2011

8/6/2019 Risk and Compliance Management News May 2011

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_____________________________________________________________International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and ComplianceProfessionals (IARCP)

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

Dear Member,

Understanding internal controls over financial reporting (ICFR) is veryimportant for the implementation of the new Dodd Frank Act.

And, who really understands internal controls?Yes, Sarbanes Oxley professionals. Absolutely.

Today we will spend some time to understand the Dodd Frank Act, andthe new ICFR environment and requirements.

Some interesting developments:

According to the Sarbanes-Oxley Act, publicly traded companies cannotpunish employees that revealsuspected fraud.

Reveal to whom?Can you reveal suspected fraud to the media?

Today we have a clear answer: No, you are not protected if you revealsuspected fraud to the media.

According to the Ninth U.S. Circuit Court of Appeals, you are protected ifyou speak to federal regulators, Congress or a workplace supervisor - tothose with "the capacity or authority to act effectively on the information"as Judge Barry Silverman said in the court's ruling.

Leaks to the media are not protected.
http://www.risk-compliance-association.com/http://www.risk-compliance-association.com/http://www.risk-compliance-association.com/http://www.risk-compliance-association.com/


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The ruling has to do with the well known case of two Boeing Co. auditorswho were fired in 2007, after telling a reporter that they were beingpressured to deliver favorable reports about the security of Boeing'sinternal computer software.

According to the Boeing spokesman John Dern, the ruling supportedcorporate policies that require employees to keep internal informationconfidential.

Another interesting development:

James R. Doty has been appointed by the Securities and ExchangeCommission as the Chairman of the Public Company AccountingOversight Board.

From 1990 to 1992, Mr. Doty served as General Counsel of the SEC.

In that role, Mr. Doty advised the Commission on matters of law andregulatory policy related to the Commission's oversight of U.S. securitiesmarkets, including initiatives relating to the integrity of financialreporting and disclosure standards in the context of the globalization ofcapital markets, enforcement practices and policies in the wake of thesavings-and-loan crisis, international technical assistance andcoordination efforts, and adoption of the Remedies Act of 1990.

Prior to and following his SEC service, Mr. Doty was a partner at the lawfirm of Baker Botts LLP, which he first joined in 1969.

At Baker Botts LLP, he practiced securities and corporate law andcounseled boards of directors and audit committees on regulatory andcompliance matters, including matters arising under the Sarbanes-Oxley

Act of 2002.

He also represented the PCAOB in obtaining a successful result in the

United States Supreme Court in the landmark challenge to its


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constitutionality, Free Enterprise Fund v. PCAOB.

Mr. Doty has earned a B.A. in History from Rice University and was aRhodes Scholar at Oxford University in England. He also received a M.A.in History from Harvard University before getting an L.L.B from YaleLaw School.

It is time to discuss the Dodd Frank Act, Section 989G and the internalcontrols over financial reporting (ICFR).

We start from the Dodd Frank Act:

SEC. 989G. EXEMPTION FOR NONACCELERATED FILERS.

(a) EXEMPTION.Section 404 of the Sarbanes-Oxley Act of 2002 isamended by adding at the end the following:

(c) EXEMPTION FOR SMALLER ISSUERS.Subsection (b) shallnot apply with respect to any audit report prepared for an issuer that isneither a large accelerated filer nor an accelerated filer as those termsare defined in Rule 12b2 of the Commission (17 C.F.R. 240.12b2)..

(b) STUDY.The Securities and Exchange Commission shall conduct a

study to determine how the Commission could reduce the burden ofcomplying with section 404(b) of the Sarbanes-Oxley Act of 2002 forcompanies whose market capitalization is between $75,000,000 and$250,000,000 for the relevant reporting period while maintaining investor

protections for such companies.

The study shall also consider whether any such methods of reducing thecompliance burden or a complete exemption for such companies fromcompliance with such section would encourage companies tolist on exchanges in the United States in their initial public offerings.


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Not later than 9 months after the date of the enactment of this subtitle,the Commission shall transmit a report of such study to Congress.

Study and Recommendations on Section 404(b) of theSarbanes-Oxley Act of 2002For Issuers With Public Float Between $75 and $250 Million

As Required by Section 989G(b) of the Dodd-Frank Wall Street Reformand Consumer Protection Act of 2010, April 2011

Section 989G(b) of the Dodd-Frank Act directed the SEC to conduct astudy with respect to the auditor attestation requirement under Section404(b) for issuers whose market capitalization is between $75 and $250million.

Specifically, the Dodd-Frank Act provides:

The Securities and Exchange Commission shall conduct a study todetermine how the Commission could reduce the burden of complying

with section 404(b) of the Sarbanes-Oxley Act of 2002 for companieswhose market capitalization is between $75,000,000 and $250,000,000 forthe relevant reporting period while maintaining investor protections for

such companies.

The study shall also consider whether any such methods of reducing thecompliance burden or a complete exemption for such companies fromcompliance with such section would encourage companies to list onexchanges in the United States in their initial public offerings.

Not later than 9 months after the date of the enactment of this subtitle,the Commission shall transmit a report of such study to Congress.Inaddition, Section 989G(a) of the Dodd-Frank Act amended the

Sarbanes-Oxley Act so that Section 404(b) does not apply with respect to


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any audit report prepared for an issuer that is neither a large acceleratedfiler nor an accelerated filer as those terms are defined in Rule 12b-2 ofthe Commission.

Pursuant to Section 989I of the Dodd-Frank Act, the GovernmentAccountability Office (GAO) is required to conduct a study on the impactof the Section 404(b) amendments under the Dodd-Frank Act and tosubmit a report not later than 3 years after the date of enactment of that

Act (July 2013).

The GAO study is to include an analysis of:

(1) whether issuers that are exempt from such section 404(b) have fewer ormore restatements of published accounting statements than issuers that

are required to comply with such section 404(b);

(2) the cost of capital for issuers that are exempt from such section 404(b)compared to the cost of capital for issuers that are required to comply

with such section 404(b);

(3)whether there is any difference in the confidence of investors in theintegrity of financial statements of issuers that comply with such section404(b) and issuers that are exempt from compliance with such section404(b);

(4) whether issuers that do not receive the attestation for internal controlsrequired under such section 404(b) should be required to disclose the lackof such attestation to investors; and

(5) the costs and benefits to issuers that are exempt from such section404(b) that voluntarily have obtained the attestation of an independentauditor.


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Approach to this Study

This study addresses the auditor attestation requirement with respect toan issuers ICFR pursuant to Section 404(b) as required by Section989G(b) of the Dodd-Frank Act.

It does not address managements responsibilities pursuant to Section404(a) of the Sarbanes-Oxley Act.

Under the Commissions rules prescribed pursuant to Section 404(a) ofthe Sarbanes-Oxley Act, issuers, other than registered investmentcompanies, are required to include in their annual reports a report ofmanagement on the issuers ICFR that:

(1) States managements responsibility for establishing and maintainingthe internal control structure; and

(2) Includes managements assessment of the effectiveness of the ICFR.Section 404(b) requires the auditor to attest to, and report on,managements assessment.

In light of the interrelationship between the requirements in Section404(a) and Section 404(b), and to be complete in our efforts to identify

potential methods of reducing the Section 404(b) compliance burden, the

Staffs research and analysis included consideration of certain existinginformation about Section 404 compliance more broadly, particularly

where such information did not distinguish among the variousrequirements in Section 404.

In order to fulfill the statutory mandate and produce this study, the Staffhas assigned meaning to certain terms as described below:

1. For purposes of this study, the Staff generally uses public float as themeasure of market capitalization.


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As the Commission described in its request for comment in connectionwith this study:

The Dodd-Frank Act does not define market capitalization and it is notdefined in Commission rules.

For purposes of the study, we believe thatpublic float is an appropriatemeasure of market capitalization.

Public float, which is the aggregate worldwide market value of an issuersvoting and non-voting common equity held by its non-affiliates, is themeasure used in Commission rules for determining accelerated filer andlarge accelerated filer status.

The Commission has used public float historically in its actions to phaseissuers into Section 404 compliance, and Section 404(c) of theSarbanes-Oxley Act of 2002, as amended by Section 989G(a) of theDodd-Frank Act, provides that Section 404(b) shall not apply with respectto issuers that are neither an accelerated filer nor a large accelerated filer

pursuant to Commission rules, which are generally issuers with a publicfloat below $75 million.

We therefore believe it would be consistent to use public float between$75 million and $250 million to describe the group of issuers that are the

subject of the study.

2.Accelerated filer means an issuer after it first meets the followingconditions as of the end of its fiscal year:

(i) The issuer had an aggregate worldwide market value of the voting andnon-voting common equity held by its non-affiliates of $75-$700 millionas of the last business day of the issuers most recently completed fiscalquarter;

(ii) The issuer has been subject to the requirements of Section 13(a) or


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15(d) of the Exchange Act for at least twelve calendar months;

(iii) The issuer has filed at least one annual report pursuant to Section13(a) or 15(d) of the Exchange Act; and

(iv) The issuer is not eligible to use the requirements for smaller reportingcompanies in its annual and quarterly reports.

3. Large accelerated filer means an issuer that had an aggregateworldwide market value of the voting and non-voting common equityheld by its non-affiliates of $700 million or more as of the last business dayof the issuers most recently completed fiscal quarter and also meets therequirements of (ii)(iv) listed above in the definition of accelerated filer.

4. The study uses the term non-accelerated filer to refer to an issuer thatdoes not meet the definition of either an accelerated filer or a largeaccelerated filer which principally are issuers with a public float of lessthan $75 million.

5. The study uses the term illustrative population to refer to the group ofissuers identified for the analyses in Section II of this study.

Executive Summary

Under Section 989G(b) of the Dodd-Frank Wall Street Reform andConsumer Protection Act (the Dodd-Frank Act), the Securities andExchange Commission (SEC or Commission) is required to conduct astudy to determine how the Commission could reduce the burden ofcomplying with Section 404(b) of the Sarbanes-Oxley Act of 2002 (Section404(b)) for companies whose market capitalization is between $75 and$250 million, while maintaining investor protections for such companies.

Section 989G(b) also provides that the study must consider whether anymethods of reducing the compliance burden or a complete exemption forsuch companies from Section 404(b) compliance would encourage


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companies to list on exchanges in the United States in their initial publicofferings (IPOs).

This study addresses the auditor attestation requirement with respect toan issuers internal control over financial reporting (ICFR) pursuant toSection 404(b) as required by Section 989G(b) of the Dodd-Frank Act.

It does not address managements responsibility for reporting on theeffectiveness of ICFR pursuant to Section 404(a) of the Sarbanes-Oxley

Act.

Although many of the academic and other studies surveyed relate toSection 404 in general and to Section 404(b) for all issuers, the researchdiscussed in this study primarily focuses on findings related to

accelerated filers.

However, in conducting this study, the SEC Staffs research and analysisconsidered certain existing information about Section 404 compliancebeyond the specific areas of the study requirements as provided in theDodd-Frank Act.

This approach was used to develop findings and recommendationsregarding Section 404(b) through the analysis of existing research, eventhough the purpose of the existing research may have been broader than

the requirements of the current study.

Broadly, the Staff gathered information for this study through:

(1) a review of publicly-available information (including the 2009 SECStaff study on Section 404, discussed in Section III of this study), focusingour data analysis on issuers that would be within the range called for bythe study;

(2) a review of prior academic and other research, including hundreds of

studies and research papers with respect to Section 404; and


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(3) a request for public comment which included 23 specific areas ofinquiry on how the Commission could reduce the burden of complying

with Section 404(b) for issuers with $75-$250 million in public float, whilemaintaining investor protections for such issuers, and whether anymethods of reducing the compliance burden or a complete exemption forsuch issuers from Section 404(b) would encourage issuers to list on U.S.exchanges in their IPOs.

The purpose of using these sources was to:

(1) learn about the specific characteristics of the issuers in the range of thestudy, how they compare to other issuers reporting as accelerated filersand non-accelerated filers, and the benefits and current and historicalcosts of compliance with Section 404(b) and current investor protections

relating to such issuers; and

(2) facilitate the development of potential new ideas for reducing thecompliance burden among such issuers, including the effects of suchcompliance burden reduction or complete exemption from Section 404(b)to encourage companies to list IPOs in the United States.

Consideration of Prior Action by the Commission and Others

In performing this study, the Staff first considered actions taken by the

Commission and others since the enactment of Section 404(b).

The Staff performed this analysis to consider the effects of the significantsteps that have already been taken to reduce the overall complianceburden on the population that is the subject of this study.

Broadly, the timeline is as follows:

1. The Commissions initial implementing rule provided a phased-inapproach to compliance;


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2. In response to concerns from issuers (particularly non-acceleratedfilers) about compliance costs and managements preparedness, theCommission provided several extensions to the compliance dates;

3. The Commission provided that Section 404 compliance is not requiredin an IPO and in the first annual report after an IPO;

4. In 2007, the Commission issued an interpretive release to provideguidance for management regarding its evaluation of internal controlsand disclosure requirements;

5. At approximately the same time that the Commissions interpretiverelease was issued, the Public Company Accounting Oversight Board (thePCAOB or Board) adopted Auditing Standard No. 5, An Audit of Internal

Control Over Financial Reporting that is Integrated with an Audit ofFinancial Statements (AS 5) to address feedback from constituents aboutthe costs of conducting an effective audit of internal controls, includingfeedback received from roundtables and other activities with theCommission; and

6. Additionally, in 2008 the Commission directed the Staff to conduct astudy on Section 404, which was released in 2009 and forms part of thebasis for the current study.

Analysis of the Issuers Subject to this Study

After considering prior actions taken to reduce the compliance burden onall issuers subject to Section 404, the Staff analyzed the characteristics ofissuers that are the subject of this study.

The Staff performed this analysis to assist with the development ofpotential recommendations specific to any unique circumstances ratherthan to identify the exact listing of issuers as of any point in time thatcould be affected by any future actions resulting from the implementationof particular recommendations of the study.


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The characteristics analyzed included the following information aboutthe issuers:

(1) size in terms of assets and revenues;

(2) industries;

(3) locations;

(4) audit fees and scalability;

(5) restatement rates; and

(6) reported material weaknesses in ICFR.

The Staff also analyzed changes to the population of the issuers over time,noting that issuers frequently enter and exit this band of public float, suchthat the composition changes greatly from year to year.

The Staff identified an illustrative population of issuers as of December 31,2009 as a proxy for those in the studied range.

The Staff observes that auditor attestation on ICFR has been required foraccelerated filers since 2004 for domestic issuers and 2007 for foreign

private issuers.

The Staffs analysis reveals that the illustrative population is, in manyimportant respects, significantly different from the population of allnon-accelerated filers (the group of issuers permanently exempted fromthe requirements of Section 404(b) by the Dodd-Frank Act),particularlyin relation to size (by revenue and assets), audit fees relative to size,restatement rates, and internal control issues discovered by managementand auditors.

Many of the characteristics point to similar financial reporting risks


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between the studied group of issuers and issuers with larger public floatthat also must comply with Section 404(b).

The Staff recognizes, as would be the case with establishing any numericthresholds, that issuers at the lower end of the studied range within theillustrative population could be more likely to have characteristics moresimilar to non-accelerated filers (i.e., issuers that are just under or justover the $75 million threshold are likely to have similar characteristics toone another).

This analysis suggests that there generally are not unique characteristicsin the illustrative population that would suggest sufficient reasons fordifferentiating these filers from accelerated filers taken as a whole,including the requirement for an auditor attestation on ICFR pursuant to

Section 404(b).

To understand whether any possible recommendations may encouragecompanies to list IPOs in the United States, the Staff analyzed thecharacteristics of global IPOs with respect to those likely to be in therange of issuers subject to this study.

Although the U.S. IPO market over time has recovered from the 2007levels, it has not reached the 1999 levels (i.e., we reviewed IPO activityover a range of years and noted that it was at a relatively low point during

the financial crisis and has since recovered, but not to the peak for therange of years studied).

The Staffs analysis shows that the United States has not lost U.S.-basedcompanies filing IPOs to foreign markets for the range of issuers that

would likely be in the $75-$250 million public float range after the IPOand that issuers filing IPOs in this range are not likely to remain in thisrange for an extended period of time.

While U.S. markets share of world-wide IPOs raising $75-$250 million

has declined over the past five years, there is no conclusive evidence from


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the study linking the requirements of Section 404(b) to IPO activity.

In addition, as noted above, the Commission has previously taken actionto reduce the compliance burden for new issuers by not requiring theauditor attestation on ICFR for the IPO and the first annual reportthereafter.

Analysis of the 2009 SEC Staff Study on Section 404

Once the Staff understood the characteristics of the studied group ofissuers, it used the data from its 2009 Section 404 study to analyze theeffects of prior efforts to reduce the Section 404(b) compliance burden onsuch issuers.

The Staff found that the 2007 reforms (broadly, the Commissions June2007 interpretive release and the PCAOBs adoption of AS 5) had theintended effect of reducing the compliance burden and improving theimplementation of Section 404, including the requirements of Section404(b) for the studied group of issuers.

This information, in conjunction with the analysis of prior reforms andgeneral information about the characteristics of the studied group ofissuers, provided the Staff with a starting point to consider new publicinput, existing academic research, and other information to determine

whether there are additional ways to further reduce the complianceburden of Section 404(b) while maintaining investor protections for suchissuers.

Discussion of Public Comments

To assist the Staff in considering possible recommendations, theCommission requested public input on 23 specific areas about how theCommission could reduce the burden of complying with Section 404(b)

for the studied group of issuers, while maintaining investor protections


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for such issuers, and whether any methods of reducing the complianceburden or a complete exemption for such issuers from Section 404(b)

would encourage issuers to list on U.S. exchanges in their IPOs.

There were few suggestions provided from the public input thataddressed techniques for further reducing the compliance burden whilemaintaining investor protections without providing a completeexemption.

For example, the three industry groups that advocated an exemption fromSection 404(b) for issuers in the studied market capitalization range didnot provide other recommendations for reducing the compliance burden.

The Staff considered this input as well as public input previously received

on the compliance burden of Section 404(b) from past Commission andPCAOB actions, but generally did not believe that those suggestions,beyond those previously implemented, were appropriaterecommendations for the issuer group the Staff was required to study(e.g., forms of rotational or reduced testing and raising the threshold of

what constitutes a material weakness).

The Staff is also aware that there are continuing negative perceptionsattributed to the Sarbanes-Oxley Act, including Section 404.

However, the Staff does believe that certain other suggestions from thepublic that involve Commission coordination and support for othergroups will likely take into account both the compliance costs andeffectiveness for all issuers, including those in the studied range.First, certain commenters recommended that the PCAOB publishadditional observations about the implementation of the PCAOBsauditing standards related to Section 404(b), including comparing suchimplementation to the PCAOBs original intent.

These commenters believed that additional observations could assist

auditors in performing more efficient and effective audits.


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The Staff supports recommending to the PCAOB that it continuouslyreview inspection results and consider whether publishing observations is

warranted to improve the effective and efficient application of its auditingstandard.

If such observations were published, they may contribute to a reductionin the compliance burden for issuers in the studied range and also provideauditors, issuers, investors, and others with important information aboutaudit performance and quality.

Second, certain commenters recommended that the Commission activelyparticipate and monitor the Committee of Sponsoring Organizations ofthe Treadway Commission (COSO) update to its internal control

framework.

COSO announced plans to update its framework, which was originallyreleased in 1992, in November of 2010.

The stated aims of the update to the 1992 framework do not explicitlyaddress the compliance burden on issuers that use the COSO frameworkto evaluate ICFR, and it is not aimed at any particular size of issuer.

However, the update is designed to describe how to evaluate internal

controls in an environment that is more complex than it was when theoriginal framework was developed.

The Staff supports this recommendation, as the update may haveimplications on the compliance burden on issuers, including those in thestudied range.

Summary of Prior Academic and Other Research on Section 404

Finally, the Staff considered existing research on Section 404 to


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understand the trends in compliance costs and the existing investorprotections provided by compliance with Section 404(b), as well as todiscern any additional ideas for reducing the compliance burden forissuers in the studied range.

The research was useful to inform the Staffs broader consideration ofhow and if the compliance burden could be reduced for such issuers byexamining, for example, compliance cost trends, listing trends, andindividuals decision making in lending and investing activities.

The academic and other research on Section 404:

1. Indicates that the cost of compliance with Section 404(b), includingboth total costs and audit fees, has declined since the 2007 reforms;

2. Does not provide conclusive evidence linking the enactment of Section404(b) to decisions by issuers to exit the reporting requirements of theSEC, including ICFR reporting;

3. Indicates that auditor involvement in ICFR is positively correlated withmore accurate and reliable disclosure of all ICFR deficiencies, andrestatement rates for issuers with the auditor attestation is lower than thatfor issuers without this attestation; and

4. Indicates that disclosure of internal control weaknesses conveys

relevant information to investors.

The Staff also considered and does not recommend an approach detailedin certain studies suggesting that the Commission allow an issuer to optout of Section 404(b) compliance.Opt out approaches can provide a mechanism to allow an issuer optionsregarding compliance rather than a strict requirement.

Under such an approach, so long as an investor was informed as to anissuers decision to opt out or comply, an investor could consider this

decision in allocating capital and otherwise making investment decisions.


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Although some suggest that allowing flexibility of this type could bebeneficial, in the context of Section 404(b) the Staff considered thesuggestion of an opt out to be too similar to providing a full exemptiongiven the Staffs view of the benefits of auditor involvement to reliableICFR disclosures and reliable financial reporting.

Academic literature also suggests it could incentivize insiders to exploitthe information asymmetry between themselves and other investors aboutthe incidence and severity of material weaknesses in ICFR.

Conclusion and Recommendations

The information compiled for the study provided the Staff with an

understanding that:

1. The costs of Section 404(b) have declined since the Commission firstimplemented the requirements of Section 404, particularly in response tothe 2007 reforms;

2. Investors generally view the auditors attestation on ICFR as beneficial;

3. Financial reporting is more reliable when the auditor is involved withICFR assessments; and

4. There is not conclusive evidence linking the requirements of Section404(b) to listing decisions of the studied range of issuers.

The Staff also received public input suggesting certain means to reducethe compliance burden that were previously considered by theCommission or the PCAOB and they determined not to adopt.

The Staff considered this input but believes these suggestions wouldpossibly be detrimental to effectiveness of audits of ICFR and, therefore,not maintain investor protections provided by Section 404(b).


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After considering the information gathered from internal and externalsources, the Staff concludes the study with the following tworecommendations:

1. Maintain existing investor protections of Section 404(b) for acceleratedfilers, which have been in place since 2004 for domestic issuers and 2007for foreign private issuers

The Staff believes that the existing investor protections for acceleratedfilers to comply with the auditor attestation provisions of Section 404(b)should be maintained (i.e., no new exemptions).

There is strong evidence that the auditors role in auditing theeffectiveness of ICFR improves the reliability of internal control

disclosures and financial reporting overall and is useful to investors.

The Staff did not find any specific evidence that such potential savingswould justify the loss of investor protections and benefits to issuerssubject to the study, given the auditors obligations to perform proceduresto evaluate internal controls even when the auditor is not performing anintegrated audit.

Also, while the research regarding the reasons for listing decisions isinconclusive, the evidence does not suggest that granting an exemption

to issuers that would expect to have $75-$250 million in public floatfollowing an IPO would, by itself, encourage companies in the UnitedStates or abroad to list their IPOs in the United States.

The Staff acknowledges that the reasons a company may choose toundertake an IPO are varied and complex.

The reasons are often specific to the company, with each companymaking the decision as to whether and where to go public based on itsown situation and the market factors present at the time.

The costs associated with conducting an IPO and becoming a public


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company no doubt factor into the decisions and may be particularlychallenging for smaller companies.

The Staff appreciates that the costs and benefits of the regulatory actionsthat the Commission takesand does not takecertainly can impactthese decisions.

At Chairman Schapiros request, the Staff is taking a fresh look at severalof the Commissions rules, beyond those related to Section 404(b), todevelop ideas for the Commission about ways to reduce regulatoryburdens on small business capital formation in a manner consistent withinvestor protection.

However, the Dodd-Frank Act already exempted approximately 60% of

reporting issuers from Section 404(b), and the Staff does not recommendfurther extending this exemption.

2. Encourage activities that have potential to further improve botheffectiveness and efficiency of Section 404(b) implementation

The Staff recommends that the PCAOB monitor its inspection results andconsider publishing observations, beyond the observations previously

published in September 2009, on the performance of audits conducted inaccordance with AS 5.

These observations could assist auditors in performing top-down, riskbased audits of ICFR.

These communications could include the lessons that can be learnedfrom internal control deficiencies identified through PCAOB inspections.

The Staff is observing COSOs project to review and update its internalcontrol framework, which is the most common framework used bymanagement and the auditor alike in performing assessments of ICFR.

The Staff believes that this project can contribute to effective and efficient


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audits by providing management and auditors with improved internalcontrol guidance that reflects todays operating and regulatoryenvironment and by allowing constituent groups to share information onimprovements that can be made that enhance the ability to design,implement, and assess internal controls.


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Basel III News

Dear Members,According to Otto von Bismarck, laws are like sausages, it is better not tosee them being made.

But this is not an option for us. Basel II / III professionals must try hardto understand both, the letter and the spirit of the law.

Banks continue to lobby for revisions of the key factors that are includedin the Basel III liquidity ratios, in an effort to minimize the consequencesand... increase shareholder value (and of course pay dividends).

Citigroup and Goldman Sachs for example, try to persuade that the NSFRshould be substantially re-calibrated.

Are you ready for the bad news? According to Moodys senior vicepresident Alain Laurin: While directionally positive, Basel 3 does notcure the structural challenges banks continue to face from a credit

perspective, such as illiquidity and high leverage, nor does it alleviate thetension between profit-maximizing equity holders and bank managers incontrast to risk-averse bondholders.

This month we had another opportunity to see that Basel III is aminimum standard:

The finance commission members in Switserland voted in favor of thegovernment's proposal, which would make the UBS and Credit Suissehold equity Tier 1 capital of at least 10 percent, 3 percentage points morethan required by new Basel III rules.

Credit Suisse puts on a brave face and considers the proposal "tough butdoable".


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UBS, more practical, calls for a year's delay to allow more clarity oninternational regulation.

Today we will study one of the new papers that explain the Basel IIIframework.

Conference on Basel III, Financial Stability Institute, 6 April 2011

Basel III: Stronger Banks and a More Resilient Financial SystemStefan Walter, Secretary General, Basel Committee on BankingSupervision

I. Introduction

Thank you for the opportunity to speak to you this morning about Basel

III.

It is has now been three and a half years since the global financial crisisbegan.

The banking sector and financial system have now been stabilised.

But this required unprecedented public sector interventions.

Despite the severity of the crisis,we are already seeing signs that itslessons are beginning to fade.

At the same time, there are still significant risks on the horizons, whilekey reforms still need to be carried through if we are to achieve a trulystable banking and financial system.

I would like to begin this morning by recalling the damaging effects ofthe crisis and why the Basel III reforms are central to promoting financialstability.


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I will then briefly outline the key reforms that comprise Basel III.Finally, I will focus on what still needs to be done to ensure longer-termstability.

In particular, I will discuss the need for global and consistentimplementation of the Basel III reform package and the ongoing work toaddress the risks of systemic banking institutions.

II. Motivation for Basel III reforms

A. Damaging effects of banking crises

There is a wide body of evidence that the most severe economic crises areassociated with banking sector distress.

While there is variation in findings across studies, the Basel Committeeslong-term economic impact study found that the central estimate in theeconomics literature is that banking crises result in losses in economicoutput equal to about 60% of pre-crisis GDP.

Why are banking crises so damaging?

Banks are highly leveraged institutions and are at the centre of the creditintermediation process.

In addition, credit and maturity transformation functions are vulnerableto liquidity runs and loss of confidence.

A destabilised banking system affects the provision of credit and liquidityto the broader economy and ultimately leads to lost economic output.

[see Table 1]


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In the most recent phase of the crisis there has also been significantspillover of risk between the banking sector and sovereigns.

Governments in a number of industrialised countries had to increase theirdebt in order to stabilise their banking systems and economies.

As a result, debt-to-GDP ratios in a number of economies increased by asmuch as 10-25 percentage points.

It therefore is clear that the economic benefits of raising the resilience ofthe banking sector to shocks are immense.


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B. Frequency of banking crises

The costs of banking crises are extremely high but, unfortunately, thefrequency has been as well.

Since 1985, there have been over 30 banking crises in BaselCommittee-member countries.

Roughly, this corresponds to a 5% probability of a Basel Committeemember country facing a crisis in any given yeara one in 20 chance,

which is unacceptably high.

[See Table 2]


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Many countries may not have been the cause of the current crisis, butthey have been affected by the global fall out.

Moreover, history has shown that banking crises have occurred in allregions of the world, affecting all major business lines and asset classes.

Moreover, there tend to be a common set of features that seem to repeatthemselves in various combinations from banking crisis to banking crisis.

These include:

1. Excess liquidity chasing yields

2. Too much credit and weak underwriting standards

3. Underpricing of risk, and

4. Excess leverage

In the current crisis, these recurring trends were magnified by:

1. Weak bank governance practices, including in the area ofcompensation

2. Poor transparency of the risks at financial institutions and in complexproducts

3. Risk management and supervision focused on individual institutionsinstead of also at the system level

4. Procyclicality of financial markets propagated through a variety ofchannels, and

5. Moral hazard from too-big-too-fail, interconnected financial

institutions.


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In particular, it is difficult to imagine a country that can maintainsustainable growth on the foundation of a weak banking system

III. Key features of the Basel III reform package

The Basel III framework is the cornerstone of the G20 regulatory reformagenda and the final Basel Committee rules were issued at the end of last

year.

This development is the result of an unprecedented process ofcoordination across 27 countries.

Compared to Basel II, it was also achieved in record time, less than twoyears.

The next step, which is just as critical as the policy development, isimplementation.

The full potential of Basel III will only be achieved if allCommittee-member countries and regions work within the global

process, and fully implement the minimum standards.

Some countries may choose to implement higher standards to addressrisks particular to their national contexts.

This has always been an option under Basel I and II, and it will remainthe case under Basel III.

Why is Basel III fundamentally different from Basel I and Basel II?

First, it is more comprehensive in its scope and, second, it combinesmicro- and macro-prudential reforms to address both institution andsystem level risks.

On the microprudential side, these reforms mean:


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1. A significant increase in risk coverage, with a focus on areas that weremost problematic during the crisis, that is trading book exposures,counterparty credit risk, and securitisation activities;

2. A fundamental tightening of the definition of capital, with a strongfocus on common equity.

At the same time, this represents a move away from complex hybridinstruments, which did not prove to be loss absorbing in periods of stress.

We also introduced requirements that all capital instruments must absorblosses at the point of non-viability, which was not the case in the crisis;

3. The introduction of a leverage ratio to serve as a backstop to the

risk-based framework;

4. The introduction of global liquidity standards to address short-termand long-term liquidity mismatches; and

5. Enhancements to Pillar 2s supervisory review process and Pillar 3smarket discipline, particularly for trading and securitisation activities.

In addition, a unique feature of Basel III is the introduction ofmacroprudential elements into the capital framework.

This includes:

1. Standards that promote the build-up of capital buffers in good timesthat can be drawn down in periods of stress, as well as clear capitalconservation requirements to prevent the inappropriate distribution ofcapital;

2. The leverage ratio also has system-wide benefits by preventing theexcessive build-up of debt across the banking system during boom times.


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To minimise the transition costs, the Basel III requirements will bephased in gradually as of 1 January 2013.

I would now like to say a few words in particular about two of the newerelements of the regulatory framework, namely the liquidity standards andthe leverage ratio. As mentioned, excess leverage and weak liquidity

profiles of banks were at the core of the crisis, and they thereforerepresent a critical part of the Basel III framework going forward.

A. The Liquidity Framework

There is broad support for the liquidity framework introduced by theCommittee.

Banks and other market participants already use methods similar to theLiquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio(NSFR).

Many of the issues that have been raised pertaining to these requirementsrevolve around the calibration of the ratios, rather than the conceptualbasis of the framework.

It is important to emphasise the Committees goal in establishing theliquidity framework: to require banks to withstand more severe shocks

than they had been able to in the past, thus reducing the need for suchmassive public sector liquidity support in future episodes of stress.

The success of the framework should not be measured in terms ofwhether it will have zero cost.

Instead, the better measure of success is whether the framework correctspre-crisis extremes at acceptable costs.

Banks that take on excessive liquidity risk should be penalised under thenew framework, while sound business models should continue to thrive.


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With these objectives in mind, the Committee will use the observationperiod to review the implications of the standards for individual banks,the banking sector, and financial markets, addressing any unintendedconsequences as necessary.

In this regard, the Committees focus is now on ensuring that thecalibration of the framework is appropriate.

Certain aspects of the calibration will be examined and this will involveregular data collection from banks.

Any adjustments should be based on additional information and rigorousanalyses.

Moreover, relying just on banks experiences from the crisis is notsufficient, as it embeds a high level of government support of banks andmarkets.

Hence, the analysis will need to include both quantitative bankexperience and additional qualitative judgement.

It is worth emphasising that a number of effects of the framework areindeed intended.

For example, with regard to the pool of liquid assets, the rules are meantto promote changes in behaviour.

Contrary to popular perception, they are not about promoting thehoarding of government debt, but about creating incentives to reducerisky liquidity profiles.

This can be achieved, for example, by pushing out the average term offunding or increasing the share of stable funds.


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In other cases, banks did not price liquidity appropriately throughout thefirm, and correcting risk management deficiencies will in turn improveliquidity profiles.

In fact, the initial response we have observed in some countries that havealready implemented comparable liquidity ratios suggest that these arethe types of strategies that are being pursued.

Also contrary to what many have claimed, the new standards should helppromote greater diversification of the pool of liquid assets held by banks.

Bank holdings of liquid assets continue to be dominated by exposures tosovereigns, central banks and zero percent risk-weighted public sectorentities.

These assets comprised 85% of banks liquid assets according to theCommittees most recent quantitative impact study.

By recognising high quality corporate and covered bondssubject to alimitthe liquidity framework will help promote a further diversificationof the liquid asset pool.

B. The Leverage Ratio

Many banks entered the crisis with excessive leverage.

This increased the probability of bank failures.

It also exacerbated the effects of the crisis on broader financial markets asmany banks rushed to de-leverage once the crisis hit.

The objective of the leverage ratio is to serve as a back-stop to therisk-based measure.


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The Committees calibration work shows that bank leverage was a highlystatistically significant discriminator between banks that ultimately failedor required government capital injections during the crisis and those thatdid not.

Moreover, at the height of the crisis, the market gravitated towards simpleleverage based measures to compare banks. [see Table 4]

The leverage ratio also serves a macroprudential purpose.

We have seen during this and prior crises the cyclical movement ofleverage at the system-wide level.

Leverage, which tends to build up prior to crisis periods, is subsequentlyunwound when a crisis occurs.

This cyclical aspect exacerbates both the upswing phase and thedownturn.


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In addition, what can appear to be very low risk assets at the institutionlevel can ultimately create incentives for the build-up of risks at thebroader system level.

The leverage ratio serves to limit excessive concentrations in such assetclasses.

[see Table 5]

As with the liquidity framework, the Committee has a process in place toassess the impact of the leverage ratio on business models.

It will take actions if necessary to make sure that the design of theleverage ratio will achieve its objectives.

As I stressed earlier, it is important that all countries and regions continueto work within this global process.


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IV. What still needs to be done to ensure longer-term bankingsector and economic stability?

Over the past three years, much has been achieved by the global

regulatory community to respond to the crisis.This policy work is now substantially complete.

But to ensure longer-term banking sector and economic stability,consistent and timely global implementation of Basel III is critical.

In addition, a key remaining area of policy development work is focusedon dealing with systemically important banks (SIBs).

Finally, we will also need to stay attuned to bank-like risks that emerge in

the shadow banking sector.

V. Implementation of Basel III

The Committee has put in place mechanisms to help ensure moreconsistent implementation of its standards.

This applies not only to Basel III but to other global standards agreed bythe Committee.

The efforts of the Committee are reinforced through additionalinstitutional arrangements introduced at the level of the FinancialStability Board (FSB) and the G20.

Going forward, the Committees Standards Implementation Group willplay a critical role in conducting thematic peer reviews of membercountries implementation of standards and sound practices.

Implementation involves not only introduction of the standards in legal

form, but also rigorous and robust review and validation by supervisors.


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We therefore are also introducing processes to ensure the integrity of keyelements of the framework.

An example of this is the review of banks risk weightings, which shouldinclude the use of test portfolio exercises.

As we have painfully learned from the recent crisis, the failure toimplement Basel III in a globally consistent way will again lead to acompetitive race to the bottom and increase the risk of another crisisdown the road.

VI. Addressing the Too-Big-To-Fail (TBTF) problem

During the crisis, the failure or impairment of certain banks sent shocksthrough the financial system.

This had an adverse knock-on effect on the real economy.

Supervisors and relevant authorities had limited options to prevent orcontain problems effecting individual firms and this led to wider financialinstability.

As a consequence, public sector intervention to restore financial stability

during the crisis was necessary, as was the massive scale of theseresponses.

The fallout from the crisis underscores the need to put in place additionalmeasures to reduce the likelihood and severity of problems emerging atsystemic banking institutions.

The Committee, in close cooperation with the FSB is working to addressthe financial system externalities created by Systemically ImportantBanks (SIBs).


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The Committees work on systemically important banks is part of thebroader effort of the Financial Stability Board (FSB) to address the risks

posed by SIFIs.

The Committee is working closely with the FSB through this process, andexpects to consult on proposals to address the risks of globally systemicbanks around the middle of the year.

VII. Shadow Banking

The final area where further work is needed is shadow banking.

Shadow banking was a key mechanism through which the crisis was

propagated.

SIVs, money market mutual funds, the securitisation process, and bankliquidity lines to off-balance-sheet exposures all served to amplify theimpact of the crisis on banks.

While it is clearly important to address issues in the shadow bankingsector, its existence should not detract from the fundamental need tostrengthen the resilience of the banking system itself.

The banking sector remains at the centre of the credit and liquidityintermediation process.

This is true even in economies that are more reliant on capital markets.

Moreover, significant parts of shadow banking were created, sponsoredor financed by the banking sector and these include SIVs, ABCPconduits, MMMFs, certain securitisation structures, and hedge funds.

Finally, much of the shadow banking sector depends on the financingand liquidity support of the banking sector.


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Basel III goes a long way to closing the gaps in exposure to shadowbanking. It does this in several ways:

1. By addressing the capital treatment for liquidity lines to SIVs and othertypes of off-balance sheet conduits;

2. By addressing counterparty credit risk;

3. By including off-balance sheet exposures in the Basel III leverage ratio;and

4. By incorporating a range of contractual and reputational risks arisingfrom the shadow banking sector into the liquidity regulatory and

supervisory standards.

Thus, stronger, consolidated banking regulation and supervision will go asignificant way towards containing the risks of the shadow bankingsector.

In addition, to the extent that bank-like risks emerge in the shadowbanking sector, they should also be addressed directly.

Supervisors should take a system-wide perspective on the credit

intermediation process.

To the extent that bank-like functions are carried out in the shadowbanking sector and pose broader systemic risks, they should be subject toappropriate regulation, supervision, and disclosure.

In particularly this is the case where activities combine creditintermediation, maturity or liquidity transformation, and leverage.


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Over the past few years, our toolkit has featured the standard monetarypolicy measures of setting interest rates, as well as a range ofnon-standard monetary policy measures.

The latter have included temporary measures such as full allotment ofliquidity, expanded eligibility for collateral, longer-term refinancingoperations and interventions in bond markets.

The ECB has also been involved in actions focused on the long term to tryto ensure that the financial sector cannot pose such a danger to the realeconomy again.

The financial turmoil that emerged from the US housing market andwhich sent shockwaves across the world economy revealed deep flaws in

the way the financial system in advanced economies operates and in theway that system is supervised and regulated.

Tackling those systemic flaws through financial reform is what I wouldlike to discuss today.

The ECBs involvement in financial reform takes place through our rolein the institutional framework of the European Union as well as theinstitutional framework of the global economythe G20, the BaselCommittee and other fora of international cooperation.

Last year several important decisions were taken on the pillars of the newsupervisory and regulatory framework.

First, the adoption of Basel III.

Second, reforms of market infrastructure.

And third the establishment of macro-prudential oversight institutions,including the European Systemic Risk Board (ESRB).


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through the work of the Committee presided over byJacques deLarosire.

The fact that it took little more than a year and a half from policy designto institutional establishment was made possible by thoroughgroundwork by the European Commission and very rapid decisions bythe European Parliament and the European Council.

I feel very honoured to chair this new body, the ESRB, together withMervyn King and Andrea Enria.

Let me discuss each of these three building blocks, focusing on bothprogress to date and the challenges that lie ahead.

1. Banking regulation and Basel III

First, banking regulation, where the Basel III frameworkrepresents thecornerstone of the newly revised international regulatory architecture.

This framework envisages higher minimum capital requirements, betterrisk capture, stricter definition of eligible capital elements and moretransparency.

It introduces entirely new concepts, such as non-risk-based leverageratios and mandatory liquidity requirements.

Beyond the micro-prudential dimension of regulationtypicallyrepresented by institution-specific solvency requirementsBasel III alsointroduces macro-prudential elements, most prominently the capitalbuffer regime based on aggregate credit growth.

From both a macroeconomic and financial stability perspective, theimplementation of Basel III should bring substantial long-term benefits.

As painfully experienced in recent years, financial crises imposeenormous costs on society.


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The main benefit of the reform will stem from the reduced frequency offuture crises.

The new standards aim at improving banks capital base and the sectorsresilience to a crisis.

Financially sounder banks will, in turn, help foster financial stability aswell as mitigating systemic risk.

The prevention and mitigation of downside tail risks for the economyimplies a sizeable reduction in the expected output losses associated withsystemic events, contributing to more sustainable growth.

Although the net benefits from Basel III are difficult to quantify precisely,

the Committees analysis indicates that the potentially negative impact ofthe new framework on long-term output is considerably lower than thegrowth benefits associated with the reduced frequency of crises.

Additional benefits include lower funding costs for banks and a decline inrisk premia.

At the same time, it is acknowledged that implementation of the newframework will impose some transitional costs on the sector as banksneed to meet the more stringent regulatory requirements.

Banks can adjust their capital ratios through a combination of severalmeasures, for example, by raising capital or reducing dividends for sometime.

The length of the implementation period matters crucially for thetransition costs.

The Basel Committee has designed relatively long phase-in arrangementsto mitigate adjustment costs.


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If the new framework had been implemented hastily, banks would haveneeded to reorganise their balance sheet structure quickly, which couldhave had adverse impacts on credit intermediation in the short term.

Implementation over the time frame 2013-2019 has been agreed to providethe sector sufficient time to adjust to the new requirements.

The gradual implementation should prevent disruptions in credit flowsand bring enough clarity and scope for banks to absorb the necessaryadjustments smoothly over time.

Looking forward, the introduction of the new standards presents theinternational regulatory and supervisory community with two majorchallenges.

The first is to ensure proper implementation of Basel III at the globallevel.

In line with the G-20 recommendations, all national authorities shouldhonour their commitment to implement the framework without anyundue postponement.

The second challenge relates to thorough assessment of the newregulatory concepts and measures.

Some of the new concepts, such as liquidity standards and leverage ratios,have sparked controversy and delayed final agreement.

To alleviate concerns about potential unintended consequences, anobservation period has been agreed to serve as a basis for the final designand calibration.

Work in progress on systemically important financial institutions, crisisresolution and shadow banking


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Let me turn to some issues of banking regulation on which it is importantthat work continues.

The first is systemically important financial institutions, which the G20and the Group of Governors and Heads of Supervision have stated shouldsatisfy additional solvency requirements beyond the levels agreed in BaselIII.

The main goal here is to reduce the externalities related to the financialdistress of such institutions, and ultimately avoid a repetition of the crisis.

The Financial Stability Board (FSB) has been working on identifyingsystemically important financial institutions and evaluating the desirablemagnitude of additional capital with which they should comply.

Its recommendations will be delivered to the G20 summit in November.

The FSBs work is a fundamental step towards an internationalframework that fully reflects the greater risks posed by these largeinstitutions.

Looking forward, it is crucial that effective peer reviews of finalimplementation are set up, ensuring consistency across jurisdictions.

Enforcing a level global playing field remains a priority for the regulatoryagenda, to prevent regulatory arbitrage to parts of the financial sector

with less supervision and weaker regulation.

In parallel with higher solvency requirements for systemically importantfinancial institutions, important initiatives are underwayboth in Europeand globallyto improve the capacity of authorities to resolve financialinstitutions, especially in a cross-border context.


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An effective resolution regime should consist of a comprehensive toolkitof gradually increasing powers, complemented by credible financingarrangements that reduce the reliance on government budgets.

It is essential to make significant progress in the coming years to ensurethat all systemically important financial institutions can be resolved in anorderly manner and without taxpayers support.

The FSB is identifying the key elements of effective resolution regimes.

At the same time, the reform of national (or in the case of the EU,supra-national) resolution frameworks is already underway in the majorjurisdictions, including the Dodd Frank Act in the United States.

Here, the European Commission has published a public consultationdocument on the planned EU framework, for which legislative proposalsare expected in June.

Let me briefly mention shadow banking.

The introduction of more stringent capital requirements for creditinstitutions may provide further incentives for banks to shift part of theiractivities outside the regulatory perimeter.

Against this background, the FSB is developing recommendations tostrengthen oversight of the shadow banking system in collaboration withother international standard setting bodies.

Work on the shadow banking system should aim to develop a betterunderstanding of the interconnections between regulated banks andunregulated entities that are conducting credit intermediation, eitherdirectly or as part of a complex chain of intermediation activity, as well asthe channels for possible contagion.


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In this context, it is crucial to understand the functioning of the repomarket. It is also vital to identify entities or activities within the shadowbanking system that may be sources of systemic risk.

2. Market regulation

Let me turn to the second building block, namely regulation of financialmarkets.

One of the key lessons from the crisis is that the risks to market returnsdid not come mainly from shocks to the real economy.

The risks came from the financial sector itself.

The financial structures that we thought were in place to assess, absorband neutralise risk were either dysfunctional or worked to magnify

volatility.

Key factors in creating this risk were opaque financial structures andpro-cyclicality in financial markets.

The lack of transparency in many financial instruments meant that somemarket players could exploitfor their own, private benefitinformationthat was not generally available.

Pro-cyclicality acts as a formidable accelerator of financial trends.

Two important factors that drive such amplification are distortedincentives and herd behaviour.

The role of distortions in economic incentives is widely understood, butherd behaviour as a driver of pro-cyclical patterns in financial markets stillneeds a thorough explanation.


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One explanation lies in the significance of market players evaluation oftheir performance relative to the rest of the market.

This is reminiscent ofKeynes famous beauty contest analogy.

To be successful in this environment, individual participants do not formtheir own opinions, but follow the general mood.

Everybody seeks to ride the wave, hoping to step off before the moodturns.

A second complementary explanation is that global markets are in factless atomistic than we think. Derivatives activity in the US bankingsystem, for example, is dominated by a small group of large institutions.

And, of course, the market for credit ratings is famously dominated bythree signatures, which act as standard-setters for an enormous volume oftransactions.

Many regulatory initiatives are underway to remedy these issues,including work on OTC derivatives, which comprise 80% of tradedderivatives.

The near-collapse of Bear Stearns in March 2008, the default of Lehman

Brothers in September 2008 and the bail-out of AIG the same monthhighlighted shortcomings in the functioning of the OTC derivativesmarket, and underlined the need for appropriate action to increasetransparency and address concerns about financial stability.

To this end, there is now a regulation underway in Europe aimed atbringing more safety and more transparency to the derivatives market.

According to the draft regulation, information on OTC derivativecontracts should be reported to trade repositories and be accessible to

supervisory authorities.


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Furthermore, standard OTC derivative contracts should be clearedthrough central counterparties, thus reducing the risk that one party tothe contract defaults.

Any possible concentration risk involved in the set-up of the CCPs couldbe assessed at the macro-prudential level.

Of course, financial market infrastructures can only help to foster thestability of markets to the extent that they are safe and sound.

To this end, the Committee on Payment and Settlement Systems and theTechnical Committee of the International Organization of SecuritiesCommission are reviewing the relevant regulatory and oversightstandards.

A consultative report published in March 2011 outlines principles that willprovide greater consistency in the oversight of financial marketinfrastructures worldwide.

3. Macro-prudential supervision and the ESRB

Let me come to the final building block: macro-prudential oversight.

As my earlier remarks suggested, the financial crisis has been revealing in

many respects.

It has revealed the fallout from the failure of large financial institutions.

It has revealed the fragility of the financial system to features and trendsthat cut across institutions, markets and infrastructures.

And it has illustrated the amplitude of the consequences of the adversefeedback loop between the financial system and the real economy.


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All these three elements are key features of systemic risk: first, contagion;second, the build-up of financial imbalances and unsustainable trends

within and across the financial system; and third, the close links with thereal economy and the potential for strong feedback effects.

The strengthening of macro-prudential oversightwith theestablishment of institutions devoted to that task such as the ESRB, theUS Financial Stability Oversight Council and the UKs Financial PolicyCommitteeshould enhance our ability to identify and address systemicrisk.

How can these new bodies reach their full potential?

The first precondition is that they have an adequate infrastructure to

identify and analyse systemic risks.

This demands a state-of-the-art analytical toolkit, which can provide asolid basis for systemic risk analysis and the ensuing formulation of

policy responses.

In the field of systemic risk assessment, great attention is currentlydevoted to macro stress testing as a tool to evaluate the impact of shockson the financial sector and the real economy.

This complements micro stress tests relating to individual financialinstitutions.

A key challenge is modelling feedback effects between the financialsystem and the real economy.

Another promising area relates to network analysis, which aims toidentify systemic inter-linkages across firms, sectors and countries.

This type of analysis, which is well established in other domains, is still at

its infancy for the financial sector.


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A key point in this context is that the effectiveness of the analytical toolkitis strongly dependent on the availability and quality of data.

There are several data gaps, which make it difficult to assess the sourcesand magnitude of systemic risks and the very complex network ofinter-linkages in the financial system.

The second precondition for the success of the new bodies is a coherentframework for macro-prudential oversight and policy development.

In this context, it is important to note that the institutions do not havedirect control over policy tools.

In the case of the ESRB it may issue risk warnings and recommendations

to other authorities, which should comply with them or give reasons fornon-compliance.

Since existing policy tools that can be used for macro-prudential purposesfall in other policy domains (e.g. micro-financial supervision, monetary

policy or fiscal policy), it is essential that effective coordinationmechanisms should be developed between the responsible authorities.

In particular, close cooperation between macro- and micro-supervisoryauthorities is essential as most of the macro-prudential tools are

micro-prudential in nature.

It is therefore of utmost importance that the mandate of macro-prudentialauthorities as well as the role of supervisory authorities inmacro-prudential surveillance are clearly defined.

Conclusion

Let me conclude. I believe we are now about halfway through thecomprehensive financial reforms that the crisis has demanded.


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We have achieved a blueprint of more stringent bank regulations thatincludes more loss-absorbing capital, better risk coverage and limitationsfor undue leverage. The oversight of financial institutions as well asmarkets and market infrastructure are being strengthened.

And the organisational structure of financial supervision is beingoverhauled.

But much remains to be done.

The key aspect is implementation of the reforms.

Moreover, the issue of systemically important financial institutionsrequires further reflection.

And oversight of the proper functioning of financial markets in a way thatavoids undue volatility, excessive influence of dominant players andoligopolistic market structures, while reinforcing transparency, needs tobe addressed resolutely.

Thanks, in particular, to prompt and resolute action by central banks andby governments, the international community avoided a great depression,after the intensification of the crisis in mid-September 2008.

With the global recovery being confirmed, numerous voices in thefinancial sector are arguing that we are now back to business as usual.

Achieving an ambitious programme of reforms of rules, regulations andoversight of the financial sector is considered by some as unnecessary andcounterproductive.

I do not at all share those views. It is an absolute obligation, for all of us,to do all what is necessary to reinforce the resilience of the financialsystem and ensure its sustainable contribution to growth.


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We must be sure that the excessive fragility that was revealed in 2008 and2009 is eliminated.

Not only because the costs of financial crises in terms of growth is alwaysconsiderable but, even more, because it is extremely likely that ourdemocracies would not be ready to provide once again the financialcommitments to avoid a great depression in case of a new crisis of thesame nature.

Our people would not permit, for a second time, that governmentsmobilize 27% of GDP of tax payer risk, on both sides of the Atlantic, toavoid the collapse of the financial sector.

For these reasonspublic authorities must pursue and implement their

G20 programme with inflexible determination, and it is essential that theprivate sector fully implements this programme.


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Solvency II News

Dear Members,The new EIOPA (the European Insurance and Occupational PensionsAuthority) has a better sense of humor. Below is one interesting slidefrom the official thoughts on the impact of Solvency II:

The same time, companies try hard to find fit and proper risk

managers, compliance officers and auditors. Fortunately, most actuariesarequalified.

Risk managers experience a massive increase in their take-home pay as aresult of the Solvency II projects.

Below is an interesting job description.Risk Manager is needed, that will:

1. Provide specialist support to the Risk Team in the delivery of agreed

Solvency II development and implementation plans,


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2. Embed new or enhanced risk processes and be accountable forassigned project plan deliverables relating to Solvency II processes.

3. Design and execute the risk oversight framework for the Internal Modeland supporting processes, including the drafting of oversight reports.

Interesting

Firms continue to lobby, to influence the final implementation of thedirective.

Below there is an interesting example:Lloyd's lobbying

Overview of Lloyd's Solvency II lobbying activitiesWe want Solvency II to recognise Lloyd's unique structure andoperations.

We dont want Solvency II to put the market at a competitivedisadvantage.

For this reason, Lloyds has been and is highly engaged in activity toinfluence the development of Solvency II legislation in Europe, alongside

organisations such as the CEA in Brussels and the ABI and the IUA inLondon.

It is important for Lloyd's to retain an independent voice in the debate onSolvency II as well as influencing the input of bodies such as the CEA.

Although its positions are closely aligned with those of other insurers,there can be subtle, yet important, differences in emphasis and

prioritisation.

Lloyds focus is on the regimes impact on non-life insurers whereas

some other major insurers in the UK and Europe are more concerned


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about proposals for the treatment of annuities and other issues primarilyof interest to life insurers.

Lloyds also aims to ensure that policymakers in the UK are aware of itsviews.

Lloyds is represented at high-level meetings with the FSA and atministerial level to address key industry concerns regarding Solvency II.

On 5 January 2011, Sean McGovern, Lloyd's Director, sent a letter toManaging Agents' CEOs and FDs with a view to providing an update onthe Lloyd's lobbying approach for the development of Solvency II.

Lloyd's aims

To ensure that:

The Markets unique structure including regulatory recognition as aunitary organisation is preserved.

The standard formula does not impose excessive capital requirementson undertakings.

Internal model tests, standards and approval processes are reasonable

and proportionate.

The types of asset commonly held in the market are appropriatelyrecognised.

Additional administrative burdens on insurers are minimised.

The competitiveness of the European industry is enhanced, notdiminished.

Also interesting


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risk and compliance management news may 2011

Documents